ICE Creating New Cryptocurrency Market: A Double-Edged Sword

Intercontinental Exchange (NYSE: ICE), parent of the New York Stock Exchange, today announced it is building Bakkt, a new ecosystem for cryptocurrencies, along with several partners. This is a major step in the mainstreaming of bitcoin and cryptocurrencies. But it’s also a double-edged sword, because it’s likely the beginning of Wall Street creating financial claims to bitcoin out of thin air (and not backed by actual bitcoins), which could offset some of Bitcoin’s algorithmically-enforced scarcity. Perhaps that’s why bitcoin’s price declined slightly after today’s announcement by ICE.

Positives

Bakkt is yet more evidence that incumbent institutions are increasingly taking the “join ‘em” approach to cryptocurrencies, as explored in Part 1 of my 3-part series about the building rivalry between cryptocurrencies and Wall Street. Bakkt could bring many positives to cryptocurrencies:

• it will likely attract more institutional investors to cryptocurrencies,
• it may solve the custody problem that has so far kept large institutions from investing in the cryptocurrency asset class due to the absence of a qualified custodian, which the SEC requires for investment advisors that manage $150 million or more,
• it may help regulators become more comfortable with the sector to see ICE involved, and
• most importantly—it will probably attract corporate issuers to raise capital using the Bakkt ecosystem. Cryptocurrencies offer issuers the prospect of covenant-free and preference-free capital at low cost. Investors have proven their willingness—rational, in my view—to trade standard investor protections in return for the low friction costs involved with cryptocurrencies—there are no underwriters, trustees, transfer agents, exchanges, custodians, clearinghouses or central securities depositories involved in cryptocurrency issuance, and—very importantly—cryptocurrency trades settle instantly and with no counterparty risk. Moreover, issuers incur only a small percentage of the costs of being a public company, such as investor relations costs, proxy solicitation costs and the significant compliance costs related to public-company financial reporting and auditing. Additionally, cryptocurrency issuers can repurchase coins or execute a tender/exchange offer much more efficiently than for traditional securities.

I doubt it will be very long before major corporate issuers join Telegram and Eastman Kodak in raising capital via these markets. This is the good type of financialization—attracting new investors to the networks, each of whom (in proof-of-work blockchains) makes the networks more secure by bringing new computer resources to the networks, directly or indirectly on their behalf—and that, in turn, makes the networks more decentralized, resilient and immune to attack.

Kudos to ICE for being first!

Negatives

But ICE’s news also has downsides. As explored in Part 2 of the 3-part series just two days ago, Wall Street’s only shot at controlling cryptocurrencies is to financialize them via leverage—by creating more financial claims to the coins than there are underlying coins and thereby influencing the underlying coin prices via derivatives markets. It’s pretty much impossible at this point for anyone to gain control of the Bitcoin network (and likely the other big cryptocurrency networks too), so Wall Street’s only major avenue for controlling them is to financialize them via leverage.

The financial system has perfected the art of leverage-based financialization, unfortunately, and ICE’s announcement about plans to launch a regulated, physical bitcoin futures contract and warehouse (subject to CFTC approval) in November means leverage-based financialization is likely coming to bitcoin in a big way.

This is exactly what I’d warned of in Part 2:

“As cryptocurrency markets develop further, here’s what I’ll be on the lookout for: financial institutions beginning to create claims against cryptocurrencies that are not fully backed by the underlying coins (which could take the form of margin loans, coin lending / rehypothecation, coin-settled futures contracts, or ETFs that don’t 100% track the underlying coins at any given moment). None of these are happening in the market yet, though.

“So far, regulators have only allowed bitcoin derivatives in cash-settled form among major derivatives counterparties. While cash-settled derivatives can affect the price of the underlying asset, the magnitude of the impact is lower than the impact if derivatives were settled in an underlying that is “hard to borrow” or “special” (using securities lending parlance). Bitcoin is especially “hard to borrow” so a requirement to deliver the underlying bitcoins into derivatives contracts would amplify bitcoin’s price fluctuations.

“Eventually it’s likely regulators will approve bitcoin-settled derivatives among major derivatives counterparties. At that point, banks will be looking to borrow the underlying bitcoin—and that’s when the custodial arrangements made by institutional investors will start to matter. Will custodians make their custodied coins available for borrowing in “coin lending markets” as they do with securities lending today? Or will they deem the cybersecurity risks of lending coins (which entails revealing private keys) too high relative to the extra return available for coin lending? And will institutional investors even allow coin lending by their custodians? Regardless, when bitcoin-settled derivatives appear on the scene, it’s very likely that cryptocurrencies will be “hard to borrow” for quite some time because HODLers (long-term holders) own most coins and rarely use custodians.” (emphasis added)

Why does this matter? Bitcoin has algorithmically-enforced scarcity, and that’s a big part of what gives it value. If Wall Street begins to create claims to bitcoin out of thin air, unbacked by actual bitcoin, then Wall Street will succeed in offsetting that scarcity to some degree.

The same pattern happened in commodities markets, such as gold and silver. It also happened in credit derivatives, which, before the 2008 financial crisis, had grown to 10x the size of the underlying corporate bond market and had become the proverbial “tail that wagged the dog” by driving the price of the underlying corporate bonds.

If a large degree of leverage-based financialization ever happens to bitcoin, the community that secures the Bitcoin network with its processing power may move on to a different currency. Unfortunately, the news on this front is already not good, as traders confirmed that daily liquidity for synthetic versions of bitcoin is already approximately $15 billion, which is 3x bitcoin’s daily spot liquidity of approximately $5 billion. Leverage-based financialization of bitcoin to date has happened mostly outside of the US—a good example of this is Hong Kong-based exchange OKEx’s confirmation today that one of its customers had major losses on a leveraged $400 million futures position, causing it to claw back $9 million from its customers to cover the exchange’s loss.

But there’s reason to be optimistic, thanks to HODLers, because bitcoin is an equity-based asset that can only be financialized if holders bring their coins into the financial system.

To sum, liquidity arising from the good type of financialization is a big positive for cryptocurrencies, but, to quote from Part 2:

“…liquidity arising from leverage-based financialization—which creates claims to cryptocurrencies out of thin air—is the opposite side of the double-edged sword. Cryptocurrency speculators will encourage this because it can drive short-term gains, but long-term HODLers will resist it simply by keeping their coins away from the financial system. Accordingly, more of the good type of financialization is likely to occur in cryptocurrency markets than the bad type. This means alpha (excess return) opportunities may be available to institutional investors. It also means Wall Street is unlikely to succeed at “capturing”cryptocurrencies.”

Finally, cryptocurrency market participants today noticed the irony of this quotation from ICE’s CEO, Jeffrey Sprecher, in its press release:

“In bringing regulated, connected infrastructure together with institutional and consumer applications for digital assets, we aim to build confidence in the asset class on a global scale, consistent with our track record of bringing transparency and trust to previously unregulated markets.” (emphasis added)

Bitcoin already has trust and transparency precisely because no centralized institution controls it. But a centralized institution that is allowed to create financial claims to bitcoin out of thin air has the potential to erode some of that trust and transparency.

Thankfully, for existing bitcoin investors, HODLers are likely to make that difficult by storing most bitcoins outside of the financial system and making it the epitome of “hard to borrow.”

Disclosure: I own cryptocurrencies and investments in blockchain companies, including Kraken, Overstock.com and Symbiont, and I worked on Wall Street from 1994-2016, most recently running Morgan Stanley’s pension solutions business.