Galen Stops takes a look at whether mainstream financial services firms are likely to be investing and trading in cryptocurrencies any time soon.

At the very start of June, Profit & Loss published an article looking at why demand for cryptocurrencies had spiked in 2017, with the price of bitcoin rising over 200% between January and the latter end of May.

Subsequent to that, demand continued to grow, with the price of bitcoin reaching $4,950 by the start of September. Meanwhile ether – the native cryptocurrency of the Ethereum network – went from $8.29 at the start of the year to $388 by September.

Price of bitcoin Jan-Sept 2017. Source: CoinDesk

Price of ether Jan-Sept 2017. Source: CoinDesk

Mainstream financial services firms have long been keeping an eye on cryptocurrencies, but while certain trading firms are already active in this asset class, many more heavily regulated institutions have generally shied away from the space due to compliance concerns.

But, given the price action previously described, the demand from mainstream financial services firms to begin trading cryptocurrencies has been growing significantly, according to market sources.

Daniel Hodd, who recently left Citi to co-found, Digital Asset Investment Company (DAICO), recalls how his conversations with investors have changed this year.

He explains that between mid-2014 until the beginning of this year, nearly all of the conversations that he had with clients were educational in nature, focused on discussing uses for blockchain technology or the nuances of various cryptoassets.

But since the start of the year, Hodd says that the conversations increasingly shifted in tone. Many of them – having become more educated about these assets – began asking how exactly they could get access to them, according to Hodd.

“To me, that is a signal that things have fundamentally changed and, after a very necessary and important educational phase, more and more investors are ready to get exposure to these products – if they haven’t already done so,” he says.

Giving another example of how the conversations he was having with clients changed, Hodd says that clients who might have invested a relatively small amount cryptocurrencies over the past few years now found that, because of the recent price action, these assets were now worth many multiples of this.

For example, according to data from CoinDesk, a trading firm that allocated $20 million to bitcoin this time last year would have been sitting on over $140 million of this asset come September of this year.

This could prove challenging for the clients, because the structure of their fund might require them to put those assets with a qualified custodian, but the custodians themselves might be unwilling or unable to accept these cryptoassets.

“There’s often a certain structural requirement certain clients to engage with the big banks, meaning that we’re at a cross-roads between the traditional systems and procedures, and the conventions built around those, and the new technologies, their native assets and the capabilitiesthey afford. That’s a very interesting and challenging juxtaposition to explore,” says Hodd.

Exchange launches 

John Dwyer, a capital markets fintech analyst at Celent, agrees that demand from investors to access cryptocurrencies is growing. 

“You can’t have an asset class grow in the order of magnitude that we’ve seen so far with cryptocurrencies and not have professional money managers want to get involved. It’s just a question of how they can do that,” he says.

With regards to “how” mainstream financial services firms might get access to cryptocurrencies without giving their compliance staff heart attacks or attracting the ire of the regulators, there were two very interesting developments this summer.

The first was that LedgerX, an institutional trading and clearing platform for digital currencies, was granted approval from the Commodity Futures Trading Commission (CFTC) to operate in the US as a derivatives clearing organisation (DCO) and a swap execution facility (SEF).

LedgerX plans to go-live at the end of September, operating as an exchange and clearing house for trading in bitcoin options.

When it comes to clearing the products, LedgerX will operate a direct clearing model in addition to the traditional FCM model. Qualified participants will be able to work directly with the clearing house, or an FCM can act as an intermediary that faces both the client and the clearing house.

“We anticipate that, as a DCO in the bitcoin space, our initial set of customers will be direct clearing members, meaning that they will actually pledge US dollars and bitcoin as collateral to the clearing house directly in order to support their trades,” says Paul Chou, CEO and co-founder of LedgerX.

He adds: “Once a trade is matched, the clearing house immediately locks the collateral, whether the participant is long or short for their net position.  At the exercise of a contract, the funds, specifically dollars or bitcoin, are moved around. So, if an exchange member decides to exercise a call option, then what we do is debit the US dollar premium, or the strike price, and deliver the bitcoin from the counterparty. 

The second big development was the announcement that CBOE plans to launch cash-settled bitcoin futures before the end of the year, use market data from Gemini Trust Company to create the bitcoin derivatives products for listing and trading.

One of the key reasons why mainstream financial services firms cannot trade bitcoin right now is because the open, permissionless blockchain underpinning this digital currency could potentially lead them to run afoul of Know Your Customer (KYC) rules.

However, because both LedgerX and CBOE are launching bitcoin derivatives, they neatly sidestep this problem. 

As John Deters, chief strategy officer and head of multi-asset solutions at CBOE, told Profit & Loss shortly after the exchange announced its plans: “I think that there is some caution from interested market participants, because they’re otherwise uncertain about regulatory oversight. This is why we believe that having derivatives for bitcoin available on a well-regulated, onshore, exchange listed and cleared type market place like the CBOE Futures Exchange makes so much sense. It will enable people to trade with confidence – they know the exchange and the regulatory environment that exists here. 

He added: “With their reservations in mind, we’re proposing cash-settled futures products, so firms will be able to trade it without engaging with the bitcoin blockchain. But at the same time, because of this direct link to the Gemini bitcoin auction – the settlement value corresponds precisely to the decimal point to a specific transaction in cryptocurrency – if a market participant does want to hold the physical product, they can become a member of Gemini and participate in that auction. What we’re doing is providing a jumping off point into this fascinating marketplace, and we think that’s really going to resonate with customers.” 

Handling hard forks

But while cryptocurrency products may soon be available to mainstream financial services firms, this doesn’t necessarily guarantee that they will be adopted.

There are a number of remaining challenges to adoption. Profit & Loss previously reported comments from Abigail Johnson, chairman and CEO of Fidelity Investments, who pointed out that networks such as Bitcoin and Ethereum, which by design have no formalised management structure, pose a problem for investment firms.

Because these networks are open projects, the blockchain underpinning them can fork, meaning that if a company like Fidelity was to build a product on these platforms, then they wouldn’t have clarity on the future form they might take, making it challenging to sell these products to their own clients.

At the beginning of August, what had always been a theoretical prospect became a reality when bitcoin had a hard fork. This posed challenges not just for market participants, but also for exchanges.

This was most clearly evidenced by the experience of Coinbase, currently one of the largest digital asset exchanges in the US. 

Ahead of the hard fork, Coinbase said it would not support the new currency created by the fork, bitcoin cash, and that users must withdraw their coins before the fork if they wanted to receive a bitcoin cash “air drop”. Some clients complained that they were unable to withdraw their coins in time and the general backlash was severe enough that Coinbase reversed its decision and, subsequent to the fork, announced that it will integrate bitcoin cash support by January 2018.

Chou argues though, that similar types of events already occur in mainstream financial markets, and that this can serve as a template for how to handle these events in the future.

“The challenge is one of collecting input from exchange participants, understanding what a hard fork could look like and then making a judgment call of how to handle it. In many ways, a hard fork doesn’t feel that different from when I was trading exotic securities at Goldman Sachs and we would be confronted with a one-time spin-off or one-time large dividend. 

“Often the clearing houses were not prepared for these events and hadn’t specified ahead of time how they would handle them. You didn’t know if they were going to split the shares or give partial shares. For one-time events, the clearing houses need to talk to their customers and regulators about how they would want to settle contracts during these instances. I don’t think that hard forks are very different in this regard,” he says.

Custody challenge

 Another big challenge for the mainstream adoption of cryptocurrencies is that the custody arrangements for these assets are, at best, problematic.

 “What needs to happen for bitcoin and other cryptocurrencies to see broad adoption in the market? I’d say that once a bitcoin ETF goes live as an investment vehicle, that will have a big impact. But another really important piece is on the custody side. Right now, it’s not clear to me where you would park these assets once you invest in them. I can’t see any major financial institutions engaging in this market in a meaningful way until this custody piece is sorted,” says a senior figure at one trading venue.

 Similarly, Hodd explains that the storage and safekeeping of crypto-assets remains one of the main challenges for firms wanting to operate in these markets.

 “If you want to have a portfolio of 20 different coins, then this can potentially be a nightmare scenario from an operations standpoint, because then you might be dealing with several different blockchains and each coin could have different storage requirements. This makes frequent rebalancing and redemptions operationally challenging.

 “This is not an insignificant issue. We often take settlement and safekeeping for granted in mainstream financial markets because the processes are generally well established and run in the background. But when there’s no major bank available to hold your assets securely, then that places a substantial burden back on the investment company,” he says.

 Of course, the price comparisons at the start of this article only went as far as the start of September for a reason. If the price action of cryptocurrencies between January and September showcased the building excitement around these assets, the price action during September showed just how susceptible they can be to downswings as well as upswings.

check one two

Price of bitcoin Sept 1-19th 2017. Source: CoinDesk

Price of ether Sept 1-19th 2017. Source: CoinDesk

From a high of $4,991 on September 2, bitcoin was down 22% to $3,875 by September 14. Then in the space of 24 hours it dropped yet another 23% to $2,981. Ether has also had a rocky ride in September, going from $391 at the start of the month down to $202 on September 15.

So what happened to shake investors’ faith in these cryptocurrencies?

Bitcoin labeled a “fraud”

Firstly, news reports emerged suggesting that Chinese authorities, having already banned initial coin offerings (ICOs) at the start of September, were planning to order bitcoin exchanges in China to shut down. China has always been a major trading hub for bitcoin and other cryptocurrencies and therefore it is unsurprising that this news had a big impact on the market. However, it does highlight the regulatory risks still associated with bitcoin. 

“It’s no secret that bitcoin was being used by people in China to get their funds out of the country,” explains a source at one financial firm in Hong Kong. “SAFE, the FX regulatory body in China, has basically been trying to stop outflows of capital since November 2016 and they’re not just looking at bitcoin. They’re trying to regulate their currency depreciation, so this is part of a much larger issue for them.” 

The other factor that is widely thought to have caused a drop in price is the comments made by JP Morgan CEO, Jamie Dimon.

At a conference on September 12, Dimon labeled bitcoin as “a fraud”, adding: “It’s just not a real thing, eventually it will be closed.”

Dimon also compared the excitement surrounding bitcoin earlier in the year to the infamous tulip bulb bubble, which occurred in Holland during the early 1600s when speculation drove the value of tulip bulbs to extremes. He added that he would willing to instantly fire any JP Morgan trader that was trading bitcoin, stating that they would be “stupid” to do so.

“There’s no question that the incumbent financial institutions are definitely seduced by blockchain and by the price action of crpytocurrencies, but equally, these don’t support their business and if there is a very large movement into crypto-assets, then that doesn’t necessarily help Jamie Dimon or JP Morgan’s business,” says Dwyer, who concedes that he himself has conflicting opinions about the long-term viability of cryptocurrencies.

And yet, by the end of September 15 bitcoin was back trading at $3,714, an intraday increase of 25%, and the price has continued to climb – albeit slower than before – since then. Likewise, ether bounced back up by 29% to $260 by the end of September 15 and is, at the time of writing, hovering just below the $300 mark.

Is the bubble sustainable?

As Profit & Loss has previously noted, bitcoin has proved remarkably resilient, surviving the Silk Road scandal, the collapse of a major exchange, some high profile hacking incidents and a hard fork in the blockchain. The bounce back in price could simply be indicative of the fact that this digital currency is not reliant on Chinese exchanges and does not need the blessing of senior figures from incumbent financial institutions to keep generating demand.

“Any lens by which you look at bitcoin – as an asset, in terms of its production volume model, as digital gold or through future value as a payments network – implies a big increase in price from where we are today,” says a source at one trading firm.

Dwyer is slightly more skeptical, commenting: “If you get a chart and look at the appreciation of bitcoin and compare it to any other bubble, it’s off the scale. Anyone in capital markets knows that this isn’t sustainable, but that doesn’t mean that it couldn’t continue to appreciate for some time longer with a few mini corrections along the way. But it means that eventually, when a big price correction happens, it’s going to be eye watering.” 

Yet regardless of long-term prospects of bitcoin and other cryptocurrencies, there appears to be a growing demand from professional trading firms and institutional money managers to access these assets. And while the infrastructure for trading crypto-assets still needs development, the key step is getting regulatory clarity regarding how these digital assets should be treated. 

“The industry needs regulation because it provides a degree of certainty to institutional investors who want to invest in this space. It just takes these assets out of the grey area and makes things black and white, so that firms have clarity about how they can enter the market and explore the opportunity in a way that protects their credibility and integrity,” says Hodd. 

That’s why the planned LedgerX and CBOE launches, assuming that the latter receives regulatory approval for its bitcoin futures, are particularly interesting. Whether or not they are successful, they will represent the first federally regulated venues in the US for trading cryptocurrencies.

It’s early days, but if regulation and the infrastructure can effectively be aligned to reflect the growing demand amongst financial services firms to trade these products, then it’s not hard to envision them moving into the mainstream.

Galen Stops

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