The Bitcoin ETF – is Bats the right exchange?

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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 However, at its first attempt at an IPO in 2012, the technology failed and the IPO had to be withdrawn at the last minute.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 volumes and volatility – now what?

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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.

 

The blockchain and the stockchain

At the very end of last year, a major milestone was reached in the bitcoin world. Or it wasn’t, depending on who you listen to. And what your definition of “stock” is. Either way, what happened was a big step forward, and a harbinger of important changes coming to securities trading and business finance.

What happened is this: Chain, which specializes in enterprise blockchain platforms, issued shares on Nasdaq. Only they weren’t traditional shares, they were digital. And not on the “regular” Nasdaq, but on a subsidiary newly created to handle this kind of transaction.

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But how does that work?

Nasdaq Linq, part of Nasdaq Private Markets, was set up to facilitate the issuance, transfer and settlement of shares of privately-held companies on The NASDAQ Private Market using a digital ledger technology similar to that which powers bitcoin. (For more on the difference between bitcoin and the blockchain, see here.) Rather than a stock exchange mirror, Linq is more a shareholding management tool, especially useful for de-mystifying the chaotic structures thought up in the early days of a business. The ledger allows settlement time to be slashed (minutes rather than days), issued shares to be easily tracked, and related documents to be dealt with and executed online.

The mechanism was developed by Chain, so it is appropriate (or symbiotic, if you prefer) that its own securities be the first to try it out. Chain creates Nasdaq’s Linq platform, Nasdaq owns part of Chain, Chain is the first to issue shares using this technology… You get the picture.

Yet Chain won’t be the last to use this technology. Nasdaq has hinted that further digital share offerings are in the pipeline from ChangeTip, PeerNova and other blockchain startups. NXT, Ripple and Digital Assets Holdings, among others, are working on similar technologies, and we will definitely see several more transactions of this type over the next few months.

peernova

And depending on your definition of “security”, it wasn’t even the first. In August of last year, smart contracts platform Symbiont sold its own digitized private equity on the blockchain to an investor, and registered its founders’ stakes as well as stock options and shares granted to employees. Symbiont’s innovation is the creation of “Smart Securities”, which not only settles and records transfers, but can also pay dividends and convert stock options automatically.

Broadening the definition a bit, in June of last year US-based retailer Overstock sold a $5m “cryptobond” on its tØ blockchain-based security trading platform. In December it got regulatory approval for the issue of company shares on the bitcoin blockchain.

Whoever came first, all three innovations stand to make a big impact: Overstock because its tØ platform and upcoming digital share offering “proves that cryptotechnology can facilitate transparent and secure access to capital by emerging companies”, according to founder Patrick Byrne; Symbiont because it is leveraging the decentralized power of the bitcoin blockchain to make trades cheaper, faster and “smarter”, which will expand the use cases for bitcoin and open up trading to non-market players; Nasdaq because it is a globally recognized name with exchanges around the world. All of them increase efficiency by reducing settlement time, increasing transparency and removing middlemen.

This is exciting, but at the same time fraught with significant obstacles.

One is the inherent conservatism of investors. New technologies can be scary, especially ones that are not easy to understand. Institutions are used to the delayed settlement systems currently in place, and could well prefer to bear the steep economic cost of that inefficiency rather than risk not only losing their investment due to a tech malfunction, but also of looking foolish.

Another is the lack of understanding of the mechanism on the part of the private companies, and the fear of attracting the attention of the regulators. Especially in the US, where each state has different securities legislation, a non-physical security residing in “cyberspace” is too much of a conceptual leap for most funds and investors to feel comfortable with.

Another is the need to balance the open nature of the blockchain with investors’ need for privacy. What some might see as an advantage – the ability to track the ownership history of a share or bond – others might see as an encroachment on their desire for anonymity.

Yet these obstacles can be overcome with time, just as other technology adoption obstacles have been overcome in the past (remember the “no-one will use the Internet” prediction?). The advantages of blockchain-based securities settlement are clear: faster, cheaper and global. The need for simpler financing is also clear: initial cap tables and shareholding structures are usually a mess, scribbled on napkins and promised in meeting rooms. A secure and inexpensive method of issuing shares will make setting up a business easier, which could help to foster entrepreneurial activity. And as more and more high-growth startups avoid regulation-heavy IPOs, a reliable and liquid alternative will empower businesses of all sizes and make them less beholden to Wall Street and its international counterparts.

Who will be the winner here? Which business model will triumph? Will shares be on private ledgers or the public blockchain? I expect we will see a combination of forms and formats, with various platforms offering different advantages, with smaller businesses benefitting from enhanced control and transparency, and with an explosive growth in creative instruments backed by cryptography and maths.

It won’t be a smooth transition, and it won’t be quick. Nor should it. When it comes to investors’ money and companies’ financing, care needs to be taken. But the shift will happen, and as it does, it will lead to a more accessible and fair financial system.