Frontier Finance: Shaky Foundations Hinder Digital Currencies

Ether was on track to become the bitcoin killer, until it seemingly committed suicide. At 3.30 pm Eastern Time on June 21 this year, the price of the digital currency was riding high at $317.81, a remarkable climb from $10 at the end of February. Over the course of the next 45 milliseconds—or about eight times faster than it takes to blink an eye—it dropped to 10 cents.

The price recovered almost immediately, driving back up to around $300, but the damage had already been done. Traders on the Global Digital Asset Exchange (GDAX) who had leveraged their positions on margin suddenly found their entire portfolios wiped out by stop-loss orders—their positions and their collateral had been liquidated by the exchange’s automated systems.

“I couldn’t believe it,” says one trader who asked not to be named, but who initially suffered tens of thousands of dollars in losses due to the event, according to trading records reviewed by Waters. “When I finally managed to log in to the exchange, my portfolio was gone. It was all just gone, in a heartbeat.”

Although hardly the first such event in the notoriously volatile world of digital currencies—another “flash crash” had taken place in the litecoin-US dollar currency pair just weeks earlier, with similar results—the event raised questions over whether appropriate safeguards are in place at these venues.

Concerns over these gaps in market structure, along with rampant volatility, have been key reasons why institutional investors have largely shied away from digital currencies, also known as cryptocurrencies, in the past. But that is beginning to change.

“In many ways, cryptocurrencies like bitcoin resemble a pyramid scheme, requiring a constant influx of new believers,” says Sean Maher, founder of research firm Entext. “But institutional investors, from family offices to hedge funds, and even traditional mutual funds have been experimenting with cryptocurrencies.”

Gathering Storms

Institutional interest in digital currencies has largely focused on bitcoin, the poster child for the nascent asset class, which has been in use for around eight years after its creation by a still-unknown programmer, or group of programmers, using the pseudonym Satoshi Nakamoto. Digital currencies that follow the bitcoin model are largely decentralized and operate on a peer-to-peer basis, relying on a distributed ledger that records and verifies transactions among participants.

Digital currency exchanges, however, allow bitcoin and others to be traded for different assets, such as conventional fiat currencies, or other digital currencies, with the exchange as an intermediary. These exchanges aren’t operated in the same way as traditional electronic foreign-exchange (FX) platforms or securities exchanges, which have defined and regulated market structures supporting them. Instead, the digital exchanges often combine roles that are usually segregated in other markets—and that can be a problem.

“For a very young, growing, but relatively small market, it’s already very fragmented,” says Paul Gordon, CEO of digital currency liquidity aggregator Quantave. “One of the key issues that we see is that the exchange model that’s used pretty broadly across the ecosystem today is very siloed, and the operators tend to act as the custodian of client assets, as the exchange platform, and as a broker as well, in terms of interfacing directly with their customers. We see that as a flaw.”

As such, the current system is rife with hazard and the potential for fraud, and there have been well-documented examples of customer losses at large exchanges due to cyber incidents, financial collapse or regulatory actions. It is not uncommon to hear digital currency markets described as the Wild West.

The best-known example of large-scale losses is perhaps the Japan-based bitcoin exchange Mt Gox, which, at its height, handled around 70 percent of global bitcoin transactions, but eventually filed for bankruptcy protection in 2014 after “losing” hundreds of thousands of customer bitcoins, as well as its own. The losses totalled around $470 million at the time.

“You look at what happened with ether, and at Mt Gox, you see outages almost every week, and you want me to put my clients’ money there? There’s no way,” says a New York-based portfolio manager at an asset management firm with over $3 billion under management. “We’re not regulated like the big banks, but we have rules we have to follow around asset segregation, custodians and everything else, particularly in Europe.”

Despite these concerns, there is real money to be made in currencies such as bitcoin, which has seen its value rise from around $1,200 per coin at the end of February to an all-time high of just over $3,000 on June 11, according to data from news website Coindesk. Trading volumes have also skyrocketed in recent years, in large part driven by a surge in the amount of initial coin offerings (ICOs) being held, which simulate equity crowdfunding on a blockchain system.

Similarities

Some see similarities between bitcoin’s explosive growth and the emergence of certain commodities as investable asset classes around 30 years ago. One such proponent is St Helier, Jersey-based asset manager Global Advisors, which operates the first fully-regulated investment vehicle for bitcoin. Ryan Radloff, head of investor relations at Global Advisors, argues that oil went through a defined period of maturation that began with fit-for-purpose vehicles being created to give institutional investors exposure to the asset class, and resulted in an evolution in market structure, as adoption took hold. He believes the same process is occurring again with digital currencies.

“We are in an environment where bitcoin is climbing its way to a larger stage, and we’re starting to see more professional infrastructure being set up,” he says. “For example, the Chicago Mercantile Exchange came out with a very sophisticated reference rate [on bitcoin]; we’re seeing groups like LedgerX in the US receiving approval for swap execution facilities (SEFs); and we’re starting to see a derivatives layer emerging.”

That derivatives layer is still highly underdeveloped, with LedgerX offering just options on bitcoin for now, but Radloff also points to a number of hedge funds that have emerged to specifically engage with digital currencies, and companies such as XBT Provider, owned by Global Advisors, which offer exchange-traded products that track bitcoin. Together, he describes these developments as “very bullish for the ecosystem.”

The sell side has not been an early adopter, preferring instead to pursue projects based on distributed-ledger technology rather than bitcoin, and projects that can simplify existing trade processes via proprietary currencies and digital assets such as smart contracts. Their eventual participation as market-makers and liquidity providers is “crucial,” Radloff says.

“It’s crucial, and it might be the hardest part. In the market-maker and broker-dealer space, you have to get these participants comfortable with dealing in this new asset class, and there are a lot of new things that are strange,” he says.

However, the buy side has flirted with bitcoin, ether and other cryptocurrencies. In May 2017, according to data from Hedge Funds Research, hedge funds that had exposure to digital currencies saw big hikes in their monthly performance compared to those that did not. The HFRO Macro Currency Index saw a jump of 3.5 percent during that month, attributable in part to this. One of the most prominent buy-side firms in this space has been Fidelity Investments.

True Believers

Fidelity, which has around $2.1 trillion in assets under management, remains one of the few traditional finance firms willing to put its name to digital currencies as the possible future of finance. In May, its chief executive, Abigail Johnson, gave a keynote address at a blockchain conference in New York—while sporting a pin badge that read “Vote Nakamoto President”—where she described herself as a “true believer.”

One experiment on the retail side has been through incorporating cryptocurrency holdings at Coinbase, the parent of the GDAX exchange, into its portfolio overviews, a feature it first trialed with staff and plans to roll out to customers shortly. Hadley Stern, senior vice president at Fidelity Labs, tells Waters that this could be the first step toward larger adoption, but it will take some trial and error.

“I think there’s going to be an explosion of experiments where people are using this technology, and multiple things may survive,” Stern says. “I don’t think it’s a winner-takes-all scenario, where it all has to be bitcoin, or Fedcoin, or something else. Different uses will meet different user needs.”

Fidelity’s approach is supportive of digital currencies and their applications across finance, where the firm believes they can be transformative, along with blockchain technology. Even so, Stern admits that as a tradable asset class, bitcoin still has some way to go.

“The asset class itself, as a tradable asset class, is immature,” he says. “Liquidity is fairly thin, especially once you go beyond bitcoin, and there’s not a futures or derivatives market, and those types of things. Everything is very early in this space and you saw that with the Securities and Exchange Commission’s (SEC’s) bitcoin exchange-traded fund ruling, where the reason they said no is that there’s not enough of a number of these financial instruments in place to make what they consider a legitimate asset.”

Taming the Wild West

One of the reasons why the GDAX ether-US dollar flash crash of June 21 spiraled so quickly was because a single, massive multimillion-dollar market order was placed at 3:30pm. As the order was set to sell at market price until filled, a combination of this downward pressure—and the subsequent liquidation by stop-loss mechanisms activated by GDAX itself—pushed ether off a cliff. It effectively sucked up liquidity on one side of the book, leading to a fire sale across the market that happened astonishingly quickly. In a normal FX or equities trading platform, this shouldn’t happen. Following the Flash Crash of 2010, where the Dow Jones Industrial Average lost around 1,000 points before rebounding, widespread uproar over the event forced exchanges to introduce market-wide “circuit breakers” that halt trading if the particular market, or even a single stock price, falls or rises beyond what is considered normal volatility.

“Pre-trade and post-trade safeguards can bring added stability to markets,” says Adam White, general manager at GDAX. “We are exploring how protections such as maximum market order sizes and exchange circuit breakers may reduce the likelihood of rapid price movements.”

The exchange said that it would refund those who had their positions and collateral liquidated out of company funds on June 23, and let in-the-money trades stand. White adds that the company is looking at market-maker incentive schemes to strengthen liquidity as well as reviewing how its policies around margin trading are set up.

While the GDAX event primarily impacted individual traders operating on margin, it highlighted the problems with current market structure that face money managers. These are issues that need to be solved, if any kind of market-making structure is eventually able to take root.

“Bitcoin has price discrepancies across many of the exchanges, and part of the reason for that is that bitcoin exchanges today work on a cash basis. This means you have to have bitcoin and/or cash credited to your account to be able to participate,” says Global Advisors’ Radloff. “Traditional finance has much more intermarket infrastructure around liquidity such as International Swaps and Derivatives Association agreements, credit lines, and prime brokers. In bitcoin, that doesn’t exist yet.”

Institutionalization

However, there are movements to try to institutionalize digital-currency markets, usually by mimicking what is already in place in traditional asset classes. One of the most significant attempts to create institutional-grade market infrastructures for digital currencies is taking place now in the US. LedgerX, which will offer options on bitcoin at launch, received temporary approval to operate a regulated SEF from the US Commodity Futures Trading Commission in 2014. Approval for its accompanying clearinghouse took longer, and was eventually issued on July 24.

Paul Chou, the firm’s CEO and a former quant at Goldman Sachs who sits on the CFTC’s Technology Advisory Council, is clear about exactly who a fully-regulated market infrastructure will attract—buy-side firms, asset managers that are looking for uncorrelated assets, as well as family offices, hedge funds and alternative asset managers.

Regulated products on bitcoin and other digital currencies have also been proposed in the past, and Global Advisors lists two exchange-traded products on Nasdaq Nordic that track bitcoin through its XBT Provider subsidiary. Other attempts have been less successful, such as the aforementioned attempt to launch a bitcoin ETF in the US.

Winklevoss Capital attempted to list an exchange-traded product that tracked bitcoin on Bats Global Markets’ BZX exchange in early 2017, and Bats subsequently filed a rule amendment to allow the listing with the SEC, which was rejected on March 10. The regulator cited concerns over the sophistication of bitcoin’s market structure and its vulnerability to abuse.

However, the SEC announced on April 24 that it would reconsider its initial decision, following a petition by Bats. In that appeal, the exchange described the SEC’s concerns as “overstated and largely theoretical.” Bats declined to comment further.

Tentative Steps

Ultimately it will not be the US that takes the first step into legitimizing digital currencies, despite market-led efforts. The Japanese Financial Services Authority (JFSA) is set to bring bitcoin and other virtual currencies under its remit starting in October 2017. From that point, any bitcoin or “alternative coin” exchange or money transfer business must submit to annual audits and other regulatory measures. Some suggest this may prompt other regions to reconsider prior rulings on digital currencies, or accelerate their own supervisory plans.

“There will be strict segregation of customer-owned currency or tokens from those belonging to the exchanges themselves,” says Entext’s Maher. “In typically quaint Japanese fashion, new customers will not be able to trade until they have received a hard-copy acknowledgment letter, delivered by registered [mail] to their home address, but formal recognition will still be an astonishing leap of faith which may prompt the SEC to revisit its ETF decision.”

One sign of regulatory impetus was clear at press time, on July 25, when the SEC issued a report into ICOs, firmly categorizing the sale of digital assets as subject to US securities laws. But while regulatory drivers are certainly providing forward motion, participants believe that it will ultimately be market-led solutions, such as investment vehicles and initiatives led by asset management firms or exchanges, which will ultimately legitimize bitcoin in the eyes of institutional investors.

“In the last two years, we’ve been in meeting rooms and people would laugh at us when we’d say bitcoin is an asset class. Nobody’s laughing now—the conversation is now around the easiest and safest way to gain exposure” says Global Advisors’ Radloff. “People are starting to realize that this is new, it’s not going away, and it’s time to take it seriously and figure out where bitcoin fits into a modern portfolio.”