This is the third of a three-part series exploring the building rivalry between cryptocurrencies and Wall Street. The first two parts are here and here, and an interim post about the ICE news is here. A ten-ton gorilla just entered the room and it sent everyone scrambling. ICE, parent of the New York Stock Exchange, is entering the bitcoin/cryptocurrency business both institutionally and for retail payments. ICE’s move throws a curve ball at the crypto industry and Wall Street incumbents alike. So now what? And what does this imply about Wall Street’s enterprise blockchain projects, now that a giant infrastructure player has embraced cryptocurrencies for trading, clearing and settling transactions?
In Part 2 of this series, I’d predicted that Wall Street would try to co-opt cryptocurrencies the only way it possibly could, which is to financialize them by creating layers of debt-based, off-chain claims against them and two days later, that happened.
The killer app for blockchain on Wall Street was always to migrate over to natively-digital blockchain assets and away from assets owned indirectly (currently, the DTC owns nearly all securities in omnibus accounts and what’s in our brokerage accounts are IOUs owed to us by a chain of leveraged financial institutions, not real stocks and bonds). Plus, Wall Street’s ledger systems aren’t in sync. That’s how situations like Dole Food happen—where Wall Street’s ledgers created 33% more shares than actually existed. There’s no excuse for this, ever. The solution is to scrap the old structure and use natively-digital assets that are issued, traded and settled on a blockchain.
ICE broke the seal. Natively-digital blockchain assets are coming to Wall Street. That’s a very big deal.
ICE’s move renders many of Wall Street’s enterprise blockchain projects obsolete because most (though not all) such projects are trying to tokenize financial instruments already issued. ICE leaped over tokenization and went straight to natively-digital. A natively-digital blockchain asset is issued at its genesis moment on a blockchain, and consequently would never need to be tokenized. Moreover, most enterprise blockchains are using insecure base layers (“blockchain-inspired” systems). ICE is now embracing the real thing a secure base layer, a true blockchain. It’s not possible to build secure applications on top of an insecure base layer, but it is possible to build secure (or insecure) applications on top of a secure base layer. ICE chose right by embracing true blockchains.
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, thereby suppressing bitcoin’s price. Indeed, this may be why bitcoin’s price dropped after the ICE announcement on Friday.
Aside from suppressing bitcoin’s price by boosting supply via off-chain bitcoin substitutes, there’s another risk to fractionally-reserved bitcoin. ICE itself is taking substantial credit risk and passing on that credit risk to any customers exposed to fractionally-reserved bitcoins, as well as to its existing customers whose collateral is commingled in the ICE clearinghouse.
Why? It’s critical to understand the counterparty credit risk implications of fractionally-reserved, off-chain cryptocurrencies, both for the issuers of such instruments and investors exposed to them. Again, fractionally-reserved bitcoins are bitcoin-claims created off-chain that aren’t 100% digitally escrowed with real on-chain bitcoins. As explained in detail in Part 2, bitcoin is an equity-based asset that Wall Street cannot control directly—bitcoin has no lender of last resort—so loss severity for fractionally-reserved cryptocurrencies (aka cryptocurrency substitutes) will be much higher than normal in run-on-the-bank stress scenarios. Holders of on-chain bitcoins would benefit from a short-squeeze in such scenarios, but anyone exposed to fractionally-reserved, off-chain bitcoins would incur high loss severity.
Again, ICE’s announcement is a double-edged sword. There’s a lot that’s good, and a lot that’s not. So, what’s next? Here are some thoughts: “Real money” institutional investors pension funds, mutual funds, endowments, foundations and insurance companies will, in some cases, quickly start revising investment guidelines to permit asset managers to buy cryptocurrencies, guided through the process by their investment consultants who are coming up to speed lightning fast;
Corporate issuers will turn to cryptocurrency capital markets in a big way, as a means by which to raise cheap capital (preference-free and covenant-free, as discussed in Part 1), and this will probably happen in bond markets first;
ICE will likely become the dominant listing and trading venue for these corporate coins (also called security tokens or utility tokens). The migration will happen first in bond markets, and this ties nicely into ICE’s leadership in “electronifying” bond markets. I expect issuance of a natively-digital blockchain bond to happen as soon as year-end. Over time, corporate coins may become ICE’s most profitable business as corporate securities migrate toward issuance in natively-digital blockchain form, which is issuer-friendly and investor-friendly (as discussed in Part 1). ICE has a huge first-mover advantage;
Investment banks are already scrambling to hire cryptocurrency teams. In a twist of irony, almost every investment bank pushed out their early cryptocurrency experts and they’re all behind the curve (except Goldman Sachs). Their capital markets competitors the firms specializing in crypto advisory, structuring and research for coin issuance will rise in relative prominence within capital markets, as investment banks are not well-positioned to structure and build technology for coin offerings;
The shortage of top-notch developers with Bitcoin and Ethereum skills will become even more acute as institutions rush to hire them;
Risk officers are likely re-open counterparty-credit and cybersecurity risk reviews of ICE Clearing US, which is guaranteeing all physically-settled bitcoin futures trades, worried that ICE Clearing US may become the biggest “honeypot” for cryptocurrency hackers. ICE describes this entity as its “central counterparty for all ICE cleared forex futures trades.” In other words, ICE is not creating a separate clearinghouse for cryptocurrencies and is instead commingling them with other asset types in ICE Clearing US, which is one of ICE’s smaller existing clearinghouses (see Bakkt’s disclosure here);
Investment fiduciaries and their consultants will quickly become experts in custody risk not just in cryptocurrency custody risk, but in all custody risk. Fiduciaries have been complacent about custody risk for years, but cryptocurrency custody is a different animal and they will learn a lot by digging into it and start applying that knowledge to securities too (i.e., what really happens to securities commingled in omnibus accounts, what are the real economics of stock loan, and how many times collateral is really rehypothecated by central counterparties). Fiduciaries will end up tightening the terms of custody arrangements as a result, and that’s a very good thing.
Customers of cryptocurrency custodians will clarify upfront how the custodian will handle cryptocurrency forks, airdrops and the like. These are akin to dividends of coins and loosely analogous to stock splits or stock dividends, except that they can come out of nowhere so if a pension fund is storing coins in a custodian’s omnibus account, its auditors may not even be able to trace how many new coins to which the fund was entitled. This is one of many reasons why omnibus accounts make little sense for institutional custody of cryptocurrencies;
Along these lines, investment fiduciaries and their consultants should ask potential cryptocurrency custodians about multi-sig, HD wallets, time locks, qualified custodianship and cold storage protections that I suspect institutional investors may not even know to ask for, but which all fiduciaries should explore as a best practice in crypto custody.
Here are a few thoughts about regulatory impacts.
The biggest loser from ICE’s announcement is the State of Delaware, which is the dominant state for corporate registrations, along with its registered agents and corporate law firms. Why? Because ICE’s announcement makes it clear Wall Street is moving toward natively-digital assets as the preferred instrument for capital raising. Delaware had a big head start and squandered it the State had been moving toward registration of natively-digital assets under its previous governor, Jack Markell, from 2016 until his term ended in 2017 but, under pressure from incumbents, Delaware slowed down the Delaware Blockchain Initiative after the change of administration, and its Secretary of State has not yet integrated with any blockchain nearly two and a half years later. Like investment banks, the State of Delaware is behind. The ICO market proves companies can raise institutional-size capital by issuing asset-backed tokens regardless of where the company itself is registered, which renders Delaware’s typical advantages mostly moot. Companies can now register wherever it’s cheapest to do so and issue asset-backed coins from any domicile;
For the SEC, ICE will likely become the first “qualified custodian” of cryptocurrency assets. Under the SEC’s custody rule, in general, investment advisors who take responsibility for client assets must segregate them using an independent “qualified custodian.” As with some other SEC rules, blockchain technology has moved the goalposts because it is so different than traditional technology. For example, natively-digital assets never leave a blockchain their ownership merely changes hands so there’s no need to safeguard assets by segregating them (and they can’t actually be segregated anyway, as only their private keys can be segregated). Regulators, auditors and portfolio managers can easily track assets on a blockchain without exposing the owners’ private keys. But requiring a third party to hold the owners’ private keys introduces cybersecurity risk where it would not otherwise exist. Cryptocurrencies are digital bearer assets, and whoever controls the private keys owns the asset. Owing to this, it is critical to update of U.S. securities laws to broaden the definition of “qualified custodian” to include a blockchain itself.
Short of this, the SEC and CFTC should beware of the heightened risks with allowing clearinghouses, custodians and warehouses to hold cryptocurrencies in omnibus accounts. They instantly become “honeypots” for hackers. Cryptocurrencies are bearer instruments and entail much greater cybersecurity risks than other types of assets held in omnibus accounts, so there’s heightened reason to require client segregation to protect the regulated institution’s solvency.
WARNING: Earlier, I covered the high loss-severity potential for anyone exposed to fractionally-reserved, off-chain bitcoins during a run-on-the-bank scenario, but there’s an even bigger risk for the CFTC and SEC to consider. Anyone exposed to fractionally-reserved bitcoins—again, these are off-chain substitutes for bitcoin that aren’t 100% digitally-escrowed by real bitcoins on-chain are at major risk to a fork of the chain. In such a scenario, any party that rehypothecated, naked shorted, or has any other type of uncovered liability (in margin loans or ETFs, for example) is vulnerable to go broke. Why? Because such a firm would still owe the liability but have little asset value, since asset value would migrate to the forked coin and no off-chain substitutes would receive any of the forked coins. Bitcoin’s long-term holders (“HODLers”) already have big incentives to keep bitcoin “hard to borrow.” But, as bitcoin’s price is increasingly suppressed by creation of more and more off-chain, fractionally-reserved bitcoins, the network’s full-node participants have a bigger and bigger incentive to fork the chain and force a short squeeze a permanent one that could bankrupt exposed institutions.
Just as bitcoin changed the conversation about money the phrase “fiat money” is now mainstream ICE’s entry into cryptocurrencies changes the conversation about how Wall Street really works. It will shed light on the reality that Wall Street makes a lot of money by creating paper claims to assets in quantities that exceed the underlying assets (e.g., the Dole Food case, in which brokerage statements showed people owned 49.2 million shares but only 36.7 million shares were outstanding and this is far from unique). Regular folks will increasingly realize that leverage-based financialization is the direct cause of unstable and unfair financial markets bull/bear markets of growing amplitude, and ever-increasing inequality as the rich get richer but the poor are left behind. And, as “real money” institutional investors pension funds, mutual funds, insurers dig into this new asset class and learn how to custody it, they may realize how much they’ve been on the losing end of securities lending and rehypothecation practices. Let’s hope they tighten existing custody and collateral arrangements for securities too.