Galen Stops looks at why demand for cryptoassets has skyrocketed in 2017 and assesses whether they have any future in mainstream financial markets.

The first working implementation of a blockchain that the world had ever seen was in the Bitcoin software released in 2009. Bitcoin the cryptocurrency then rose to prominence in 2013 when, driven in part by a flurry of media attention, its value rose past $1,000 for the first time.

Following that, 2014 represented a long and painful year of price decline for Bitcoin as an asset, but it continued to garner a lot of attention, not always for good reasons. Then in 2015 the narrative began to change as people really started talking about the potential applications of blockchain technology distinct from any digital assets.

In October 2015 Blythe Masters appeared on the front of Bloomberg Markets magazine with the headline caption “It’s All About the Blockchain”, while the October/November edition of The Economist ran a story about blockchain, “The Trust Machine”, on its front cover.

Google search volumes for “blockchain” begin to noticeably spike upwards around this time period as a result of the attention on this technology. Although a new cryptoasset called Ethereum began to get some attention in 2016, the overall message coming out of financial institutions was that blockchain, or distributed ledger technology (DLT), was useful to them and cryptoassets were not.

In 2017, however, demand for cryptoassets has soared, driving the value of Bitcoin on a strong upward trend, from $802.83 per Bitcoin on January 12 to $2,476.30 on May 24. Ethereum, meanwhile, went from $8.29 at the start of the year to over $204.31 by May 30.
“If we think of this space as a pendulum, on the left hand side you have just the blockchain technology itself and on the right side you have Bitcoin and all the other cryptoassets,” says Christopher Burniske, blockchain products lead at Ark Invest, which became the first public fund manager to invest in Bitcoin back in 2015.
“The pendulum started on the right hand side with the assets in 2013, it then swung towards blockchain and away from the assets and that swing peaked around the summer of 2016,” he continues. “That’s around the time that the DAO hack occurred, questions were starting to be raised about smart contracts and about blockchain technology more generally and Bitcoin prices were starting to make another big move.
“I would say that since that period the pendulum has started to swing back towards the assets, and ultimately I think that cryptoassets will have a much wider reaching impact on our world and business processes than blockchain technology will as a software update in financial markets,” he adds.
The obvious question then becomes: who and what is driving all of this demand for cryptoassets?
Intelligent Investing
Paul Chou, CEO of LedgerX, says this is a difficult question to answer because the people who are trading these assets in size often want to be as quiet as possible about it. 
“My impression from private conversations is that a lot of large traditional finance firms that are more quant-focused, HFT-type businesses have staff that understand this technology and are excited by it. So these flows are being driven by managers that purchase and trade Bitcoin at a scale that is dwarfing the original techies, miners and retail customers. The people that have done well in finance that understand technology are starting to become involved in a large way, that’s where I see the volumes coming from in 2017,” he says.
Giving one example of this, Chou points to recent news reports citing comments from Mike Novogratz, the former CIO of Fortress investment Group’s macro fund and Goldman Sachs partner who was on the Forbes billionaire list in 2008, that 10% of his net worth is invested in cryptocurrencies.
Speaking to portfolio managers at financial institutions, there also seems to be a growing enthusiasm for investing in digital currencies.
“I think that cryptocurrencies represent a huge opportunity. I think you’re supposed to have some allocation of cryptocurrencies as part of your alternative assets class because that really is a place where you get de-correlated returns but there’s also a huge amount of growth from the technologies there,” says a portfolio manager at one major bank.
A quant at another bank adds: “I think there’s a lot of value to be had in the way the work is paid for in a lot of these blockchains. Honestly, I think that Bitcoin is a bit of a weird one because there isn’t that much value there, but things like Ethereum have a lot of value because it pays people to verify transactions and enforce contracts and a lot of big banks and other financial institutions have begun to buy into this. I think that this network that pays for the services of verifications and contract enforcement is in itself valuable.
“If you’re investing intelligently because you’ve read the white paper, understand the math behind it, and the product they’re bringing to market – that ecosystem where you can create these methods of payments that disintermediate places that are already charging for it – that’s where you get the value and there’s a lot of upside left in those products.”
Lottery Ticket Mentality
Neither of these quants, however, is allowed to buy cryptocurrencies in the portfolios they manage at their banks, they only buy them when trading for their own account. Both are also based in the US, and Michael Moro, CEO of Genesis Trading, says that their attitudes to these assets are fairly typical amongst those trading them in that country.
“I think that in the US there is often something of a lottery ticket mentality, people allocate a small percentage of their portfolio for cyrptocurrencies because of the non-correlation, diversification benefits, realising that it might go to zero or it might go to one hundred thousand dollars and then they look like a hero,” he says.
According to Moro, the attitude towards cryptocurrencies in Europe is often similar, but he notes that concerns about Brexit and the future of the EU have caused some people to view Bitcoin as an alternative store of value to the pound and the euro. 
Outside of the US and Europe, Moro says that in early 2016 Bitcoin started being used as a remittance avenue, particularly in countries where the domestic currency is under severe pressure, such as Venezuela.
“We see people using it to quickly and efficiently get funds out of the US or into the US when their domestic currency market and government are continuing to destabilise,” he says. “We work every day with a number of remittance companies that need to get funds from the US to Mexico, or from the US to remote parts of Africa, and going from the US dollar to Bitcoin and then out to the Mexican peso or the native currency is much more efficient from a time and cost perspective.”
Barriers to Adoption
Despite anecdotal evidence suggesting that more individuals from mainstream financial services firms are privately investing in cryptoassets, there are a number of barriers preventing many institutions from actively trading them. Speaking at the recent Consensus 2017 conference in New York, Abigail Johnson, chairman and CEO of Fidelity Investments, highlighted four key challenges regarding the adoption of cryptoassets and blockchain technologies for firms such as hers.
Firstly, she focused on the technology problem, pointing out that there are still questions to be answered about the ability for the core technology involved to conform to the requirements of major financial institutions.
“We understand that there are important trade-offs that have to be made as these systems grow. We care about the trade-off between scalability, privacy and achieving peer-to-peer settlement. It seems like right now you can’t have all three,” said Johnson.
The second issue that she addressed in her speech was the policy challenge associated with technologies that Johnson desfribed as moving faster than regulators’ ability to keep up with them. She argued that in order for these technologies to achieve their full potential there needs to be an ongoing and productive dialogue between regulators and firms like Fidelity.
“Thirdly, we have the control challenge,” she continued. “Networks like Bitcoin and Ethereum by design have no formalised management structure, they’re open projects, anyone is free to fork and this is great but companies like ours that build products on these platforms don’t have the clarity on the future form they might take or how to influence the developer communities. Control is also an issue for private networks. The financial services industry will need to work to understand the risks associated with who controls the features of these new systems.”
Finally, Johnson was at pains to emphasise the human problem associated with the adoption of these new technologies. Specifically, she noted that individuals need to avoid the temptation to look at the technology behind blockchain and Bitcoin “through the lens of the present” and instead think about ways they could be used in a future financial services industry.
“We need to come up with use cases for this technology that drive clear benefits for individuals and institutions,” she argued. “Too often we see Bitcoin and blockchain technologies as solutions in search of a problem, we don’t just need these systems to be technically better, we need them to be more user friendly.”
KYC/AML Challenge
While Johnson talked about the adoption challenges for both cryptoassets and blockchain technology, there are some unique factors that make the former more problematic than the latter for many mainstream financial services firms.
One major issue for many firms is the decentralised nature of how cryptoassets are traded makes adhering to Know Your Customer (KYC) and Anti Money Laundering (AML) regulatory requirements much harder, if not currently impossible. 
The major cryptoassets, such as Bitcoin and Ethereum, operate using public, permissionless distributed ledgers, meaning that anyone from anywhere in the world can potentially interact with the network used to trade them. In addition, although every transaction performed on these ledgers is visible to others on the network, the identity of those trading the assets is not. This is why the KYC and AML aspect of crypto assets is such a problem for many firms.
Burniske breaks down the KYC/AML issue into two parts, noting that when people discuss “permissionless architecture”, what they’re referring to is the actual computers that provide the hardware necessary to secure and provision the digital resource.
“The fact that anyone can connect to that hardware is actually a beautifully open system and so the concern from the incumbents becomes more about the transparency of information, because one bank doesn’t necessarily want other banks to see everything they’re doing. But there are resolutions for this problem that are percolating, whereby you can have selective privacy on permissionless blockchains, so that some transactions are transparent and some are obscured, depending on the use case,” he explains.
The second part of the KYC/AML question, according to Burniske, has nothing to do with the actual computers securing the network, but the users of the digital resource of that network.
“That is where there is full transparency, but those entities aren’t represented by their name, date of birth and nationality, they’re represented by a string of characters. What we’re increasingly seeing now though is that the cryptoasset exchanges are implementing rigorous AML and KYC processes, and this is part of the bridge towards the mainstream,” he says.
Oh, The Irony
Regarding this subject, the argument from Moro and Chou is that their respective firms can help solve this problem by operating as a regulated intermediary or infrastructure provider that does the KYC/AML leg-work on behalf of firms wanting to trade these cryptoassets.
For example, Genesis Trading is already regulated as a broker-dealer by the Financial Industry Regulatory Authority (FINRA) and the Securities and Exchange Commission (SEC), and therefore has regulatory oversight and certain constraints surrounding with whom it can interact.
“The reason why family offices and hedge funds buy from us is that they know we’re only buying and selling with the right people, so the Bitcoins are blessed by a regulated entity,” he says.
Genesis Trading has also submitted an application for a BitLicense with the New York Department of Financial Services (NYDFS), which is currently pending approval.
Meanwhile, LedgerX is an institutional trading and clearing platform that has applied for registration with the Commodity Futures Trading Commission (CFTC) as a swap execution facility (SEF) and derivatives clearing organisation (DCO). If the application is approved by the CFTC then users of the LedgerX platform will have to meet certain requirements, ensuring that firms coming to trade Bitcoins there will not end up interacting with a counterparty that could fall foul of their KYC/AML obligations.
Chou agrees that currently the KYC/AML issue is a legitimate concern for financial institutions, but is quick to point out that this concern is hardly unique to Bitcoin trading. After all, he says, cash is more anonymous than Bitcoin and harder to track, yet it is still considered an entirely legitimate asset.
There is, of course, a clear irony in the fact that in order for these cryptoassets, which that were largely built around the concept of decentralised authority, to enjoy large scale adoption trading might need to be centralised into venues where regulated authorities can act as gatekeepers.

ETF Rejection
The decentralised regulation of crypto assets might also prove a hindrance in the short-term to their adoption by major financial services firms. In much the same way that it is impossible to centrally regulate the global foreign exchange market, these cryptoassets cannot be centrally regulated at an international level. 
Even at a national level, however, some firms involved in the trading of these assets in the US suggest it can be hard to know which regulatory playground they’re playing in at any given point in time, considering the number of regulators wanting to claim some form of oversight of cryptoassets.
“The regulatory environment needs to coalesce and solidify,” opines Chou. “We need to have a regulated spot or futures market for Bitcoin so that people can be comfortable with the underlying price and then this can be securitised with ETFs in a way that I think the SEC will someday be comfortable with.”
Chou here refers to the SEC decision in March to reject the proposed Bitcoin ETF put forward by investors Cameron and Tyler Winklevoss, which would have been listed on Bats Exchange. The price of Bitcoin continued on an upward trend despite the rejection, which the SEC has subsequently said that it will review following a petition to do so from Bats.
“The SEC’s decision was structurally based on the idea of information sharing agreements between exchanges, preventing market manipulation or showing that this particular market place would be protected against market manipulation. So the SEC declining the ETF was almost a marching order and I think it’s telling that the SEC has taken up Bats’ petition to review their decision,” says Ron Quaranta, chairman of the Wall Street Blockchain Alliance (WSBA).
The idea that the SEC has paved the way for a future Bitcoin ETF in the explanation that it provided for its decision to reject the proposed Winklevoss ETF appears to be shared amongst a number of cryptoasset holders and service providers, with one source arguing that the regulator has “created a roadmap for folks to follow”.
The source adds they don’t believe the SEC is anti-Bitcoin, but that the regulator might have some valid concern about some of the cryptoassets being brought to market.
For example, they point out that some firms launching new cryptocurrency startups now use an Initial Coin Offering (ICO), where a percentage of the cryptocurrency is sold to early backers of the project in exchange for legal tender or other cryptocurrencies, to raise funds for their venture, by-passing the regulated capital-raising process required by venture capitalists or banks.
The source says that the SEC might have questions about whether companies raising funding via selling digital tokens are actually selling equity by doing so, adding that “my guess is that most of these ICOs are illegal or grey murky areas at best, and the SEC tends not to like that”.
Bottom Up Demand
Apart from greater regulatory clarity around the trading of crypto assets, what else needs to happen to drive these products into the financial services mainstream?
For Chou, part of the answer is simply that the market cap of these assets needs to increase. For the biggest fund managers such, as BlackRock and Vanguard, who have trillions in assets under management, the market cap for digital currencies is just too small for it to be worth the risk of investing in them right now, he explains.
Likewise, Moro points out that financial institutions want to make money and if the market cap of Bitcoin and other cryptoassets continues to grow it becomes harder for these institutions to ignore. He says that anecdotally banks are reporting an increase in the number of reverse inquiry demands from customers regarding cryptoassets, and that if this trend continues it will help strengthen the business case for these banks offering their clients access to some of the products available.
“So far, in my opinion this has mainly been a retail move,” says Burniske. “Of late though, there’s been a lot of mainstream attention as Bitcoin broke $1,000, there was a lot of anticipation around Bitcoin ETF, and you had some of the other assets take off post-ETF rejection, so there’s been a lot of retail activity and attention.
“The institutional sale cycle has been much longer and needs to go through risk committees, which can take years,” he continues. “I think often as disruptive technologies like this evolve, institutions end up embracing them because consumers demand it, and increasingly with our social media driven world there can be a lot of pressure put on institutions based on a cacophony of the masses.
“So I think as the user interfaces of the crypto asset ecosystem improve that will make it easier and easier for more retail participants to become part of the community and therefore institutions will increasingly get involved,” he adds.
WSBA’s Quaranta is optimistic about the potential for mainstream adoption of cryptoassets, but argues that more work needs to be done to educate both investors and regulators about this rapidly evolving asset class.
“Improved education across the entire spectrum of cryptocurrencies and assets as well as clarity on the regulatory framework internationally will help solidify the next steps of institutional players using these assets in terms of seeking alpha and generating long-term strategies,” he says. “It’s an evolving market and in the next one to two years I expect to see a deeper institutional engagement with it.” 
Baby Steps
For all the hype and VC money pouring into blockchain and DLT, there is still plenty of interest from large, regulated financial services institutions in potential of cryptoassets. One only needs to look at the speakers listed at the various cryptoasset conferences that have sprung up around the world to see which big banks are keeping an eye on this space. 
For example, CME Group recently revealed more details about its project with The Royal Mint, which looks to create “digital tokens” of physical assets, and Grayscale Investments – a sister company to Genesis Trading – is trying to register a Bitcoin Investment Trust (BIT) with the SEC for which it has three authorised participants signed up: Credit Suisse, KCG Americas and Wedbush Securities.
Yes, the CME venture actually uses a private, permissioned ledger rather than the public, permissionless type used by Bitcoin, and yes, the BIT is structured so that the participants aren’t actually buying Bitcoins, they invest in the trust which then goes out and buys the Bitcoins to fill the order based on the cash coming into it. But what this represents are baby steps towards major financial institutions investing and trading digital or cryptoassets. 
Just as the DLT evangelists predicting how that technology will drive major changes in the way that financial markets operate are often far too optimistic in their estimated timeline for this change, so too some Bitcoin enthusiasts misjudge how long it will take to build and regulate the infrastructure needed to make trading or holding this cryptoasset palatable to banks and big fund managers.
Yet it is important to remember that the success of one of these technologies is not predicated on the failure of the other. They are, after all, being used to solve very different problems.
For those that were writing off cryptoassets as a curiosity, a passing fad or just fundamentally incompatible with mainstream regulated financial markets, however, it’s worth noting how resilient Bitcoin has proven. Eight years since the Bitcoin software was released and the digital currency has survived major scandals around illegal purchases on the Silk Road, the Mt. Gox bankruptcy and the Bitfinex hack.
Yet demand for Bitcoin continues to grow, and as it does so too does the pressure on regulators and financial institutions to find a safe and transparent way to bring the trading of cryptoassets into the mainstream. Ultimately, however, it all depends on exactly how far the pendulum swings.

Galen Stops

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