Hi all!
A week that was heavy on macro news and roiled markets was obviously going to see a lot of insight into bitcoin’s role in a changing economy. There's some of that below, as well as some fascinating sector overviews, market developments and new approaches to fundamental analysis.
In THE BRIEFING, I look into the confusion about LedgerX’s non-launch of physically settled bitcoin derivatives, and what that says about the potential future of crypto markets (it’s probably not what you think).
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And if you’re enjoying a relaxing summer holiday, well, you’ll have a lot to catch up on when you get back. ;)
Read on…
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Bitcoin derivatives: regulation and unintended consequences
Last week’s kerfuffle over the launch-that-wasn’t of LedgerX’s physically delivered futures platform highlights two very important lessons, one obvious and one less so.
The obvious conclusion is that one needs to tread very carefully when it comes to claiming regulatory approval. LedgerX announced the launch of its retail physically delivered bitcoin futures platform, only to find that the CFTC had not yet approved a necessary amendment to its clearing license. Tensions flared and the launch was walked back.
The confusion over the licensing process is a hindrance, but an understandable one given the complexity of the new products (physically settled bitcoin futures have many more moving parts than traditional futures, even beyond the custody issue). And the “ask for forgiveness rather than permission” approach to financial innovation is probably going to end up expensive.
Below I want to focus on the less obvious takeaway: the role of regulations in determining eventual market structure, and the danger of unintended consequences.
Apples and oranges and fruit
Obviously, established rules can encourage or discourage the take-up of new financial products. The LedgerX confusion, though, highlights a different type of barrier, also heavily influenced by regulation, but one based on relative risk rather than investor protection.
I’m talking about the difference between swaps and futures. In conversation with CoinDesk, Paul Chou pointed out that “the difference between futures and swaps is ridiculous, it’s the same product.” This is not true. While their hedging and speculative properties may be identical and their economic outcomes similar, in the eyes of regulators they are very different.
Before digging into why, let’s pull apart the semantics. A “future” is an agreement to pay a certain price for something at a fixed point in the future. A “swap”, on the other hand, is the commitment to exchange cash flows. In bitcoin, this could mean something as simple as “I’ll send you fixed payments in exchange for variable payments based on the bitcoin price.” Structured a certain way, the net effect could be the same as a futures contract.
But the markets are not the same. Futures are standardized products that trade on exchanges. Swaps, on the other hand, evolved as bilateral contracts negotiated between two parties. They traded over-the-counter in opaque markets until the 2008 crisis revealed the size of the outstanding risk and the convoluted web of obligations that had not taken counterparty default into consideration.
The Dodd-Frank bill, enacted in 2010, mandated that most swaps move towards a standardized model and be traded on and cleared by centralized intermediaries. The aim was to add transparency and reduce risk, while enhancing liquidity. The result was a bifurcated derivatives system that skews development momentum in the direction of futures.
Why? Because of cost.
Ebb and flow
Centrally cleared financial swaps require a much higher margin than futures. In part, this is most likely due to the perceived relative illiquidity in swaps.
It could also be to compensate the additional risk to clearing houses. With futures, a trader will ask her futures commission merchant (FCM) to place a trade on a designated contract market (DCM), where it is executed and passed along to the clearing house. If a trader’s position goes spectacularly wrong, the risk to the clearing house is partially buffered by her funds held at the FCM and the margin deposited at the DCM.
With swaps, FCMs can be used, but they are optional and a relatively new feature. Often, a trader will enter into a contract directly on a swap execution facility (SEF), which will then pass it on to a clearing house. All else being equal, fewer buffers means greater risk which justifies a higher required margin.
In markets, however, all else is rarely equal, and some swap contracts are more liquid than some futures contracts, so there is considerable pressure to amend this rule as it is seen to unjustly favor futures over swaps.
Furthermore, swaps are almost exclusively an institutional product, whereas futures are also traded by retail investors. Most other financial regulations operate on the assumption that institutions understand and accept extra risk – asking them to pay more than they deem fair will nudge their business into other product types.
True, as always with financial regulation, there is a matrix of other causes and consequences to consider, and loopholes and exceptions keep lawyers busy.
But the point is that regulatory decisions in financial markets often have unintended consequences which affect capital formation. The higher cost of swaps compared to futures has led to the “futurization of swaps,” in which a swap is wrapped in a future and traded as such, with lower margin requirements. This favors DCMs over SEFs, since the latter cannot trade futures and therefore cannot enter into this type of regulatory arbitrage. Many complain that this does not mitigate risk, it just redistributes it, to the detriment of sector diversification.
Didn’t see it coming
Note that I am talking about non-crypto derivatives here. Bitcoin swaps and futures tend to have a much higher margin requirement than their traditional counterparts (maintenance margin for cash-settled bitcoin futures on the CME is 40% vs under 3% for gold futures). Rather than an attempt to dissuade investors from trading crypto products, this extra caution is deemed necessary given the assets’ heightened relative volatility. Fair enough.
As the contention mentioned above shows, we need to keep an eye on regulatory decisions within an asset class; what’s more, not just on what the regulator is doing today, but on what the unintended consequences could be.
In the LedgerX case, we can glimpse the potential evolution of a sector structure that is probably not what either the regulators or service providers hoped for.
In taking extra care with LedgerX’s clearing license, the CFTC is shining a light on the role clearing houses will have in the crypto ecosystem. This additional scrutiny, and the hoops and hurdles that are being imposed, could lead to crypto asset clearing house concentration further down the line, as scrutiny and hurdles create barriers to entry and add to operating costs. More clearing house concentration will increase risk rather than decrease it, by centralizing the potential for something to go very wrong. In this case, the unintended consequences could be the opposite of the original goal.
An important factor is that LedgerX plans to sell bitcoin derivatives to institutional and retail investors. That generally makes the regulators sit up even straighter in their chairs, as protecting retail investors is a political imperative. So, we can expect even more care to be taken with settlement operations.
Another consequence of the delay is to give other potential competitors a chance to catch up: ErisX and Bakkt, both with bigger backers, are also gearing up to offer physically delivered bitcoin futures. I’m not saying this is the intention, it’s more likely to be another “unintended consequence,” but a greater choice for investors lowers risk overall.
The end game
In a fit of frustration, the CEO of LedgerX, Paul Chou, threatened to sue the CFTC over their handling of the approval. While it is generally not a good idea to be anywhere near Twitter when angry, attempting to sue the CFTC has precedent. In 2013, Bloomberg did just that over the “unfair” additional margin requirements for financial swaps vs futures that I mentioned earlier, which it saw as detrimental to the profit of its SEF. A court later threw out the suit.
I’m neither a lawyer nor a regulator, but it’s likely that the result would be the same should LedgerX press ahead with its stated intention. It would have a hard time arguing – as Bloomberg did – that the CFTC is favoring one product over another, thus putting its business model in jeopardy. The firm already trades swaps for institutional investors. The delay is affecting its intention to broaden its offering to include futures and options, and its target market to include retail investors.
It cannot even argue that the CFTC is anti-crypto. Outgoing Chairman Christopher Giancarlo has long been a thoughtful and informed advocate of innovation and blockchain technology’s potential.
It’s likely that tempers will calm and the fuss will blow over. The eventual launch of physically delivered bitcoin futures, whoever is first to market, will add a layer of maturity to a rapidly evolving sector by offering an alternative hedging mechanism in a format the market has been waiting for. That, plus the lessons learned along the way, will push the sector forward.
Meanwhile, we should all keep an eye on regulators’ actions – not on the obvious reasons, but on potential consequences and hidden messages. What they mask is often revealing.
– Noelle Acheson
(Disclosure: I hold a modest amount of bitcoin with no short positions.)
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*six items you should skim if gazing at the charts on your screen is taking up too much of your time
BIG IDEAS
*Quarterly Macro Outlook (Delphi Digital) – A sweeping, data-rich and thought-provoking overview of the global economy, crypto development, market sentiment and growth in Asia, with some interesting contributed pieces.
Crypto’s Watershed Moment (Josh Ben-David) – Why cryptocurrencies such as bitcoin make a better global macroeconomic hedge than gold, and why we might need one.
Why Bitcoin Is Rising As Stocks and the Yuan Fall (Barron’s, paywall) – Something about a hedge against monetary policy.
Ex-Trump Advisor Steve Bannon: ‘Global Populist Revolt’ Helps Crypto (CoinDesk) – What’s more, he recognizes that cryptocurrencies could present a meaningful alternative to fiat.
Bitcoin A Safe Haven Asset? (Altcoin Magazine) – Correlation does not imply causation.
*The different uses for bitcoin (Linda Xie) – Bitcoin has many simultaneous narratives, since there is no single target user.
Coinbase CEO Armstrong Says Crypto Is Path to Financial Inclusion (CoinDesk) – Speaking about the company’s roadmap at an open house, Brian Armstrong stressed crypto’s role in global economic freedom.
US Senator: ‘I Don’t Think You’ve Persuaded Anyone’ Crypto Creates Financial Inclusion (CoinDesk) – Senator Brian Schatz (D-Hawaii) was not convinced.
The Slow but Steady Institutionalization of Bitcoin (SFOX) – A review of the crypto sector’s “institutionalization” timeline, and a look at what’s next.
When will the trillion dollar club take the crypto plunge? (Caspian) – What’s holding institutions back from investing in crypto assets?
Bitcoin Won’t Be a Global Reserve Currency. But It’s Opening the Box (CoinDesk) – The article from last week’s newsletter, about what Bretton Woods can teach us about bitcoin’s potential role.
Webinar: Crypto Assets are a Data Science Heaven (intotheblock, video) – Every asset class in history has introduced a new set of metrics, crypto is no different; although it is, because in this case, the technology itself provides them.
Webinar: 2Q19 (Digital Asset Research, video) – A recording of market research boutique Digital Asset Research’s Q2 presentation on crypto markets, breaking down returns, macro correlations and asset and infrastructure developments.
An impressive thread in which Crypto Voices (@crypto_voices) offers interesting detail on the relative size of the bitcoin market cap to that of other currencies: bitcoin is currently the 11th largest money in the world.
Investing in Blockchain: A Breadth of Unparalleled Opportunity, Part 2 (Hutt Capital) – A look at some other crypto assets that represent compelling use cases for blockchain technology.
MARKETS
China seems to be softening its hardline stance against bitcoin, says crypto services CEO (CNBC) – Jeremy Allaire, CEO of crypto asset platform Circle, said in an interview that he was seeing “a lot of Chinese national participation” in the bitcoin market.
Cryptocurrency in China: Over the Counter, Under the Table (CoinDesk) – Asia-based investor Dovey Wan clarifies the legal status of bitcoin and other crypto assets in China, and how much this actually affects Chinese participation.
Bitcoin Reacted EXACTLY As It Was Supposed To (Arca) – Some potential reasons for the recent rally, which (surprise) include a deteriorating macro backdrop.
What Happened: Why the First Physical Bitcoin Futures Haven’t Launched (CoinDesk) – LedgerX’s announcement last week that they could now offer physically settled bitcoin futures turned out to be premature. (See also THE BRIEFING.)
ICE CEO: Bakkt Will Launch Bitcoin Futures In ‘Very Near Future’ (CoinDesk) – Just waiting for “final regulatory approvals.”
MIT’s AI Lab Analyzed 200,000 Bitcoin Transactions. Only 2% Were ‘Illicit’ (CoinDesk) – The analysis of a study from crypto data analytics firm Elliptic shows progress in applying machine learning to crypto transactions to reduce “false positives”.
Grayscale’s $2.7 Billion in Crypto Assets Will Now Be Held by Coinbase Custody (CoinDesk) – This will more than double Coinbase’s last reported amount of assets under custody.
Crypto Exchange Launches ‘Shitcoin Futures Index,’ Offering New Way to Short Alts (CoinDesk) – Derivatives platform FTX has created three SHIT-PERP index, which consists of 58 low market cap tokens.
CRUNCHING NUMBERS
*How do Cryptocurrency Price Rallies Look on the Blockchain? (Jesus Rodriguez) – The anatomy of a price rally using elements of behavioral psychology, address data and transaction size.
Data Signals vs. Noise: Misleading Metrics and Misconceptions About Crypto-Asset Analytics (Jesus Rodriguez) – Crypto markets are relatively new and complex; experimentation on analytics methods and tools is necessary, but should be accompanied by common sense.
Token Daily Capital Newsletter #7 (Token Daily) – A look at the charts of bitcoin’s price movement at the previous halvings (when the miners’ reward is cut by 50%, expected mid-2020) shows that the market’s expectations of a price pump may be over-inflated.
REGULATORS AT WORK
SEC Commissioner Hester Peirce Calls for Support of Crypto Innovation (Cadwalader) – Speaking in Singapore, she said that she would like to see more "momentum" from the SEC toward greater clarity around digital assets.
ICYMI: Circle CEO Urges Senators to Create a National Framework for Digital Assets (Circle) – Listening to the crypto platform’s founder and CEO Jeremy Allaire rail against the lack of regulatory clarity for crypto assets in the U.S., it’s worth remembering that the firm recently announced its intention to move its crypto exchange to Bermuda.
UK Finance Watchdog Issues Guidance on Regulation for Bitcoin and Crypto Assets (CoinDesk) – The FCA’s new rules do not drastically alter the regulatory landscape, focusing more on classifying crypto assets and providing a definition of security tokens.
Global Regulators Warn on Privacy Risks of Facebook’s Libra (CoinDesk) – Data privacy commissioners from several countries published a joint statement expressing concerns over the lack of detail on Libra’s information handling practices, and set out a list of questions for Facebook to address.
SECURITY TOKENS
The tokenization of securities is happening right now and no one is noticing (Venture Beat) – With approval from the SEC, two security token issuers are finally gearing up for Reg A+ offerings; a sign of things to come?
Overstock to Pay Shareholders a Dividend in tZERO-Listed ‘Digital Securities’ (CoinDesk) – Online retailer Overstock.com announced it will pay shareholder dividends in digital preferred stock listed on its affiliate company tZero’s trading platform.
Seychelles Beats Zurich With First Blockchain-Based Equity Token (Bloomberg, paywall) – MERJ Exchange Ltd., operator of the Seychelles stock exchange, is about to list tokenized securities in its own stock, according to its CEO.
STABLECOINS
Payments is replacing trading as stablecoins’ major use case, and companies like Coinbase want to ride the trend (The Block) – The payments use case for stablecoins is still largely confined to cryptocurrency holders, but companies are seeking ways to engage regular consumers.
Walmart Wants to Patent a Stablecoin That Looks a Lot Like Facebook Libra (CoinDesk) – The filing suggests that the proposed coin could help provide finance for those with limited access to banking services.
PODCASTS
STEPHAN LIVERA PODCAST: Stephan talked to macro investor Raoul Pal on how to value an asset that doesn’t have a traditional category, how some of the early hedge fund managers in the space got involved, how bitcoin might behave in a recession, and how the stock flow model drives the bitcoin price.
*VENTURE COINIST: Luke Martin chatted to Chris Burniske about how bitcoin has traditionally led the crypto market out of a slump, and the deeper impact of the bitcoin price: it’s part of the marketing, and run-ups have brought a ton of capital and labor into the space.
OFF THE CHAIN: In one of his most entertaining episodes ever, Anthony Pompliano chatted to Anthony Scaramucci of SkyBridge Capital (and ex-Director of Communications of the White House) about the financial history of the US, and bitcoin’s role in the global economy.
INSIDE THE ICE HOUSE: Recorded at ICE’s recent event for institutional crypto investors, Bakkt’s CEO Kelly Loeffler gave a brief update and spoke about the birth of a new asset class, after which SEC Commissioner Hester Peirce talked about the regulator’s role in innovation, the possibility of a safe harbor for security tokens and the importance of talking to the SEC.
AXIOS PRO RATA: Dan Primack interviewed Ben Mezrich about his book and research on the Winklevoss twins’ big bet on bitcoin.
A-HA!
US Treasury officially labels China a currency manipulator (Financial Times, paywall) – This is a big deal.
*The Invention of Money (The New Yorker) – An enjoyable romp through financial innovations, focusing on the stories of John Law and Walter Bagehot, and on how little we seemed to have learned.
*Stigmatized money (JP Koning) – How culture can hold back the success of payment systems (including bitcoin).
A thread that begins with “May not feel like it, but this week may be one of the most important in the lifetime of most investors,” and ends with “Whatever you're going to do, do it” is generally worth a read – this one by John Hussman (@hussmanjp).
Rich countries must start planning for a cashless future (The Economist, paywall) – What could be done to minimize the social costs?
Sports Cars, Psychopaths, and Testosterone: Inside the New Frontier of Fund Manager Research (Institutional Investor) – What personal branding says about fund manager performance, and the privacy issues this could raise.
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FUNDING
Bahrain-based cryptocurrency exchange Rain has closed a $2.5 million funding round co-led by BitMEX Ventures.
FIRMS
Cryptocurrency exchange Kraken has acquired Interchange, an institutional-grade accounting, reconciliation and reporting service provider for hedge funds and asset managers with crypto holdings.
Kraken also announced a new service that will allow users to transact in U.S. dollars, euros, Canadian dollars, British pounds, and Japanese yen from anywhere in the world, via Etana Custody.
PEOPLE
Tim Wagner, vice president of engineering at crypto exchange Coinbase, is leaving the firm.
Dan Matuszewski, head of trading at cryptocurrency firm Circle, and Beatrice O’Carroll, head of institutional sales, have left the firm.
Daniel Gorfine, the director and chief innovation officer of the CFTC’s experimental fintech initiative LabCFTC, is stepping down to join the private sector.
The CEO of SharesPost Digital Assets, John Wu, has left the private equity marketplace subsidiary, apparently to focus on a new venture.
It’s not all about departures: Facebook has hired Susan Zook, a former aide to the chairman of the U.S. Senate Banking Committee, to lobby for its new Libra cryptocurrency project.
Have a tip? Drop me a line at noelle@coindesk.com. |
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| So many crypto introductions start with “what?”. That’s an important question, essential to fully understanding the asset class – but in our first report aimed at institutional investors , we decided to look at “why?”. Our aim is to provide a glimpse of why this asset class is compelling and worth a further look.
In "Crypto in Context", we talk about the value proposition, who is buying bitcoin, and correlations with more traditional assets. We don’t tell you how a blockchain works, what a hash function does or the secret of Schnorr signatures. We look at the opportunities of and the barriers to crypto investing. We don’t try to convince you that bitcoin is what your portfolio needs – that’s up to you.
If you’d like to find out more, the report is free and you can download it here.
And watch this space – there’s more coming!
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(I know, not the usual tone, but it's August...) |
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CoinDesk is not an investment advisor. This newsletter is for informational purposes only, and any comments here do not constitute investment advice. |
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Institutional Crypto - Bitcoin derivatives: regulation and unintended consequences