This is the second of a three-part series exploring the building rivalry between cryptocurrencies and Wall Street. The first part is here.
A parallel financial system is forming outside the incumbent financial system, and institutional investors are “financializing” it as they enter. The new system is based on cryptocurrencies—natively-digital assets that are exclusively issued, traded and settled on open blockchains. Cryptocurrencies are not like other financial assets, so historical precedents provide little help in predicting their financialization path. And, at a fundamental level, is financialization even a good thing for cryptocurrencies? It’s a double-edged sword and the answer depends on how you define financialization.
Why Existing Financialization Precedents Don’t Apply to Cryptocurrencies
Cryptocurrencies are equity-based assets, which means they are no one’s liabilities—they are not IOUs, and they have no counterparties. Examples of other equity-based assets are land, physical commodities and personal property.
All other financial assets—with only one exception—are debt-based assets, which means the assets are simultaneously someone else’s liabilities. When you own a debt-based asset, someone owes it to you (and they might default).
The shares in your brokerage account, the deposits in your bank account, and even the dollar bills in your wallet are debt-based assets—IOUs. In these cases, you own an IOU from someone who owes you the underlying asset. Only financial assets that are issued as paper certificates are equity-based. If you possess the paper certificates for your stocks or bonds, you own them. If not, you own an IOU—not the actual stocks or bonds, which your broker owns and then owes to you. All forms of fiat money (dollars) and all securities held in brokerage accounts are debt-based assets.
Why does this distinction matter? It’s easy for the traditional financial system to financialize debt-based assets, but it’s not easy to financialize equity-based assets.
There are two reasons why the financial system can easily financialize debt-based assets: (1) the financial system controls whether to allow debt-based assets to be leveraged (since it holds title or a security interest in them), and (2) financial regulators permit leverage in the financial system—the piling of IOU upon IOU upon IOU on top of debt-based assets.
By contrast, financializing equity-based assets is not so simple because the financial system does not hold title to equity-based assets, and therefore does not control them. Owners of an equity-based asset must be willing to give up title to it, or pledge it, before a debt claim can be created on top of it (much less a daisy chain of debt claims created on top of it). An example is a landowner taking out a mortgage against the land—the land cannot be leveraged unless the landowner agrees to place a mortgage against it. Once that initial mortgage happens, the financial system can then “go to town” by piling multiple debt claims against the mortgage. But until the landowner first agrees to pledge the land, the financial system cannot financialize it.
Ponder this: How willing are cryptocurrency owners to pledge their cryptocurrencies (i.e., give up their private keys) to the financial system, thereby permitting creation of debt claims against them? Many cryptocurrency holders are long-term holders (“HODLers” in the parlance). Will HODLers permit the financialization of cryptocurrencies?
Two Ways to Look at Financialization—One Positive, One Negative
But wait a minute—am I implying financialization is bad? The term “financialization” has two different connotations, one positive and the other negative. In the positive sense, an asset class is “financialized” when it becomes investable by large institutional investors, which means it has become liquid and has sufficient history for institutional investors to invest.
By this definition, cryptocurrencies are already becoming financialized and that’s a big positive.
As evidence of this, major institutions invested in two multi-hundred million dollar cryptocurrency funds started in June by an ex-Sequoia partner and by Andreessen Horowitz, respectively. Additionally, daily liquidity in cryptocurrency markets is big enough for institutional investors, despite the sector’s recent price correction, as discussed in Part 1. Hedge funds and family offices are already involved, and mutual funds, such as Wellington, are preparing. And many service providers have recently hosted invitation-only discussions for institutional clients—publicly-confirmed examples include those servicing high-net worth investors (Alliance Bernstein), pension funds/endowments/foundations (Wilshire Consulting) and trading shops (Quantifi).
And here’s a big positive impact stemming from the good type of financialization: New investors in cryptocurrencies bring with them network effects—exponential network effects, actually—when they join cryptocurrency networks. This is what early bitcoin investor Trace Mayer means when he defines financialization as Bitcoin’s “sixth network effect.”
Why are cryptocurrency network effects exponential? Because most cryptocurrencies (by market value) are secured by a consensus mechanism through which new users increase network security when they join the networks, and this generally pushes up the price. Indeed, this is how proof-of-work cryptocurrencies work, by design. New users either add processing power to the network directly or another participant does so indirectly on their behalf. Such cryptocurrency networks are controlled by participants who dedicate computing resources to them, and all participants benefit when more computing resources enter the networks—by making the networks more secure, decentralized, resilient and immune to attack. Moreover, cryptocurrencies generally have low inflation rates that are set by algorithm, and participants have no incentive to agree to change the algorithm in a manner that dilutes their economic interest. Taken together, these design features create force-multiplying network effects.
Net-net, the good type of financialization is especially good for cryptocurrencies.
By contrast, new investors in debt-based assets do not bring force-multiplying network effects. New investors do bring network effects to debt-based asset markets, for sure, but they’re linear rather than exponential. New investors do not make debt-based assets more secure.
That brings us to the second—and negative—definition of financialization, which I’ll refer to as “leverage-based financialization.” This is the process of creating something out of nothing.
All debt-based assets always have a counterparty. The counterparty for most financial assets, directly or indirectly, is a centralized entity whose role is to issue and settle financial transactions—in the case of money, it’s the Federal Reserve, or in the case of securities, it’s the Depository Trust Company (DTC).
These central authorities have the power to (1) create more of the asset itself and/or (2) enable creation of debt claims (IOUs) on the asset itself, by not enforcing a 1-for-1 relationship between claims to the asset and the underlying asset itself. In the case of money, the Fed does both #1 and #2, with the help of banks. In the case of securities, the DTC does #2, with the help of securities custodians and prime brokers.
Leverage-based financialization, in other words, arises either from the issuance of more assets out of thin air to dilute existing holders, or from the creation of more claims to the asset than there are assets.
But here is a critical distinction: not all leverage is bad. One type of debt is good, but the other is bad.
The good type of debt is this: someone owns an asset and lends it, for example to a short-seller, so there's an actual asset backing each claim—even if that asset is debt-based. The bad type of debt is this: someone doesn't own the asset and still lends it anyway, so now more people believe they own the asset than there are actual assets.
It's a game of musical chairs—fun while it lasts, but eventually everyone realizes there isn't a chair for everyone and scrambles to grab one. Prices plunge as gains prove fleeting.
Leverage-based financialization—the process of creating something out of nothing—is ubiquitous in securities markets. A shocking example is the Dole Food case, in which 49.2 million valid claims were filed in a 2017 class action lawsuit for the 36.7 million shares of Dole Food outstanding. All 49.2 million claims were supported by valid brokerage statements. Yes, the financial system created 33% more real claims to Dole Food shares than there were Dole Food shares. This happens in securities markets every day, albeit not usually to this degree.
Bitcoin futures contracts that trade on the CBOE and CME are cash-settled. In other words, they do not require delivery of the underlying asset—bitcoin—and therefore do not create more claims to bitcoin than the quantity of bitcoin in existence.
Margin lending at cryptocurrency exchanges is happening, of course. But, so far, margin loans are generally more than 100% collateralized with coins held in digital escrow, and consequently these loans do not create unbacked claims to the coins.
But pressure for leverage-based financialization will build, and here’s the upshot: long-term HODLers of cryptocurrencies will naturally keep their coins out the reach of financializers (mostly in cold storage, disconnected from the Internet), while speculators are more likely to make their coins available to leverage-based financializers. HODLers will likely keep the upper hand in this tug-of-war, helped—ironically—by regulators and high price volatility. Here’s why.
Will Incumbents Be Able to “Capture” Cryptocurrencies?
Financial regulators were stung badly during the financial crisis of 2008 because they allowed the credit derivatives market to balloon during the years before the crisis, so much so that it dwarfed the size of the underlying corporate bond market. The credit derivatives market became the proverbial “tail that wagged the dog” as credit-default swaps grew to almost ten times the size of the underlying corporate bond market in 2008 and derivatives drove the price of the underlying asset.
In theory, this could happen to cryptocurrencies too—and this is probably the only way for incumbents to “capture” cryptocurrencies (since it is pretty much impossible at this point for anyone to gain control of Bitcoin and likely the other big cryptocurrency networks too).
Derivatives markets should be 1-to-1 connected to their underlying assets, but that’s not how financial markets work. Financial markets regularly create more claims to assets than underlying assets.
If the credit derivatives history were to repeat and cryptocurrency derivatives were to grow to a multiple of the underlying coins, incumbent financial institutions could de facto “capture” them by making the derivatives market the “tail that wags the dog.” In practice, though, this is unlikely. Banks’ capital requirements are higher today than they were in 2008. Moreover, regulators are not likely to allow a derivatives market to grow so big relative to underlying assets again, especially in an asset class that has high realized volatility (such as cryptocurrencies) and attracts a high capital requirement.
As cryptocurrency markets develop further, here’s what I’ll be on the lookout for: financial institutions beginning to create claims against cryptocurrencies that are not fully backed by the underlying coins (which could take the form of margin loans, coin lending/rehypothecation, coin-settled futures contracts, or ETFs that don’t 100% track the underlying coins at any given moment). None of these are happening in the market yet, though.
So far, regulators have only allowed bitcoin derivatives in cash-settled form. While cash-settled derivatives can affect the price of the underlying asset, the magnitude of the impact is lower than the impact if derivatives were settled in an underlying that is “hard to borrow” or “special” (using securities lending parlance). Bitcoin is especially “hard to borrow” so a requirement to deliver the underlying bitcoins into derivatives contracts would amplify bitcoin’s price fluctuations.
Eventually it’s likely regulators will approve bitcoin-settled derivatives. At that point, banks will be looking to borrow the underlying bitcoin—and that’s when the custodial arrangements made by institutional investors will start to matter. Will custodians make their custodied coins available for borrowing in “coin lending markets” as they do with securities lending today? Or will they deem the cybersecurity risks of lending coins (which entails revealing private keys) too high relative to the extra return available for coin lending? And will institutional investors even allow coin lending by their custodians? Regardless, when bitcoin-settled derivatives appear on the scene, it’s very likely that cryptocurrencies will be “hard to borrow” for quite some time because HODLers own most coins and rarely use custodians.
As mentioned in Part 1, the lack of a “qualified custodian” of cryptocurrencies—which the SEC requires for registered investment advisors managing more than $150 million—is a big barrier to the entry of pension funds and mutual funds into cryptocurrency markets. Many smart players are working on this issue. When it is solved, it remains to be seen whether custodians will develop a leveraged “coin lending market” akin to the securities lending market—and that, plus regulations and capital charges, will determine how much leverage-based financialization creeps into cryptocurrencies.
Liquidity arising from the good type of financialization is a big positive for cryptocurrencies, and it comes both from new investors entering the market and coin lending arrangements backed 100% by the underlying. By design, most cryptocurrencies (by market value) become stronger and more immune to attack as more entrants join the networks. These force-multiplying network effects have already proven powerful to early entrants.
But liquidity arising from leverage-based financialization—which creates claims to cryptocurrencies out of thin air—is the opposite side of the double-edged sword. Cryptocurrency speculators will encourage this because it can drive short-term gains, but long-term HODLers will resist it simply by keeping their coins away from the financial system.
Accordingly, more of the good type of financialization is likely to occur in cryptocurrency markets than the bad type. This means alpha (excess return) opportunities may be available to institutional investors. It also means Wall Street is unlikely to succeed at “capturing” cryptocurrencies.
The final post of this three-part series will examine incumbents’ enterprise blockchain projects. Will incumbents succeed at fixing the existing financial system, or will the new parallel system—based on cryptocurrencies—outflank them?
This post is intended for educational purposes only and should not be construed as investment advice.