The cryptocurrency ecosystem is poised for a major overhaul.
Goldman Sachs, the investment bank which has blown hot and cold over bitcoin in recent times, finally confirmed its intentions to enter bitcoin trading last week. In an interview with the New York Times, Rana Yared, Goldman’s managing director of securities, said the firm would begin trading bitcoin in “the next few weeks”. Yared claims to be a bitcoin skeptic and said the firm is entering the industry with “its eyes open”. Separately, NYSE owner Intercontinental Exchange (ICE) is also reportedly developing one-day physically settled swap operations, which are essentially CFTC-blessed futures contracts.
While individual investors have warmed up to the idea of bitcoin investing in the last year, institutional ones have largely stayed away from the cryptocurrency. A survey earlier this year found that institutional investors have yet to commit funds for bitcoin or cryptocurrency investing. Their concerns are mainly focused on its utility and security after a spate of hacks and scandals. Scathing criticism from prominent individuals and regulators hasn’t helped matters either.
But the recent set of announcements could prove to be a turning point for the cryptocurrency industry in more ways than one.
A Change In Infrastructure
Apart from increasing the liquidity profile for cryptocurrency markets, derivatives contracts could also provide a boost to the existing infrastructure in cryptocurrency ecosystem. Nolan Bauerle, research director at Coindesk, said that Goldman’s selection of a crypto-native architecture or firm for its trading operations would be “a tremendous signal to the industry.” According to him, cryptocurrency exchanges are a “weak point” in the industry because they do not have the features required for sophisticated trading operations, such as handling of derivative contracts.
The entry of Goldman Sachs, which possesses enormous heft and clout in the financial services industry, could prove to be the necessary trigger for crypto exchanges to develop features for catering to new clients.
As an example, Wesley Hansen, Director of Trading Operations at The Crypto Company, identifies the lack of trading operations as a key drawback of the existing ecosystem.
“Complexity of order types is absent,” he says, adding that current infrastructure is geared towards investors interested in buying and holding cryptocurrencies, as opposed to volume traders who rapidly shift in and out of their positions. “Currently I have to wait for the order to complete, wait for it to cycle out (before placing another order),” he explains. This presents another problem. “Right now, anyone who trades more than a few times has to dump all their trades in an Excel sheet and calculate average costs there,” he says.
Part of the reason for this problem is the absence of a trader perspective. Traders who move positions rapidly did not contribute to development of infrastructure for trading cryptocurrencies and developers have a different perspective , he explains. To that end, Hansen also predicts a consolidation among cryptocurrency exchanges in the near future. In fact, he says the crypto problem is not about the absence of liquidity but about that liquidity being spread out between “100 different exchanges, centralized and decentralized.” A consolidation of exchanges will also agglomerate liquidity and make investment more attractive for institutional investors, he says.
Are New Derivative Contracts On The Way?
But the bigger consequence to the current ecosystem may lie in development of new forms and types of derivative contracts and hedging strategies. As mentioned earlier, ICE is already thinking beyond futures contracts and is working on swaps. Bauerle from Coindesk says hedging strategies between outfits based in different geographies might also prove to be an attractive proposition for trading firms. Specifically, he pointed to the arbitrage opportunities between LedgerX, a US-based firm which received CFTC permission last year to trade derivatives contracts, and BitMEX, a Hong Kong-based operation. LedgerX, several of whose senior executives are Goldman alum, recently reported a seven-fold bump in trading activity while BitMEX had a trading turnover of approximately $2.9 billion, as of this writing. It announced a new cryptocurrency options product on the last day of April. “There’s a certain type of sophistication that has emerged on the BitMEX platform (after years of arbitraging between markets in America and China),” says Bauerle.
Hansen from The Crypto Company posits that traders will soon “get bored” of existing options and contracts. As a result, options and contracts for other cryptocurrencies, such as ethereum and litecoin, will soon enter the market. Consensys, a smart contract development firm, recently inked an agreement with TrueEx to develop a benchmark price for ether and “the infrastructure needed for the broad adoption of digital assets by the institutional community.”
The Custody Problem
The other big change within the cryptocurrency ecosystem could be the evolution of custodial services for bitcoin as important players in the cryptocurrency ecosystem. Goldman has indicated that it will begin trading in non-custodial forward futures contracts. But Bauerle says that holding physical bitcoin might become “seductive” for them once they’ve had some experience with the contracts. Unlike cryptocurrency exchanges, which have mushroomed across the ecosystem, there are relatively few custody services. ICE’s swap options may involve actual physical ownership of bitcoin. According to Bauerle, the multisignature wallets and liquidity policy (or their policy regarding the percentage of overall holdings kept away from the Internet) are key to evaluating custody services. “It will be a crash course in bitcoin for them (Goldman and other institutional players) if they take custody services route,” he said.