The Risks of Traditional Finance Meeting Cryptoassets
By: Claire Belmont
Tags: Futures Trading, Risk Management, Institutional Investor, Finance, Bitcoin

The underestimated risks of ICE’s new crypto-asset platform

I usually don’t cover cryptocurrency markets but the announcement that Intercontinental Exchange (NYSE: ICE), a company that operates many of the world’s largest stock and futures exchanges (including the New York stock exchange), is building a new ecosystem for digital assets is worth pausing on: there are risks I’m suspecting few understand.

Background

ICE’s new company Bakkt is working with Microsoft, Starbucks, BCG, and a number of hedge funds on an “integrated platform that enables consumers and institutions to buy, sell, store and spend digital assets on a seamless global network.”

They’re starting with a physically settled bitcoin futures contract, which unlike other (CBOE & CME) existing bitcoin futures contracts requires delivering the settlement in bitcoin (the underlying asset) vs. settling in cash. This new type of futures contract is known as a “bitcoin-settled” (vs. cash-settled) derivative.

Risks

Up to now bitcoin price speculation claims were made in cash but with Bakkt’s new futures contract these claims will be happening in bitcoin. The challenge is that bitcoin is designed to be scarce and thus hard to borrow. Wall Street however, has a solution: rather than lend the actual asset itself (i.e. bitcoin) create off-chain bitcoin substitutes that aren’t 100% digitally escrowed with real on-chain bitcoins.

“We are about to see “fractionally-reserved bitcoin” en masse for the first time — more paper claims to bitcoin (created off-chain) than there are real bitcoins on-chain — and these paper claims will offset bitcoin’s natural scarcity to some degree.” [Source]

If you’re not in finance and thinking that’s crazy, well not really… Creating financial instruments in excess of the number of underlying assets is a big part of Wall Street’s business model. However, crypto is a more dangerous game than traditional finance. If something goes wrong, then the government can’t help by printing more cash. Issuance of the underlying asset is instead dependent on the protocol’s algorithmic monetary policies.

One way things could go wrong is if a party has a non-hedged position such as a naked short, a hard fork happens, and the new coins (from the new chain) pick up all the value. Since the substitute coins of the old chain are off-chain they don’t get the new coins, leaving those exposed with nothing. This could lead exposed institutions to bankruptcy.

And it doesn’t stop there: due to custodial regulation institutional investors almost never own the underlying asset, which means they’ll never possess the private keys to the coins they “own.” Instead they need to rely on the custodians who today don’t get audited, creating more obscurity in the system.

So it may be encouraging to see big institutions finally embrace this new decentralized technology but with it will come a whole set of concealed financial mechanisms that could lead to another economic melt-down should these become popular.

In conclusion, ICE is essentially laying down the foundations for building fragile financial houses of bitcoin-derived cards and unless regulation institutes a new rule requiring crypto-derivatives to be explicitly tied to an on-chain coin this could all go very wrong.

Want to know more?

Read Caitlin Long’s (Forbes) three-part series here:

Or listen to a summarized version on the Unconfirmed podcast: Why the ICE/Bakkt News Makes Some Crypto Investors Nervous

From around the web

A red ocean for smart contract protocols (Tony Sheng blog) — Strong post that takes a realistic look at the state of protocol developer communities. Sheng argues that crypto-projects should “slow down their ecosystem efforts until they figure out how to reach end-users” by taking an “LTV” approach to growing their community. Otherwise they’re just wasting money on “mercenary developers.”

The Distributed Computing Update (USV blog) by Dani — Excellent summary and some interesting reflections on the state of the ecosystem today.

Mapping The Decentralized Ecosystem (Token Economy) — Great for anyone new or overwhelmed by the number of projects in this space. This long read provides a complete and well explained overview of the ecosystem.

An Overview of Privacy in Cryptocurrencies (Medium) by Richard Chen — Comprehensive and well articulated summary of all the technologies out there.

Money Crypto vs. Tech Crypto (Token Daily) by Erik Torenberg — Looks at the two crypto narratives that exist today: one powered the bitcoin vision and the other by the ethereum vision.

The Bitcoin Second Layer (Medium) by Nick Bhatia — Uses “gold as an analogy to describe why bitcoin will evolve in layers on its way to world reserve currency status.”

Sponsored burning for TCR (Medium) by Alex Van de Sande — Proposes a method to align token holder incentives and ensure better quality content using “an external profit model which doesn’t require token holders to sell or rent their tokens.”

Aggregation Theory, Thin Protocols, and Recentralization: Augur Edition (Multicoin Capital blog) — Takes the reader through a thought experiment: what happens when dapp steals value from the protocol its built on?

Ethereum Is Getting Its First Top Level Domain Name (Coindesk) — The Ethereum Name Service (ENS) and MNX, a traditional DNS registrar, are partnering to create “.luxe”; a top-level domain that will resolve on both systems.

Smiley Corner 😄

Weekly newsletter published internally at Google. The views expressed are my own and do not necessarily represent the views of my employer.

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