Blockchain and capital markets: foreign exchange trading

FX market

For something so little talked about, the foreign exchange (FX) market is a big deal.

The world’s largest and most liquid financial market, over $5tn a day changes hands in FX cash and derivative transactions. That’s more than the entire annual GDP of some countries.

The bulk of transactions are for FX derivatives, and few appreciate how integral these are to the functioning of the world economy. In terms of value, FX swaps are the most traded instrument in the world, exchanging an average of $2.4tn per day. When a central bank, commercial bank, corporation or fund manager needs a foreign currency for a purchase, an investment or a hedge, they generally resort to FX swaps – basically, they lend their domestic currency to foreign institutions, and simultaneously borrow from them the currency they need. This works out to be much cheaper and faster than directly borrowing the money in another country. In principle, the collateral for each side is the payment (or series of payments) they commit to making to the other.

As with most derivative markets, the system is clunky and relatively expensive, operating on dispersed, decentralized exchanges with duplicate processes, a lack of standardisation, an emphasis on direct relationships and increasing capital requirements. Although the infrastructure has radically improved over the past few years with the introduction of new trading venues, greater liquidity, algorithmic execution and improved data aggregation, the industry still regards settlement risk as one of its greatest threats.

New technologies and processes are making a difference, and are becoming even more essential in light changing regulation and increasing costs. Clearing houses are becoming even more important, for example, and traditionally opaque over-the-counter markets are being given a welcome (but expensive) wash of sunlight as post-crisis financial regulation demands greater transparency and less risk.

Given the decreasing profitability of swap market making (due to greater capital requirements and a recent slump in volume due to macroeconomic conditions), many prime brokers are either pulling out of the sector or closing out smaller clients, leading to lower liquidity and increased risk. This encourages even more prime brokers to pull out. Non-bank dealers and infrastructure innovations are picking up some of the slack.

Several capital markets businesses – both startups and incumbents – are looking at how blockchain technology can help reduce operating costs.

One of the most prominent is Cobalt, a startup working on a blockchain platform for FX post-trade settlement which it claims can reduce risk and cut costs by 80% (according to the FT, banks currently spend about $500m a year on technology for currency trading). In May, it announced that two of the world’s largest FX traders – Citadel Securities and XTX Markets – will use its service. They join 22 other banks and traders, including Deutsche Bank, UBS, BNP Paribas and Bank of America Merrill Lynch, in testing the platform ahead of a launch expected later this year.

While Cobalt is currently building on a blockchain platform designed by UK-based startup SETL, it aims to be ledger agnostic. The startup cites Tradepoint (a foreign exchange trading technology provider), First Derivatives (a database technology developer, which will apparently feed the data) and Kx (focused on high-speed data processing) as tech partners, and counts CitiGroup (which has the lion’s share of the global FX market) and DCG among its investors.

From startup to industry incumbent… NEX Group (formerly ICAP) has been working on a distributed ledger for FX trades – called Nex Infinity – built with technology from New York-based startup Axoni. The company recently began allowing clients to test the platform.

This makeover is a key part of the company’s strategy as it moves away from its history as one of the market’s leading interdealer brokers and into trading infrastructure. Its subsidiary Traiana will most likely end up playing an important role in the rollout of NEX Infinity, as it is one of the market’s leading post-trade and risk specialists. (As an aside, the founder and CEO of Cobalt – Andy Coyne – used to be CEO of Traiana.)

And, moving up the ladder, CLS Group – the world’s largest FX settlement service (handling over 50% of global FX transactions) – is working on CLS Netting, a blockchain-based settlement system for trades in currencies outside the standard service. The platform won’t be used in the core settlement system, but rather to improve liquidity in other currencies with more challenging legal frameworks that are currently settled on a bilateral basis, such as the renminbi and the rouble.

CLS is a founding member of blockchain consortium Hyperledger, and the platform is being built on Hyperledger Fabric. Several banks – including Bank of America, Goldman Sachs, Citi, JPMorgan Chase, Morgan Stanley, HSBC, Bank of China (Hong Kong), Bank of Tokyo-Mitsubishi UFJ, FirstRand and Intesa Sanpaolo – have expressed an interest in participating. Not bad for a fledgling project. Development is expected to near completion in early 2018.

The FX market is not an easy one to disrupt, even though the opportunity is obvious. First, scale matters – small startups, unless they have influential backers, are at a disadvantage in a sector in which most participants know each other, and trust is an important factor. What’s more, the incumbents increasingly seem to be aware of the potential of blockchain technology, as well as the need to innovate.

Second, the spectre of tightening regulation and the impact of macroeconomic trends add risk to the outlook for any foreign exchange project, for both startups and incumbents. FX volumes have been declining for a couple of years, although the slump has been concentrated in the spot market – derivatives are growing nicely, for now.

The next 12 months should see some key announcements in the nexus between blockchain technology and FX trading, as projects mature and more proofs-of-concept emerge. As regulations change, economic trends realign and even newer technologies develop, the market will continue to evolve towards a more efficient, transparent and trustworthy financial service. We are witnessing what will be looked back on as a fundamental shift in capital markets.

Blockchain and capital markets: equity swaps

by Jan Vasek, via StockSnap
by Jan Vasek, via StockSnap

The world of capital markets is littered with terms that sound simple on the surface, but thoroughly confusing once you start poking at them.

Take, for instance, “equity swaps”. Easy, you swap equities with someone else, right?

It turns out that you don’t swap equities. You swap the returns that the other party’s equities give. That way you can diversify your portfolio without having to actually sell underlying holdings. Selling large holdings incurs costs and can move the market, which you probably want to avoid. Or, maybe your fund’s bylaws prohibit you from doing so. Or, maybe you would rather avoid capital gains tax. Other possible advantages include retention of voting rights (you want to retain your holding in a company but would rather have a fixed dividend than a variable one), access to illiquid markets, or being able to legally go around holding restrictions (eg. limitations on foreign funds).

So, let’s imagine you have a holding that pays you a fixed rate, the same payment every year. But you would rather a variable one. Rather than sell your fixed rate security, you enter into a swap with another party that has a holding that pays (for example) the return on the S&P 500 stock index. They are tired of so much volatility and want something more stable (or maybe they have fixed payments coming up and need to lock in those receipts).

So the two of you enter into a swap – you get the other party’s payments from their security, they get yours.

Now, just imagine the complicated and duplicated paperwork that backs up this operation.

Digitisation helps, obviously. Traiana, founded in 2000 to provide pre-trade risk assessment and post-trade solutions, is the market leader in electronic processing of over-the-counter (OTC) swap trades. It connects derivatives exchanges, institutional investors, interdealer brokers and swap execution platforms, channelling trades to clearing houses and providing analytics.

It is owned mainly by the Nex Group (formerly ICAP Ltd.), which at one stage was the world’s largest interdealer broker for OTC trading with daily transaction volume of over $2.3tn. After a tumultuous few years (which included whopping fines from the Commodities Futures Trading Commission in the US and the UK’s Financial Conduct Authority), that division was sold at the end of 2016, and Nex now focuses on market infrastructure.

Traiana counts among its investors such blue-chip firms as Bank of America Merrill Lynch, Barclays, Citigroup, Deutsche Bank, JP Morgan, Nomura, and the Royal Bank of Scotland.

Yet in spite of the presence of a clear market leader, the sector does not have a common infrastructure, leading to costly data reconciliation.

Could equity swaps benefit from blockchain technology? That’s what New York-based startup Axoni is hoping to determine.

Last year it completed a trial involving nine market firms, including Barclays, Credit Suisse, IHS Markit and Capco (a capital markets consultancy owned by FIS), as well as shareholders Citigroup and Thomson Reuters. The project established a blockchain processing network for equity swap trades using Axoni’s proprietary distributed ledger software.

One interesting aspect is the involvement of Traiana competitor IHS Markit in the trial. One of Axoni’s investors is Euclid Opportunities, the investment arm of Traiana’s parent Nex, and the two firms also both have Citigroup and JP Morgan as investors.

Although it worked with IHS Markit in this trial, Axoni has collaborated with Traiana on other projects in the past, such as a securities post-trade prototype in early 2016 and a foreign exchange one currently under development.

Could there perhaps be industry consolidation further down the line?

While equity swaps are a small part of the global OTC derivatives market, they could be considered the “low hanging fruit” of the sector for capital markets blockchain integration. The processes are complex, and the market is distributed and fragmented. What’s more, changing regulation calls for increased transparency and reporting. Coherence and coordination will benefit all participants, adding liquidity while reducing costs.

A blockchain-based platform would have the additional advantage of scalability, perhaps also including other types of swaps and offering even further efficiencies to market participants.

While blockchain exploration is ongoing in other areas of capital markets, Axoni’s equity swaps test is an interesting snapshot of a concrete use case. Furthermore, it points to how the sector will be restructured: carefully, one application at a time.

(This is the first in a series on the potential impact of blockchain technology on capital markets. Up next: FX.)

Could Brexit encourage blockchain development?

by Rob Bye via Stocksnap
by Rob Bye via Stocksnap

The FT reported yesterday on the intensifying staring match between the EU and the UK over financial services.

London has for some time been in danger of losing its position as the world’s clearing center for euro-denominated derivatives. The city’s clearing houses handle up to three-quarters of the global euro-denominated derivatives market.

The European Central Bank (ECB) has long argued that oversight of euro clearing services would be easier if they were relocated to within the Eurozone, and in 2011 issued a policy reflecting this. The UK took the case to the European Court, which eventually sided with the UK. The reason given was not because geographical restrictions would discriminate against some member states (the UK’s main argument), but because the ECB’s role is to supervise payment systems, not securities settlement. The ECB still alleges that settlement oversight is essential for payment system stability.

Now that Britain will soon no longer be an EU member, the battle lines are shifting. The European Commission (EC) is preparing legislation for June that will impose geographical restrictions on euro-based clearing. An interesting twist is that the EC is not waiting until Brexit becomes a reality.

The policy, due for publication tomorrow, moves to extend the ECB’s role to include supervision of clearing houses if they provide “critical capital market functions” (such as derivatives swaps). If this goes ahead, it will mean that either the activity needs to relocate, or the UK has to allow ECB supervision on British territory (which it’s unlikely to be happy with).

If the activity has to relocate, the fallout will be considerable, and the impact could be felt around the world. Euro-denominated derivatives clearing accounts for about one third of the global interest rate swaps market.

It’s probable that some clearing houses will prefer to wind down than move (CME Group recently decided to pull out of London due to lack of profitability). The larger ones may find that they lose clients. Either would be enough to contract medium-term liquidity in the market.

Short-term, the potential problem is more serious. Clearing houses reduce liquidity risk in financial markets by standing between two traders in a transaction. They also increase transparency by being in a position to publish the price at which a trade executed.

Disrupt those functions, or even temporarily interrupt them, and you increase systemic risk. You also increase the cost of clearing, as economies of scale are reduced.

Some clearing houses are looking into blockchain applications as a way to reduce costs and enhance liquidity. In 2015 a group including settlement giants CME Group, Euroclear and LCH.Clearnet formed a working body to discuss how the technology might be used to settle transactions. The Depository Trust & Clearing Corporation (DTCC) in the US is specifically looking at credit derivatives settlement.

And notable blockchain startups such as Setl, Digital Asset, Clearmatics, Symbiont and others are also working on protocols to either help or replace traditional clearing houses.

So, there is movement to seek greater efficiencies in settlement, reduce dependence on clearing houses and reinforce transparency. But it’s happening slowly.

Understandably so. Blockchain technology is still new and relatively untested in financial applications. And systemic market infrastructure is not something you play around with.

However, the clock is ticking. And heavy investment in new systems that perpetuate current inefficiencies and are not future-proof will end up adding even more pressure to financial services firms’ already squeezed margins.

I’ve written before how financial shifts due to pending regulation end up spurring research on new uses.

Now we can add political pressure to the list motivating factors.

Could a bitcoin ETF happen in the near future?

Now that the market excitement over the possibility of a bitcoin ETF seems to have been put to bed with the SEC rejecting both the Winklevoss and the SolidX proposals, it’s worth thinking about what needs to change for an official bitcoin investment vehicle to happen.

Forbes published today an interesting article by Moe Adham that unpacks the SEC decision. He pins the causes on two things:

    1) The lack of “surveillance-sharing agreements with significant markets”, in this case between the listing exchange (BATS) and a commodity exchange operator (Gemini, which does not have a significant market position). The concern is that the market insignificance of the exchange on which the underlying asset will be traded could leave it vulnerable to manipulation.
    2) The Gemini Exchange is not regulated enough (it is, though, one of only two regulated bitcoin exchanges in New York – but apparently that’s not enough).

Moe then goes on to hypothesize on what would need to happen before a US-listed bitcoin ETF is approved:

    1) The majority of bitcoin trading needs to happen on US-based exchanges.
    2) US-based bitcoin exchanges need to be regulated.

I agree with Moe that both of the above are unlikely to happen in the near future, but I don’t believe that those are the necessary conditions.

In its ruling, the SEC specified that the main reason for the rejection was:

“because the Commission believes that the significant markets for bitcoin are unregulated.”

While this may be true today, it’s unlikely to remain the case for long. As we have seen, several other major markets have made moves to regulate their cryptocurrency exchanges, and we will most likely see this trend pick up steam.

Even if the SEC were to insist on most exchanges being US-based (which I think even they would agree is an unreasonable condition), it’s not totally out of the question. Almost 40% bitcoin trading now happens in US$, making it the largest market, according to Cryptocompare.

via Cryptocompare - Bitcoin ETF
via Cryptocompare

Although only two of the top five US$-BTC exchanges are based in the US (Poloniex and Coinbase), one of them (Coinbase) already has a New York BitLicense. Poloniex, on the other hand, pulled out of New York rather than have to apply for a BitLicense. But that might change, either because Poloniex shifts priorities or because the requirements become less costly and cumbersome.

In the bitcoin sector, regulation is a trend that can only move forward.

With increasing exchange oversight and greater liquidity in the major trading markets, bitcoin prices will become more reliable and transparent, solving another of the SEC’s concerns.

So, I’m more optimistic than Moe that we will see a listed bitcoin ETF in the near future.

I don’t, however, think it will happen in the US first. Another country is far ahead in terms of regulation and acceptance by the financial system, and its regulators are more likely to approve a liquid, listed bitcoin investment vehicle in the short term.

Where?

Japan.

 

Stock exchange technology problems

New-York-Stock-Exchange-Facade1 800

The Wall Street Journal reported this morning that the NYSE’s Arca exchange, which hosts the trading of more than half of the exchange-traded funds (ETFs) listed in the US, suffered a “glitch” at the end of trading yesterday. All live orders were cancelled, and a “backup method” was used to determine settlement prices.

Why is this interesting? In part because of the lack of information. The NYSE is not disclosing details about why the system failed. Either this is because they don’t know (disconcerting in this day of electronic information) or because they’re trying to figure out how to spin it (which could mean that it’s more complicated than just a simple “glitch”).

It’s also interesting given recent progress made in blockchain applications for trading and settlement of securities.

The NYSE is not as deeply invested in blockchain exploration as other exchanges (notably the Australian Stock Exchange, Nasdaq and Deutsche Börse). It is an investor in cryptocurrency exchange Coinbase, although the exchange’s interest in bitcoin seems to be limited to the index it launched in 2015. Nor is it one of the more technologically advanced exchanges. Bats, for example, has a better reputation on that front.

Maybe what happened yesterday will underline the need for a more robust, transparent solution. Maybe this will affect the scope of the resources thrown at the problem. Maybe the end result will be a blockchain platform, or maybe not – either way, we will likely end up with answers to questions we haven’t even asked yet.

 

Bitcoin funds – alternatives to ETFs

by Steve Buissinne via StockSnap - bitcoin funds
by Steve Buissinne via StockSnap

Now that the Winklevoss Bitcoin ETF is off the table, it’s worth looking at the alternatives, present and future. What can you invest in if you want exposure to bitcoin without holding bitcoin?

In chronological order of listing, we start with a couple of Scandinavian funds.

The first publicly traded vehicle was an Exchange Traded Note (ETN), not an Exchange Traded Fund (ETF). An ETN is a debt note designed to provide investors with a return linked to a certain benchmark. On maturity, the investor will get the initial cash back, plus or minus the change in value of the underlying asset. An ETN can be liquidated before maturity by trading it on an exchange, or by handing in the relevant amount of the underlying asset to the issuing bank.

ETNs and ETFs are similar in that both track an underlying asset, both have lower expenses than actively managed mutual funds, and both trade on major exchanges. The main difference between them is that with an ETF, you’re investing in a fund that holds the underlying asset. With an ETN, you’re not – the return is tracked and calculated. Since an ETF is not backed by an asset, its credit worthiness is tied to the reliability of the underwriting institution.

In May 2015, Stockholm-based XBT Provider launched the first bitcoin-based ETN, on the Stockholm Stock Exchange (part of Nasdaq Nordic). It was called Bitcoin Tracker One and was denominated in kronor. Bitcoin Tracker EUR, denominated in euros, followed a few months later.

Trading of the two was briefly suspended a year later when XBT Provider’s parent company – KnC Group (which also owned bitcoin miner KnC Miner) – declared bankruptcy ahead of the bitcoin halving. XBT Provider was swiftly bought by Global Advisors (Jersey) Limited, a Jersey-based investment manager (of which more down below).

Both notes are now available in 179 countries (if investors have an account on Nasdaq Nordic), and both prospectuses have been approved by the Swedish financial supervisory authority.

In December 2016, Global Advisors (Jersey) Limited listed the Global Advisors Bitcoin Investment Fund on the Jersey Stock Exchange. While the vehicle had been created in 2014 and had received regulatory approval from the Jersey Financial Services Commission, this listing made it the first regulated bitcoin fund to trade on a recognized, regulated exchange. Rather than just hold bitcoin, it actively manages holdings in order to outperform the underlying asset.

The custodians for the fund are Gemini and itBit, both regulated bitcoin exchanges. Although the fund is pitched as a pure bitcoin play, its charter allows it to hold up to 25% of its wealth in non-bitcon assets.

The Bitcoin Investment Trust (BIT) was the first US-based private investment vehicle to invest exclusively in bitcoin. While technically it is a fund that can be traded and is available to certain segments of the public, holders can only sell one year after purchase.

BIT began raising capital on SecondMarket, an alternative exchange for private stock owned by Digital Currency Group CEO Barry Silbert, in September 2014. SecondMarket made a $2m seed investment in the fund. BIT is aimed exclusively at institutional and accredited individual investors, with a minimum investment of $25,000.

In 2015 it launched a new sponsor, Grayscale Investments. It also moved its trading to the OTCQX, the leading over-the-counter exchange in the US, where it resides today. The fund usually trades at a significant premium to the underlying asset, largely due to the low liquidity.

Other bitcoin ETFs are awaiting their turn in the spotlight. Next up is SolidX, which submitted its proposal in 2016. A ruling is due by the end of this month. And earlier this year, Grayscale Investments filed a proposal with the SEC to list BIT as an ETF in a $500 million initial public offering.

Furthermore, the Winklevoss brothers have said that they will continue to work with the SEC to address its concerns. While the barriers are high, it sounds like they haven’t given up.

The SEC and the Bitcoin ETF – what now?

Well, that was exciting…

source: CoinDesk
source: CoinDesk

The SEC decided to not approve the proposed Winklevoss Bitcoin ETF, citing the lack of regulation on bitcoin exchanges, and the possibility of using protocol forks to manipulate the price.

While disappointing, none of that is surprising.

What is surprising is that the price didn’t plummet further. That it found strong resistance at $1,000 and then started trending back up is testament to the underlying strength of sentiment.

CoinDesk provided an excellent post-game wrap-up, with comments from Tyler Winklevoss (striking an upbeat tone, way to go Tyler) and others, reflecting on the motives and consequences.

Since the rejection was based on the fundamentals of the bitcoin market, rather than on specifics to the proposed vehicle, it looks unlikely that an SEC-regulated ETF will be forthcoming any time soon. It is possible that other jurisdictions will take a more relaxed approach – but following SEC guidance, it’s unlikely.

So where now for the Winklevoss brothers? One option is to change the scope and objectives of the fund, and limit the availability to a certain type of participant, much like the Bitcoin Investment Trust which is only available to “professional” investors.

Or, the twins could choose to continue to “work with the SEC” (as Tyler said in his statement) to get the fund approved in its current form.

This will require unpacking what the SEC is likely to mean the next time around by “unregulated”.

Bitcoin itself cannot be regulated. It was born as an unregulated currency. To regulate it is to control it.

The exchanges, however, can be regulated. In fact, Gemini is. Gemini is the Winklevoss exchange, from which the ETF price would have been determined, and is one of only three companies to have been awarded a New York BitLicense, which authorizes it to carry out bitcoin exchange activities in the state.

And yesterday, an official from the Central Bank of China was reported as saying that the PBoC is looking (again, but apparently more seriously this time) at regulating the Chinese exchanges.

So, hopefully the Winklevoss brothers will try again (although I shudder to think what all this must be costing them in lawyers). It’s unlikely that deliberations will take quite so long next time around, but even so, a couple of years is a long time in bitcoin – it’s only been around for eight.

A couple of years is also a long time in politics, and the current US administration does seem eager to dismantle financial regulations swiftly. It also appears to be bitcoin-friendly, and can no doubt count on serious lobbying by people both within government and without to harness the potential without stifling it.

Let Round 2 begin.

Intriguing public comments on the Bitcoin ETF proposal

by Gemma Evans via StockSnap
by Gemma Evans via StockSnap

While you have most likely heard about the upcoming decision by the SEC on whether or not to approve the proposed Winklevoss Bitcoin ETF (given that most mainstream press is attributing the recent bitcoin price increase to positive expectations), what you maybe didn’t know is this:

Comments sent to the SEC advising on this decision are public. Anyone can tell the SEC what they think. And you can see what they wrote.

It’s fascinating, especially since some sector influencers have sent in their opinions.

For instance, Joshua Lim and Dan Matuszewski of Circle Internet Financial write:

“Both institutional and individual investors stand to benefit from the potential listing of the Winklevoss Bitcoin Shares. Such a listing would create a trusted, safe, transparent and regulated entry point into this maturing asset class, which is growing in importance as an investible store of value globally.”

Chris Burniske of ARK Invest (manager of the first ETF to invest in bitcoin) disagrees:

“After thorough examination, we think it would be premature to launch a bitcoin ETF because we do not believe the bitcoin markets are liquid enough to support an open-end fund, or that an ecosystem of institutional grade infrastructure players is yet available to support such a product.”

Attorney and professor of law Philip Chronakis is in favour:

“Denial of the proposed rule will not stop Bitcoin’s progress, but approval of the proposed rule, and the underlying COIN ETF, will put the SEC in the ideal position to oversee Bitcoin’s development as an investment asset – and provide fair, broad-based investment opportunities for not only the connected (or technologically savvy) few, but to all Americans who deserve the same chance to benefit from this technological breakthrough and financial opportunity.”

Michael Lee is against, and sheds some interesting light on recent price movements:

“The price of bitcoin is being heavily manipulated at this very moment on exchanges which somehow began the day of the SEC’s Feb 14th meeting but before the news of this very meeting was released to the public. Currently, we are at all time highs based on rumors and speculation on this meeting alone and it feels like we are again in a price bubble which could result in a huge loss for new investors. An approval of the COIN ETF at this time would only exacerbate this bubble and result in a price crash even before ETF trading will be fully available.”

Ben Elron uses stirring language:

“The Bitcoin ETF represents a rare opportunity for our country to embrace a revolutionary financial technology (the blockchain) with relatively low risk. Indeed, if approved, this fund would arguably be the most transparent, efficient and secure instrument ever offered – requisites enumerated in the Commission’s founding charters.

Blockchain is the future. If American regulators fail to embrace it, others will, and we will then be forced to follow. Let us lead once again.”

And in a somewhat quirky and impassioned comment, Diego Tomaselli implores:

“We understand your role is to protect the American Investor.

Please, just don’t forget to protect also the American Spirit.”

The magnitude of the price bump that approval would generate is uncertain. Given that the bitcoin price has increased by more than 18% since the beginning of the year, a case could be made that approval is already largely priced in.

Today CoinDesk revealed that GABI (currently one of the largest institutional investors in bitcoin) believes that the market is over-optimistic and is therefore reducing its holdings. Since early yesterday morning, the price has been falling, and at time of writing is down almost 8%.

Whatever happens over the next few days, it’s safe to assume that the bitcoin price will be volatile. Which may not be what you want in the underlying asset of an ETF.

That said, I’m hoping that it gets approved. 🙂

The Bitcoin ETF – is Bats the right exchange?

trading 700 - Bitcoin ETF exchange

The Bats exchange has been in the news this week – and not just because it is the preferred venue for the listing of the Winklevoss Bitcoin ETF, also much in the news recently.

Why the extra attention? Because CBOE Holdings Inc., has completed the acquisition of the operator of the Bats exchanges.

The merger represents a major shift in the exchange landscape in the US. CBOE Holdings Inc. is the owner of the Chicago Board Options Exchange, the largest options exchange in the US. Bats is the second largest stock exchange operator in the US, and the largest in Europe.

Could this affect the probability of the SEC approving the Winklevoss’ fund?

Let’s look at why they chose Bats for the listing. They were originally going to go with Nasdaq, but in mid-2016, they filed an amendment changing the exchange to Bats. Press comment at the time stressed the advanced technology of the trading platform, hinting that the Winklevoss brothers were choosing the more forward-thinking option.

No doubt the technology is part of it, but it’s likely that a larger role was played by Bats’ experience with ETFs: it is the largest ETF exchange in the US.

Nasdaq is no slouch in the technology department. Of all the US exchanges, it has invested the most in blockchain exploration. Its Linq platform enables private company shares to trade on the blockchain, and it recently released the results of a blockchain-based voting trial it conducted with Chain in Estonia last year.

But Nasdaq has fallen behind Bats in market share, and does not have its clout in ETFs.

Also, Bats technology is by many accounts the best in the business (all of CBOE Holding’s operations will migrate to Bats’ platform, a strong vote of confidence). However, at its first attempt at an IPO in 2012, the technology failed and the IPO had to be withdrawn at the last minute. The systems have been considerably strengthened since then, but the SEC could see the dependence on technology as a vulnerability.

That is unlikely, though, since the trend for exchanges is to move to electronic trading. Bats was founded in Kansas in 2005 out of frustration at the duopoly of trading markets, shared between Nasdaq and the NYSE. Unlike other, older exchanges that have incorporated technology bit by bit into their operations, Bats was technology-first.

The merger with the CBOE could be interpreted as enhancing Bats’ stability and reputation. The new entity is expected to have a market capitalization of approximately $10bn, close to that of Nasdaq. While Bats is a relative newcomer, the CBOE is over 40 years old. While Bats is known for its technology, the CBOE still operates physical trading pits. And CBOE Holdings is poised to join the S&P 500.

Furthermore, the CBOE is strong in options, and already talk is circulating of the new enterprise developing an exchange for options on ETFs. This could enhance the revenue prospects in a sector suffering from declining volatility, tougher competition and lower fees.

Even if the SEC denies approval for the Winklevoss ETF fund, it is only a matter of time before a proposal is presented that it will approve. When that day happens, the exchange of choice will probably be Bats.

The merger with CBOE is likely to work in favour of the ruling: if the SEC harboured any doubts about Bats’ durability and reliability, the additional clout and growth potential should put those to rest. Furthermore, the expertise in ETFs should facilitate sensible governance and compliance. And the combined entity’s reach across financial products and geographical jurisdictions underscore the potential that innovation in ETFs could bring to a diversifying segment of the economy.

That does not mean that approval is probable – there are a host of other complications to consider. It does mean that the choice of exchange unlikely to be a negative factor.

Bitcoin ETF approval: the long game

by Louis Blythe for Unsplash - Bitcoin ETF approval
by Louis Blythe for Unsplash

The looming decision by the US Securities Exchange Commission (SEC) is, according to market analysts, putting wind under the bitcoin price sails. Market attention and media headlines seem to be focusing on the short-term impact. A pity… they’re missing out on a more interesting story.

A brief summary of the situation so far: in June 2013, Cameron and Tyler Winklevoss – the owners of the New York-based Gemini bitcoin exchange – submitted a proposal to the SEC for a bitcoin exchange traded fund (ETF) to list on Nasdaq. Since then, the Winklevoss Bitcoin Trust proposal has gone through several amendments, including switching to the BATS exchange (newer, and allegedly more technologically advanced) and establishing pricing mechanisms and custodianship procedures. After seeking public comment and using up all the deadline extensions available, the SEC is due to make a decision on approval by March 11th.

Many doubt that it will be approved. In fact, BitMex is running a book on the outcome, which places the probability at less than 40%.

Why would the SEC say no? The decision is a complicated one, but can be broken down into three sections: the intrinsic (issues pertaining to the fund itself), the extrinsic (issues pertaining to the market) and the bigger picture.

Amongst the intrinsic considerations are the suppliers of the various services that the fund will need. The Winklevosses propose that price determination and custodianship be carried out by their Gemini exchange. In the ETF world, it is unusual for one entity to fulfil both of those functions and at the same time be the sponsor.

The SEC also has concerns about bitcoin and its market. Its recent request for information included questions about forks, immutability and hacking, which reveals uncertainty over the strength of the technology. Furthermore, most of bitcoin’s trading volume is in China and Japan, which raises the spectre of manipulation of a US asset by foreign entities.

While structure and market concerns are fundamental, the SEC is no doubt also considering abstract issues such as its own reputation, and the possible effect on financial instruments. Here’s where the more interesting long game shows itself.

The SEC’s main purpose is that of protecting investors. Supporting innovation is not on its list of priorities. Given the relative youth of bitcoin and the potential vulnerabilities of the technology (mining decentralization, accidental forks, quantum technology), the risks are high. And if the SEC approves and something negative happens, that’s their reputation shot.

So, will the SEC embrace evolution and innovation, and acknowledge that bitcoin is here to stay? If so, that would mark a precedent that could shape expectations for years to come.

Or, will the SEC play it safe and defer difficult decisions until a later date? In which case, think about the message sent to change-makers. While it’s impossible to suppress creativity, a “no” decision could send innovators scurrying to find alternative (and less-regulated) outlets.

It’s also important to think about the bitcoin market beyond the immediate impact.

The Winklevoss proposal was recently amended to increase the initial amount from $65m to $100m, which signals strong initial demand. Analysts Needham & Company estimate that $300m could pour into the fund if approved, which given the limited daily volume (US$ trading is usually under $50m/day) would push up the price. How much of that is already priced in, we don’t know. And it’s worth remembering that the estimated inflow is just that, an estimate based on the performance of other similar funds (which is tricky, given that this is a first).

If the SEC decides “no”, it’s probable that the price will fall sharply. But bitcoin has many other fundamentals in its favour, and the price is likely to find support at lower levels (how much lower, I don’t know).

So, the immediate impact, even if the ETF is approved, is uncertain. The longer-term impact, however, is clearer.

There’s the liquidity aspect. If approved, the increase in bitcoin demand will boost trading volumes overall, which will reduce volatility, making bitcoin even more attractive to investors. Most of the increase will be in the US, since the fund will be doing its trading on the Gemini exchange. This will even out the current geographical imbalance in trading volumes, and calm the unease of regulators. It’s worth noting that Gemini is one of two bitcoin exchanges to have a BitLicense, which makes it one of the most highly regulated exchanges in the world.

Beyond price and liquidity improvements, there’s the reputation. Bitcoin will go from being “something criminals use” to “something approved by the SEC”, which would add a lasting veneer of respectability. Institutions and investors, not just in the US, would start to see it as an asset class rather than a libertarian speculation.

This could rattle economists and policy makers, since bitcoin represents an alternative to the established system. But it is in line with increased interest in blockchain technology from institutions. Central banks around the world are studying cryptocurrencies, some with a view to launching their own. And the recent appointment of bitcoiner Mick Mulvaney as Trump’s Director of Office of Management and Budget could herald a shift in the official attitude.

Finally, it’s important to bear in mind that an approved bitcoin ETF would be the first “mainstream” fund to be based entirely on a digital concept, with no tangible underlying asset. This could unleash a stream of creative financial engineering which could usher in a new era of opportunity. Or, it could end up increasing market instability, especially when combined with a federal policy of more relaxed regulation of financial institutions.

So, the ramifications go well beyond a “yes” or “no” and the resulting impact on the price. The initial swings will be exhilarating or horrifying, depending on your position. But the bigger picture, which affects us all, is much more compelling.