Bitcoin: Fake Asset or Security?

[This post on Bitcoin: Fake Asset or Security? was originally published on The Institutional Risk Analyst from R. Christopher Whalen.]

“I came of age on Wall Street when the Chairman of the Federal Reserve Board—he was William McChesney Martin — condemned even trace amounts of inflation as an economic and moral evil.  In the interval of 1960-65, there was not one year in which the CPI registered a year over year rise of as much as 2%.”
—Grant’s Interest Rate Observer

Below is my latest commentary on housing finance reform in American Banker, “Fannie, Freddie are irrelevant to a government-backed mortgage system.” I’ll be participating at the CoreLogic Risk Summit next week in Dana Point, California. Come say hello!

We’ve all heard of fake news, but consider the growing possibility of fake or at least virtual assets.  Investors face a deliberately orchestrated shortage of real investments c/o global central banks in markets such as stocks and real estate.

Is there any wonder that the financial engineers of Wall Street have again begun to manufacture new derivatives leveraging the real world?

Case in point, bitcoin.  The most recognized “digital currency,” bitcoin is a form of high-tech gaming instrument that fulfills just one of the traditional roles of money, but is among the world’s fastest appreciating – and most volatile– “asset” classes.

Adherents call the limited supply of bitcoin the ultimate expression of Milton Friedman style monetarist discipline.  They view the digital medium as a rational response to the fiscal and monetary chaos visible in most of the industrial nations.

But despite the huge gains seen in bitcoin vs conventional currencies, Jim Rickards says he’s sticking with his preferred investments: gold, cash and silver.  “I don’t own any bitcoin, but for those who have a preference for bitcoin, good luck,” he told Kitco News.

Bitcoin has been blessed by a federal regulatory agency in Washington.  “On Monday, a bitcoin options exchange called LedgerX won approval from the U.S Commodity Futures Trading Commission (CFTC) to clear bitcoin options, making it the first U.S. federally regulated platform of its kind,” reports The Wall Street Journal.

LedgerX’s chief executive Paul Chou is on the CFTC’s Technology Advisory Committee.  Not surprisingly, a CFTC spokeswoman said “no committee, including the Technology Advisory Committee, plays any role in any registration decision.”  OK.

Regardless of whether you view bitcoin as an investment or the electronic version of tulip bulbs, the fact of a traded options contract is intriguing.  It allows speculators to take a flutter on bitcoin without actually touching the ersatz currency or the varied folk who are said to traffic in this ethereal world.

To be fair, drug dealers, terrorists and members of organized crime organizations in nations like China, Russia and North Korea are not ideal counterparties for a US bank or fund.  But a US traded option contract may allow you to play the bitcoin game, pay your taxes, and sleep at night.  A lot of managers may find that degree of separation attractive.

Of note, less than 24 hours after the CFTC announcement, the Securities and Exchange Commission has declared that “tokens” such as bitcoin can be considered securities, and therefore, may be need to be registered unless a valid exemption applies,” Reuters reports.

“The innovative technology behind these virtual transactions does not exempt securities offerings and trading platforms from the regulatory framework designed to protect investors and the integrity of the markets,” said Stephanie Avakian, the co-director of the SEC’s enforcement division.

Part of the “problem” with bitcoin is that it is not easy for an individual to move in and out of the stateless, “offshore” market.  It will be interesting to see which financial institutions are willing to provide the infrastructure to allow a bitcoin options contract to settle in dollars and in size large enough to satiate institutional players.

But the more interesting question is how investors will deploy capital in this volatile and entirely opaque market.

The idea of an option on bitcoin certainly seems to have some utility.  Bitcoin may not be a store of value or a unit of account, but it serves that same purpose as the dollar in terms of acting as a means of exchange.  Like the dollar, bitcoin promises to pay, well, nothing, so the two moneys have rough equivalence in that regard.

Our guess is that a successful launch of the bitcoin option contract could significantly increase cash trading volumes, which will manifest in higher value vs traditional currencies.  But the real issue is how to gauge the ebb and flow of demand for the bitcoin tokens.

A large portion of the “float” in bitcoin cannot trade because the “owners” have lost their ID numbers, thus measuring how much supply is available to meet a given amount of demand is a challenge.

Additional bitcoin cannot be issued beyond the 21 million limit of the system, although the coins can be subdivided.  In the short run, the only variable that can change with demand is the spot price.

Also, high and sometimes variable settlement costs add to the complexity of trading bitcoin.  In many respects, a conventional option contract may be significantly more efficient than the cash market for bitcoin driven by the clunky blockchain technology.

While the news of the CFTC’s approval of the bitcoin options contracts may turn out to be good news for the digital currency, please note that our dim view of the blockchain clearing technology that enables bitcoin has not changed.

The Journal reports that CFTC Acting Chairman Christopher Giancarlo states publicly that he’s optimistic about blockchain technology’s future. We’d like to see him explain why, paying specific attention to operational efficiency and cost.

A derivative contract on a derivative digital currency has a lot more promise that the technological dead end known as blockchain.  To date, we have yet to see a single commercial application of what people call “blockchain” that has real commercial potential.  The same robust and expensive encryption technology that helps the bitcoin market ward off attempts at manipulation also makes blockchain unsuitable for other business uses.

As Saifedean Ammous wrote in American Banker last year:

“[D]espite banks’ attempts to test and use blockchain technology for their own commercial gain, it is outside the realm of possibility for the technology to serve any useful purpose for the intermediaries it was designed to replace. That is akin to burdening horses with engines in the name of technological innovation: the approach would only slow down the horse and alleviate none of its problems. Such a ridiculous notion will find no real world demand.”

In simple terms, blockchain is just a form of industrial grade encryption tied to a bulletin board for the public portion of the keys.  When it comes to clearing options contracts, the existing centralized technology solutions are far more attractive in terms of speed and cost.

Indeed, it will be interesting to see how LedgerX manages delivery of bitcoin as contracts expire or whether it will require cash settlement, as is customary with gaming instruments.

So let’s keep our eyes on this bitcoin options contract.  It promises to expose a far greater number of investors to this global gaming instrument. We suspect that the SEC is right when they refer to them as tokens, albeit ones that can only be settled electronically.

If bitcoin are eventually determined to be securities by the SEC, however, it both validates and changes the market forever.  With recognition comes regulation and reporting.

What the success of bitcoin says about the world of dollars, euros and yen is unsettling at a number of levels, but then again, bitcoin is ultimately just a brilliantly designed virtual market that, initially at least, promised security and anonymity.

Whether those qualities can endure as the audience grows is a very intriguing question that investors need to consider.

Christopher Whalen
for The Institutional Risk Analyst

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