Derivatives: Will Institutional Investors Put The Digital Market in A Debt Hole

We continue the topic of traditional financial institutions on the digital market that are beginning to develop their products and services with virtual assets. Earlier, we wrote about central banks and the goals they pursue launching national digital currencies. Now it is time to talk about banks and stock exchanges that offer digital derivatives.

On the 10th of September it was reported that the international financial conglomerate Citigroup is developing a new mechanism for trading the most popular virtual currency. Acting as an agent, the bank will issue so-called digital asset receipts (DARs), which will allow clients to invest in Bitcoin directly while eliminating the necessity to own and store the underlying coins on their accounts. The new digital product is conceptually similar to the American depositary receipt (ADR), the largest issuer of which is Citigroup.

The underlying assets of ADRs are shares of the foreign companies that are not traded on the US stock exchanges and OTC trading platforms. An investor receives a receipt while American depositary stores the shares of foreign companies.

In the case of DARs, a separate custodial service will be engaged in coins storage while clearing will be performed by Depository Trust & Clearing Corp (DTCC), which as an intermediary carries out payments on Wall Street. The corporation's involvement in this project will undoubtedly contribute to the DAR popularity since investors will be able to track their investments in the system they are accustomed to.

Despite a long bearish trend financial institutions are actively developing new financial derivatives with digital currencies and Citigroup is not the only one. Chicago stock exchanges CME and CBOE launched Bitcoin futures in the winter of 2017. Contrary to all rumors Goldman Sachs continues to work on a non-deliverable forward, and Morgan Stanley plans to offer its customers the opportunity to take short and long positions using the so-called price return swaps.

The interest of financial institutions in derivatives is facilitated by the opportunity to attract new customers, expand the range of products & services offered to existing clients, charge fees for derivatives transactions. Chief Investment Officer at Arcadia Crypto Ventures Nithin EAPEN believes that financial institutions will come up with other derivatives with the virtual underlying: “It is the natural evolution and it is a method of risk transfer. Some of these instruments like options and insurance products will be developed as smart contracts without the need of a financial institution as a middle man”.

In the traditional financial space, the main opportunity derivatives provide to investors is hedging the risk of price fluctuations. This advantage is relevant for the digital sector, that is constantly facing the problem of high volatility. In accordance with Coinmarketcap, the main virtual currency lost 63% of its value in less than two months from the 17th of December in 2017 to the 7th of February in 2018 - the rate dropped from $19,536 to $7,387.

Such price fluctuations attract speculators and traders but can discourage investors, who are interested in strategic investments on the long term, from entering the market. Those investors for the most part are institutions and holders of large capital. The emergence of derivatives will transform the digital market into a more attractive investment environment for them.

Derivatives solve the problem with keeping and storage of electronic coins in private wallets, which are subject to hacking attacks that happen quite frequently. In the case of derivatives, digital assets will be stored in qualified depositories and specialized custodial services, which stand out with their high level of security.

What is more, the DLT industry remains a relatively unregulated sphere of the economy, and this uncertainty cannot but worry serious investors. Derivatives can accelerate the institutionalization process of the digital market and thus contribute to greater transparency in pricing. Meanwhile, such hedging instruments will support the establishment of insurance and arbitration institutions, both of which are fundamental for traditional financial players. Gianluca GIANCOLA, co-founder of one DLT-ecosystems, believes that derivatives, which are more tightly regulated than digital currencies, should help to decrease the volatility as the market matures.

"Crypto community will benefit with more players coming into it and increasing liquidity. That will enable easy transfer of risk without price slippage”, - say Mr. EAPEN. In his opinion, newer digital institutions like Coinbase and Binance will support derivatives introduction to the market while older giants, who missed the boat and opportunity to acquire new clients, like TD Ameritrade, will spread FUD and insist on the unreliable and fraudulent nature of such instruments, putting psychological pressure on investors.

Diversification of derivatives offer may find its logical continuation in Bitcoin-ETF approval. Despite of the fact that the SEC rejects incoming applications, the US Securities and Exchange Commission does not deny the possibility of the asset to be introduced to the market in the future, so the asset legalization is a matter of time. “The ETF's will eventually be approved. The genie is out of the bottle, this is an asset class and there is nothing stopping that. The regulators want control over the underlying. They are equating this like equities or bonds but this is a beast on it's own and it cannot be tamed by central authorities with their rules. If they are late, automated contracts will develop and financial institutions will miss the chance being the servicer in this business”, - said Mr. EAPEN.

But not all the members of the digital community are willing to see the ETF obtain legal validity. For instance, the institutional hedge fund consultant and Bitcoin early adopter Michael GRAUB hopes that ETF will be delayed as long as possible, although he admits that a minority in the Bitcoin World supports this position. “The reason is that Bitcoin doesn’t need Wall Street, Wall Street needs Bitcoin.  Wall Street is only interesting in trading the spread to make fees. They will attempt to have products which are derivatives and probably will succeed in the short term but eventually owners of these derivatives will realize that they actually don’t own physical Bitcoin but paper Bitcoin and will fail. The whole purpose of Bitcoin is to be your own Sovereign Bank free from any censorship”, -  the expert insists.

At first glance this financial instrument seems an attractive investment, however, it has a second side of the coin. Almost every derivative, except options, which give the right, contains an obligation to buy or sell a product. In the ideal, each financial liability should be secured by real assets.

However, practice shows that security often does not cover a tenth of the debt. During the mortgage crisis in 2008 the investment bank Lehman Brothers went bankrupt due to high leverage - the ratio of borrowed funds to equity amounted to 31 to 1 in 2007. The bank held the majority of assets in mortgage-backed securities and mortgage derivatives. Moreover, at the time of default, the bank was a major counterparty on the market of credit default swaps (CDS). After the announcement of the bank's bankruptcy payments on the bank's CDS positions amounted to $5.2 bln, which is 7.2% of the gross volume of the bank positions estimated at $72 bln by DTCC.

 

The derivative financial instruments were one of the triggers of the financial collapse in 2008 when the notional amount of derivatives increased close to mindblowing $600 trln. Real assets with a $600 bln value provided coverage of only 0.001% of derivative debts.

Michael GRAUB has every reason to be concerned about the Wall Street players entrance as they are the main holders and investors in derivatives in the traditional financial space, which means that part of their investments in the digital industry will be made at the expense of their borrowed capital.

In other words there may be a situation when a part of financial liabilities on the digital market will be secured not so much by virtual coins as by other debt obligations, which will build a tight correlation between the hitherto independent digital space and the traditional financial industry.

Co-founder and CTO of Blockchain Training Alliance Ernesto LEE notes: “Derivatives are essentially a hedge or a way of "selling risk" in an asset while tying it to another asset. Therefore, by introducing this financial vehicle into the cryptocurrency economy you are also introducing the associated risk. This risk has a natural "built-in" contagion potential because derivatives tie assets together and therefore a collapse of one negatively impacts others. The fact that cryptocurrency derivatives are largely unregulated only exacerbates the risk”.

The expert also adds that the DLT technology, that is at the heart of digital assets, provides a solution to the problem of trust in transactions with virtual currencies, but not in derivatives, which can cause a rise in speculation and frauds. As a result, the digital market may turn into a bubble considering a limited supply of Bitcoin and a large number of unsecured debt.

Now it is quite difficult to assess whether the new investment instrument will bring more benefit or harm to the digital community. Big money of big investors will come along with their debts. Time will tell if Bitcoin is able to balance them.