Last week may be remembered as the turning point when cryptocurrencies joined the mainstream financial system, as the clearing and trading platform LedgerX opened for business.
About 20 institutional investors -- including investment banks, asset managers, hedge funds and proprietary-trading shops -- executed bitcoin forward and option trades at narrow spreads and without difficulty.
This creates the possibility of large-scale trading among traditional financial institutions supporting both the vastly increased use of the currencies in business and their inclusion as an asset class in investment products from pension funds to hedge funds.
But before anyone gets too excited, remember that activity on LedgerX seems to have been limited to tests, 176 trades from Oct.16 to 20 represented only $1,000,000 of notional value. Will institutions take advantage of their new capability to trade bitcoin in size either for their own accounts or to offer crytocurrency-linked products to their customers? If so, LedgerX has plans to introduce longer-dated contracts and Etherium and possibly other cryptocurrency swaps and options.
As expected, most of the interest is in the day-ahead bitcoin swaps, and 170 of these were traded. Bid/ask spreads were impressively tight, $5 on a $6,000 notional contract. Six bitcoin options traded, four calls and two puts with $5,600 strikes at implied annual volatilities of 80 percent and 77 percent respectively. This is considerably smaller than more than the 100 percent historical annualized volatility of bitcoin, and the even higher implied volatilities that option buyers have had to pay on unregulated exchanges.
To the extent we can extrapolate from small-volume transactions, they suggest LedgerX, which won Commodity Futures Trading Commission approval in July to offer options, could make bitcoin both more liquid and more stable. Institutional cryptocurrency trading has been held back by the absence of a clearing facility and fragmented liquidity among unregulated exchanges that do not all adhere to modern best practices of settlement, information security and legal compliance.
Yet LedgerX has competition. I attended a panel at the Financial Industry Association Expo in Chicago on Oct. 19 that featured speakers from five companies -- including LedgerX -- offering different solutions. Coinbase is a well-known retail-friendly way to hold and trade cryptocurrencies. DRW has been assembling institutional-sized blocks of bitcoin for some time. BitGo offers an institutional-quality wallet that allows companies to transact in bitcoin as if it were a physical currency, without having to take custody and worry about hacking, lost keys or other headaches. The Cboe Options Exchange has plans to offer futures and options based on a bitcoin index, bypassing the need to trade bitcoin.
If acquiring and holding cryptocurrencies becomes easier for institutions we can expect to see more passive investment, which in turn could lead to higher and more stable prices. But LedgerX has the potential to do far more. It could attract traders hoping to profit on the volatility of cryptocurrencies, offering liquid markets, secure clearing, a menu of options and -- most important -- physical settlement. That could bring cryptocurrencies squarely into the conventional financial system.
This is good news for anyone wishing to own or trade cryptocurrencies, but may be bad news for bitcoin true believers because institutionalization threatens the decentralization, anonymity and inflation-protection that were the reasons for inventing the virtual money. It could be equally bad news for those who think cryptocurrencies are Ponzi schemes.
A bellwether for the potential mainstreaming of cryptocurrencies is the open-end unit investment trust GBTC. It trades like a stock, but holds only bitcoin. Throughout 2017 it has traded at a 60 percent to 120 percent premium to the bitcoin it owns. This presumably represents the additional value of having a regulated financial product with standard clearing and settlement terms. The premium was 100 percent at the end of September, but it has eroded over the last three weeks down to 25 percent. If LedgerX, or anyone, is able to make cryptocurrencies standard institutional holdings, the GBTC premium should shrink to zero. Therefore, the sharp decline in the GBTC premium suggests the market is betting cryptocurrencies are moving into conventional financial channels.
The next few months could be a crucial test for virtual money. How will LedgerX do, and what other new products are going to get approval? What will be the effect on liquidity and volatility? Will the institutional acceptability of a few big cryptocurrencies kill off the rest, or increase the frantic pace of introduction? Failing this test does not mean the end of cryptocurrencies, but would deal a blow to hopes that they can exist amicably alongside traditional assets anytime soon. The best advice I have is to fasten your seatbelts; it's going to be a bumpy ride.
In July, LedgerX became the first (and so far only) company to receive approval from the Commodities Futures Trading Commission to operate as a Swaps Execution Facility and Derivatives Clearing Organization for cryptocurrencies.
It is standard practice when dealing with a new trading venue to put through a minimal-size trade just to verify that the plumbing works on both ends.
Before LedgerX, if an institution wanted to assemble a portfolio of bitcoin to back a financial product, it would need to set up accounts with at least a dozen major exchanges that vary in their procedures, costs, terms and standards. Wiring money in can take days or even weeks, and getting money back is slower and not always certain. It can take minutes to get confirmation that an order has been submitted and more minutes to know if it has been filled. Trade sizes are typically small, bid/ask spreads wide and market impact high. In a financial organization based on millisecond trading and basis-point spreads, these sorts of uncertainties and delays gum up the works. Moreover, it's difficult to apply Know Your Customer and other compliance standards to many of these exchanges, and challenging to get valuations that satisfy auditors.
Through its Cumberland Mining subsidiary.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Aaron Brown is a former Managing Director and Head of Financial Market Research at AQR Capital Management. He is the author of "The Poker Face of Wall Street."
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