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.

Bitcoin futures contracts – reading the tea leaves

Let’s talk about bitcoin derivatives. I’m not an expert, and need to do more research on the actual figures, but my main worry has been this:

PoW supporters talk about the consensus working because “breaking” the bitcoin network would make participants’ holdings worthless. Miners won’t collude because they would lose not only the value of their bitcoin holdings but also the investment in the mining equipment (which is considerable). So, bitcoin is safe.

But what about short positions? A big enough short position could produce enough of a profit to make colluding to “break” bitcoin worthwhile.

My worry has been that bitcoin derivatives weaken the consensus incentives.

Now, I need to check into the volumes required, and the mechanism (can you even short that much, or are there limits?). So this is the beginning of a thought exercise rather than the sounding of an alarm.

My concern has (so far) been largely offset by a fascination for what bitcoin derivatives can tell us about sentiment. I thought that open positions could point to where the price was heading. Until I read this, that is, from Christopher Langner’s article on Bloomberg Gladfly, “Is Bitcoin Growing Up?”:

“The quarterly contract sold at Bitmex entered backwardation — the future price fell below the spot price — in January, shortly after the PBOC started cracking down on the exchanges. In a market with limited supply, the fact that most of the big traders are betting prices will go down must be bad news. So it proved, but this time hedging may have limited the downside.”

Let’s go beyond downside limitation. What if derivative positions were mainly used as a hedge, rather than as speculation in their own right? Backwardation could simply be an offsetting hedge on a large long position. The bearish signal would be false.

In other words, the derivatives traders are not necessarily betting that prices will go down – they could have a big long position (which means they think prices will go up), and the futures contract is a way to protect their downside if it turns out they’re wrong.

A smart trading strategy (assuming the premiums are not too steep – I need to look into that part some more). It does, however, make reading the tea leaves of futures contracts not much more than an entertaining pastime.

Bitcoin volumes and volatility – now what?

trading 700

CoinDesk reported yesterday on the change in the pricing strategy of the three largest Chinese bitcoin exchanges: BTCC, Huobi and OKCoin. This weekend they announced that they were suspending their “no fee” policy and moving to a 0.2% flat fee, “in response to guidance from the People’s Bank of China”.

Today we reported on the impact of this decision on trading volumes. No surprise – they’re much lower.

A bit of background: the “no fee” model may sound like an extraordinary business strategy (not charging for your main business), but it’s actually not very different from the “Freemium” models we see all over the place, in which most stuff is free, but some things not. The basic service is available to anyone, but for better content or service, you pay something. It’s an old strategy, even used by physical retail outlets – to get you in the store, they price some products so cheaply that they lose money on them. These are called “loss leaders”. The idea is that while you’re there, you’ll buy other stuff as well, and the store will make money there.

In the case of bitcoin exchanges, they don’t make money on the trades they execute, but they do charge a fee for entries and withdrawals. If you want to put money into your account, there’s a fee for that. If you want to take money out, also. But the trading you do in between, no charge.

The practice recently seeped into European exchanges, with London-based Coinfloor (number 25 in terms of fee-based bitcoin trading volume, according to Coinmarketcap, and the largest in the UK) announcing last week that it would adopt this pricing strategy.

The objective is to bring in liquidity. The result is to inflate volumes.

Since there is no charge for buying and selling, traders feel that they can churn holdings as much as they wish. And even small gains are worth it, especially if repeated several times during the trading day, since there is no associated monetary cost.

So, volumes are much higher under a “no fee” policy than they would be otherwise, and the PBoC regarded this as “fake volume” which added unnecessary volatility to the market.

In fact, the impact of no fees is so stark that Coinmarketcap (where I get my relative exchange volumes) only includes exchanges with fees in their main ranking (although you can get the whole list in another tab).

So, the volume hit was not a surprise. The announcement last week that the exchanges have halted margin trading (in which the exchange lends you the money to trade, which further encourages speculation) is no doubt also likely to have an impact.

The question now is: will this lower volatility? Or will it increase it?

Intuitively, less “churning” of holdings should make prices more stable. Trades are more “real” in that they are not about grasping at small gains. Positions are (in theory) held for longer, since changing them now incurs a cost. Less “fake” volumes, the PBoC’s reasoning goes, means more stable markets and less risk for non-professional investors.

But, lower volumes means lower liquidity, which means more vulnerability to swings due to large buy or sell orders. With higher liquidity, large orders have less of an impact as there are more funds available to settle those orders. Lower liquidity means that prices move more to tempt traders to take a side.

That, at least, was the argument that LedgerX gave in a CoinDesk interview yesterday. Here we have a derivatives exchange arguing that approval by the Commodity Futures Trading Commission (CFTC) would decrease bitcoin’s volume. Yes, you heard right, derivative trading can decrease volatility. Or so they say, and maybe they’re right, but I’m having a hard time getting my head around this.

The argument is that the increased liquidity from regulated bitcoin options will provide the market with a cushion to absorb large orders and avoid the price swings that usually result. My skepticism stems from the fact that it often is the need to close out derivative positions that generates these large orders in the first place, orders that often need to be filled in a hurry, at any price.

I do buy the argument that increased derivatives trading enhances price discovery, as future expected prices tend to react less to current events. And I understand that an active (and regulated) futures market can reduce the need to place large market-moving buy orders to “bet” on a certain direction – it’s cheaper and easier to buy futures contracts instead. They can also reduce the need to liquidate large positions, by “insuring” them at a relatively low cost.

However, here’s what has me worried: with derivatives, it is not very costly to accumulate large enough a position to benefit from sharp moves. It is conceivable that a speculator could accumulate a ton of puts, and then attack the bitcoin blockchain. The potential profit from the derivatives position from a sharp plunge in price could outweigh the cost of the attack.

And, I am not yet convinced by the increased liquidity argument. It could reduce volatility, but it could also increase it by encouraging speculative positions. That seems to be the PBoC’s position, that “fake” volumes are not good for the market nor for its investors.

As always, time will tell. And no doubt, other factors will throw in additional complications. Attributing changes in trends to any one announcement, in bitcoin as in life, tends to miss the bigger picture.

 

Blockchain and settlements: why?

I used to work, many years ago, as a broker of Canadian equities in London (don’t judge, it was the ‘80s). It was so long ago that I confess that I don’t remember much about the process, other than that we would write down our clients’ orders on bits of paper, and hand them in at the end of the day to the head of the desk. From there they would get passed on to the settlements department, which had its own floor, it was so large. Several days of stock price and currency movements later, the settlement would go through. I never thought to question the efficiency, I just assumed that that’s what it took to get ownership transferred.

When I started studying the blockchain, I assumed that aha!, here was a way to save billions in tied up money, simply by reducing the settlement time to seconds rather than days. I assumed that the blockchain’s transparency and immutability would make the cumbersome checking of ownership and payments unnecessary. Matching, verifying and netting would be reduced to code. So it needn’t take several days, right?

As with most financial concepts, it’s not that simple.

by Josh Pepper for Unsplash - trading settlements
by Josh Pepper for Unsplash

To see why, let’s start with a simple example. You and I are together in a café. I have a share certificate in my hand, and you want to buy it. You hand me the cash, I hand you the certificate, and we have instant settlement.

But wait a minute: how do you know that that share certificate is not fake? How do I know that the cash is not fake? My doubts are easier to resolve than yours (I just happen to have a fake bill detector in my pocket). How are you going to check that the certificate was not forged or copied? That’s going to take you a while. We no longer have instant settlement.

Back in the day when share certificates were bearer items (pieces of paper that belonged to whoever held them, much like the €20 in your pocket), checking authenticity could have been enough for the transaction. But now you need to know for sure that I have the right to sell that certificate, because if not, once I’ve disappeared with the cash, you could find that the rightful owner appears and wants the sale declared null and void. How do you do that?

And while you’re doing all your checking, I could decide to change the price. Markets move, after all. How do you prevent that from happening?

The settlement is getting more complicated, right? Now let’s throw in the delicacies of electronic payment, and electronic transfer. To the same doubts about authenticity, we can now add doubts about settlement. Even if we’re satisfied that we are who we say we are, and that we have the right to send the digital certificate/payment, I’m not going to transfer ownership until you send the money, and you’re not going to send the money until I transfer ownership. Who can help us with that?

And, since it’s unlikely that I hold my digital certificates, I have to route all instructions through my certificate custodian. And, how did you and I find each other in the first place? Suddenly a lot of other parties are getting involved, and each is going to want to verify and check that everyone is who they say they are.

So, a lot of verification is going on. And it’s that verification that takes the time.

In theory, the blockchain can help us with verification, in that if something is stored on the blockchain, it’s fact. But is it? Let’s presume that I, personally, don’t have the power to publish my share ownership on the blockchain. My custodian would have to do that. (Why he would do that is an interesting dilemma, since once he has published all his clients’ shares to the blockchain, he is out of a job.)

And how do we know that my custodian will publish the correct information? That my share holdings are 100% intact (nothing has been siphoned off), verifiable, and in a universally accepted format? Who decides what that format is? Would that not be a very, gasp, centralized decision? For a technology that rests on decentralization?

Let’s assume that we figure out a way for my custodian to blockchain all of my holdings and manage to keep his job. So, he transfers the digital ownership of the shares I want to sell to my broker, who is in contact with your broker. Why is my broker going to trust your broker to make the payment on your behalf? It’s easy enough if they know each other or have done business before. But what if you are in Azerbaijan and I am in Iceland? (And let’s not even go into how long it would take a payment to get from Azerbaijan to Iceland…). Right now regulation makes this all work relatively smoothly. And regulation insists on verification and re-verification of the facts and identities. It’s very unlikely that just putting it on the blockchain would be “good enough” for the regulators.

And we shouldn’t want it to be. Efficiency is great, yes. But when it comes to large sums of money, reliability is more important. And when you think of all of the verification that needs to happen for a trade to take place, settlement of two or three days doesn’t sound like that much, after all.

It is possible that the financial sector could come up with a way to encode verification, identity and transactions. But to do it going back far enough for it to be useful would entail a colossal cost. And to do it in a uniform manner in a fiercely fragmented business would require almost magical management skills.

But that’s not to say that blockchain settlement is not a good idea. Some asset classes take longer to settle than others. So, it’s quite possible that we’ll end up seeing separate settlement practices for separate types of deals, and some of those may well use the blockchain. I can especially see blockchain-style settlement being used for future asset classes that haven’t even been invented yet. Building a new settlement system from scratch would be an excellent opportunity for the blockchain to show its power. Converting current systems? Not so much.

And while decentralized trading sounds efficient and, well, democratic, we need to take a look at the steadying role a centralized control can play. Imagine what could have happened in September 2001, and again in the 2008 crash, withoutSEC interference. And the need to reverse a trade, either because of error or because of contractual conditions, is a relatively common occurrence, and something that the blockchain is not set up to allow.

The “blockchain as a new settlement system” dream is appealing. But as with much of the information and talk surrounding this powerful technology, it is largely hype. An improvement on the current system would benefit liquidity and profits, and make the sector more resilient to shocks. And the blockchain does have a role to play in making payments and data transfer more efficient. But it would be a mistake to assume that technology alone is the barrier to an instant settlement system. There is much to explore, though, and much to learn, and things can always be improved, indeed should be if the solution is practical. The sector and the blockchain will find ways of working together if we can move away from sweeping proclamations and towards practical applications that can help today.

Web-based vs. desktop vs. mobile bitcoin wallets

Assuming you’ve decided to download a bitcoin wallet, do you want a web, desktop or a mobile version?

This is more confusing than it sounds, since each performs a different function, with different levels of security. As we’ve seen before, a wallet is simply a way to store your public and private keys, and to display the net amount of bitcoin that you have associated with those keys. They can usually also show you the transaction history of those keys.

The word “wallet” may be confusing as it implies that your bitcoins are stored in it. They’re not, they’re actually stored on the blockchain, which itself is stored on servers (bitcoin “nodes”) around the world. Thanks to the user interface, the wallet just looks like it stores your bitcoins. And just like an online bank, it can show you your transaction history.

bitcoin wallet

Web-based wallets

Web-based wallets store your keys online, which is convenient as you can access them from any computer. However, it is not as secure as some other options, as your keys are stored on someone else’s server. Those servers are well protected – no wallet service provider wants to be hacked – but they’re not under your control. Since this is what bitcoin was created to avoid – your funds being in someone else’s control – this solution may seem ironic. It is convenient, though, especially if your wallet service provider also allows you to purchase bitcoin through their exchange.

Some web-based wallets such as Blockchain encrypt the keys before storage in the online server, which is a slightly more secure option than those that store the keys on their servers, such as Coinbase.

Desktop wallet

It’s worth remembering that an online wallet is not the same as a desktop wallet, although you access your online wallet via your desktop. For a desktop wallet, you install the software directly on your PC. Assuming that your security is thorough, this is one of the safer options, but if your hard drive is hacked, chances are your bitcoin keys will be copied and your bitcoins transferred without your knowledge. In other words, your bitcoins will be stolen.

Most desktop wallet are “lightweight”, which means they don’t download the entire blockchain (just as well, since it currently occupies almost 50GBs). Lightweight wallets only store block headers, rather than entire blocks – this allows them to take up less than a tenth of the space. However, the trade-off is that they are less secure than full blockchain wallets as they can’t examine all the transactions in the blocks to make sure that they are valid, because they doesn’t have the transaction history. Lightweight wallets, otherwise known as “SPV” (for Simplified Payment Verification), can only validate the transactions that concern them. They trust the fully validating nodes to check all the others.

If you have downloaded the bitcoin protocol, that acts as a wallet as well as a full node.

Mobile wallet

The mobile wallet is the most practical option in that your bitcoin are accessible at any time. Your smartphone can be used to pay for products with bitcoin, or to easily transfer funds to someone else. Your camera scans the recipient’s QR address, which is so much easier than typing in a long string of letters and characters. True, the desktop and web versions usually allow for copy and paste, but pointing your phone at a pixelated square is simpler and faster. Some phones enable NFC connections, which means that all you have to do in certain circumstances is tap your phone against a reader to pay.

Mobile wallets are also SPV or “lightweight” (see above), which compensates a reduction in necessary space with a reduction in thoroughness and blockchain integrity, but for most daily applications, they work very well.

However, since your phone can be lost or stolen, and your keys along with it, you could lose your bitcoins unless you have been smart enough to keep secure backups.

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This may seem like a confusing sea of options, and differentiating between the different providers can get complicated. But it is not necessary to choose just one. Most bitcoin users have several wallets, to cover a variety of different needs. I have three, two of them web-based (Coinbase and Blockchain) and one mobile version (Blockchain, for now).

The three options covered here are especially useful for frequent transactions. With a few taps or clicks you can send bitcoin to any other wallet, move funds amongst your own, or purchase more to top up your holdings. These wallets do, however, imply a trade-off between ease of access and level of security. They are easier to use, but not as secure as some other more complex options. To safely hold a significant amount of bitcoin, offline storage is a stronger solution, and we’ll talk more about that next week.

(For more on how Bitcoin works, see Bitcoin Basics.)