Plodding Mediocrity (Part VI)

These series are from April 2018

Token instruments

Two major concerns in prior sections were a) is bitcoin commodity or currency and what consequences this might have and b) how taxing bitcoin as a property by IRS might stifle its adoption as a currency. These previous two sections are interrelated and important primers. If they become clear over time they will solve lot of upcoming issues and will provide more clarity. Now I’d like to go through various implications that tokens have as financial instruments. Some are well-known and some are really brief because they are not yet fully implemented. Again lot of information to digest, but this is exactly the point, we do not deal with well defined assets and market, the more things I cover the better I paint the chaotic picture that I think we have.

Classification and Licenses

In section “Commodity class of bitcoin - hurdle to stability” I’ve tried to mainly cover bitcoin and how currency, foreign currency and commodity notions are intertwined. This debate seems to be more interesting and harder to move a needle, while the topic of security/commodity seems to be mentioned in every second tweet and federal report. It is true that ICO bonanza of 2017 has put security or not question on top of SEC’s agenda and I love this discussion when it implies some unique approaches. For example discussing if a token can be a security at some point and at some point not is still relevant, a question what disclosure mechanisms should be built in is as well relevant and how these tokens should be issued, regulated and traded all seems very interesting from regulatory perspective because it concerns securities regulation which is thorough and considers lot of risks. Still I will not provide at this stage how Howey Test works because Coincenter and Coinbase did an outstanding job in covering this, so did SEC in its investigation report over DAO tokens. It should be clear by this time that easiest way to raise money in token sale is by filing Form D and by following SAFT (although recently as rumored some SAFT projects were subpoenaed by SEC we’ll get to that later).

The whole conundrum from regulatory standpoint is that of classification, it the source of all “uncertainty”. I would like to point to one interesting observation that might be indicative of how cryptocurrencies might be treated and that is following “seized cryptocurrencies”. There were multiple instances where U.S. have seized bitcoins from civil forfeiture or criminal prosecution, unfortunately (because this is not interesting) they were of course auctioned. Who seized the coins is important as well, because if it was a federal agency they have to auction them, but in case it was your local sheriff who seized your digital assets following civil forfeiture, then unfortunate things can happen. Now if you keep an eye on seized digital assets and if any of the federal agencies puts them at official use once they are seized, it can indicate how assets might get regulated.

Why classification is important? Classification of assets leads to acquiring proper licenses. For example if you want to advise someone on a non-commission basis regarding investments you must acquire Series 65 license, if you are a hedge fund manager with AUM over $30 million you need to register and have a license. If you want to trade futures contracts you need to acquire Series 3 license and if you want to buy and sell securities on behalf of customers you need general securities representative (GS) license that is Series 7. All these licenses are administered by FINRA. It is common sense actually, if you want to deal with substantial amount of capital on behalf of somebody and if you want to provide financial advices that you need to prove your proficiency in a given field. And each class or activity requires its separate license (as of October 2018 there will be one consolidated license). We have already seen that CFTC sued companies that provided these kinds of services without acquiring licenses, I doubt that there are many people who exclusively deal with crypto and have their licenses in place, unless you manage a large hedge fund. But this is as well understandable because there is no much clarification, if we can not decide what class bitcoin is, we are not going to settle on what type of license we will need to execute trades. In future if FINRA and NFA add cryptocurrency topics, they will help general broker/dealers and CPO/CTA exam takers know about these assets, further validate and expose cryptocurrencies to general public. Investment advisor can help to tell you where to put your money, based on basic rules, he ’s not welcome to make you invest in a volatile token if you’re retiring for example etc. Moreover your investment advisor will be in fiduciary duty with you and will be liable for breach of rules in you relationship.

I like the licensing approach for financial professionals, because compared to lawyers who must provide their J.D degrees from law schools or proof of reading the law, financial professionals might come from various backgrounds, prepare and understand the basic workings of the financial instruments they want to trade and start right off. This is an example of a founder who studied comparative literature at Yale - go ahead and figure out how his brain is wired.

ICO

Here I’d like to cover some of the current topics and some that are interesting observations in my opinion. I am not going to cover security-or-not issue regarding ICOs, I think Senate and House hearings as well as loads of content on that topic is pretty much extensive for somebody to form an opinion. I’d only say at this stage I support Howey Test approach, but yes, generally speaking most of the funds raised through ICO risk to fall under security umbrella but this is not generally applicable to all the cases, and not only this but “airdropping” as well is considered to be securities offering at some instances. On the debate of security/commodity in a lifetime I’d rather leave the ball to likes of Santori and Rosenblum, until I am able to develop my own opinion.

I will start with Swiss ICO guidelines, out of all the jurisdictions that claim to have figured it out, or created sandboxes, Finma has provided most concise guidelines to assess digital tokens. It must be mentioned that Swiss financial market and US financial markets widely differ by size, legal approach and complexity of regulations. I am not going to say I know Swiss securities regulation, but I’m pretty sure it might not be as stringent as one from SEC. The guidelines from Finma reads in a nutshell as: a) Payment tokens must comply with AML and are not securities; b) Utility tokens are not securities as long as they have actual utility and c) Asset tokens are definitely securities and have to fully comply with regulation. I like this guidance as a starting point, but would like more legal prose to elaborate on what constitutes utility token, is it a commodity per se or is the payment token equivalent and alternative to the legal tender? Once these are cleared then we will move to the waters where we will debate whether this specific token is a security or a commodity, but let’s postpone this deliberation for the next time, it’s early for that.

What ICO have done is that it have equipped general audience with fundraising minutiae. Although white papers are much lower in quality compared to PPMs and they serve different goal in their essence, they still educated buyers to be aware of risk disclosures, to look into teams behind the products and to follow market trends. I would say that this is a decent upgrade from millions pouring into kickstarter pitch pages that provided video and some formatized information about projects. Slowly, but we make wide audience literate in interpreting financial instruments. Now the downsides are of course big. I like to say that white papers are now prospectuses. I would like to make my case here based on the TON leaked white paper. According to solicited investors their SAFT PPM is more detailed with over 100 pages, but their white paper initially and ambitiously set a goal to raise over $1 billion, according to current subscriptions it subscribed even more than this. Now I’m not trying to be harsh, but based on the leaked white paper with almost non-existent technical specifications, delivering on its ICO is too much to ask. I’d suggest the reader to think if these 23 pages of white paper are justifying a billion U.S. dollar round and to think about what your average investor would demand. Telegram initially pumped the rumors of its high ICO and what it actually does now is that it shops the private investors with seemingly neglected its initially announced minimum $20 million buy-in, asking any accredited investor to join. Telegram is being blunt in its discounts for pre-sales, ranging from 30 to 80 percent discounts while it provides multiple offers it also confuses investors all along (If you’re offering SAFT that trades on the secondary market, there are the questions to be asked). During SEC’s enforcement wave, it is interesting if Telegram will pause for the public sale and prefer to stick with SAFT (which itself came under scrutiny last month). This is not a critique of a project, because I’m not familiar with details, this is a critique of the form of a document through which cryptocurrency projects raise funds that we consider admissible today. Even though I mentioned that ICO phenomena raised our awareness towards investment contracts, we still see poor examples that are reflective of the hype. Telegram’s white paper is the sales paper per MIT research team of white papers.

For this reason I think crypto markets will benefit from the similar standard as Red Herring Prospectus and Gray Markets. Red Herring administered (until clear regulations are set) under SRO (that yet has to be designed and approved) will enable investors to read standardized filings with necessary information, while existence of the gray market (like in Eurobonds) will provide issuer / underwriter with the ability to validate the price. I’m not saying none of this happens right now, because it does, whenever I’m dealing with large amount of capital, I try to test the price, try to get ahold of the draft offering, but issue here is that none of these are standardized, none of these are regulated, because we do not have clear guidance of what we are dealing with, we know don’t who to address in case of a manipulation. You’d notice I’ve put few conditionals in brackets, this is to indicate how far we are from this needed scenario.

Regarding the SAFT instrument, last month SEC subpoenaed few dozen of token issuers, though it stays unclear whether they were investors, issuers or lawyers. General consensus is that SEC went after fraudulent issuers, while some sources provided information that SEC might be after SAFT (filecoin and other big name ICO projects, mostly those who complied with SEC through Reg D, Telegram included) and this is due to the fact that SEC might be considering tokens to be both securities and utilities, with a promise that token will bring utility to the platform later and that it was initially sold on the premise of increased value on it. This is interesting take from SEC, something similar was heard earlier from other federal agency commissioner Brian Quintenz from CFTC. It is interesting how SEC will decide upon this approach. This approach has been humming in the crypto space for a while by various stakeholders and as well challenged by the others.

According to the source, subpoenas were very detailed. Upon the final ruling of SEC token issuers will be able to negotiate with SEC or go to court. Both will result in public disclosures. Negotiations can result in issuers to comply with the securities law while cases that will go to court might not satisfy SEC’s requirements at all. During these times investors should not be scared if SEC is coming after SAFT it is because they must understand that if anything is on the agenda of the SEC it is investor protection (subject to Senator Elizabeth Warren’s believes). SEC will not step away from situations where people give promises and raise large sums of money. In my opinion subpoenas from SEC might be in part related to tZero filing for ATS, because per tZero filing they mainly deal with SAFT tokens, if this is the case, we’ll soon see an Alternative Trading System (registered with SEC) that will list SAFT tokens. This is positive outlook for the subpoenas, on a grimmer note, it might mean that some of the landmark projects that propelled crypto in 2017 to the great highs will come crushing by regulatory enforcement.

Another concerning statement came from FinCEN regarding ICOs. What at first struck me as a panic due to how the news were framed by Coincenter, it seemed that doom has come and the most unpleasant and hellish regulation in crypto up to date known as MSB were to be exerted toward ICOs as well. Peter Van Valkenburgh published this report where his opinions raised concerns about the regulator (FinCEN) who indicated need to of applying MSB licensing to ICO issuers (state-to-state licensing requirement to operate as money transmitter), but his opinion is itself an edited understanding of the FinCEN letter itself. In the letter there was no direct warning and even the definition of a token seller was left blunt, preceding with “Generally” with whatever followed as the definition of issuer. It was omitted in the Coincenter’s report, but in legal terms “generally” does not imply the totality and imminence, it leaves the room for additional interpretation. The ICO expletive paragraph was even followed by the one where it clearly said that in cases where “Token Sales” constituted sale of securities, SEC’s oversight should be observed and not theirs. FinCEN would definitely abide to the prior SEC’s definition which said that most ICOs are securities, otherwise it would bring even more contradiction to the market by fragmenting agencies’ visions. This way FinCEN is just wiping its hands on the SEC in these regards and this is completely understandable, government agency would not jump out and preach a new concept when token classifications are not even its business.

Peter goes even further and brings the case whether the agency has the authority to be so indicative in a letter. Coincenter later provides a well elaborated distinction between “administrators” and “exchangers” and the proof of why miners and developers must be considered exempt from the MSB. It is obvious that FinCEN letter provides more ambiguity on this matter, but it does not indicate any enforcement or any strict position from the agency, through its language the letter is mostly a nod to SEC. As previously stated by FinCEN, miners are not transmitters so as investors, but unfortunately it did not raise the question of developers doing ICO, this letter mostly prompts to put ICO issuers under MSB, but saying they are under SEC ruling (securities case) clears FinCEN’s authority. Coincenter published in 2017 a great guide that goes deeper into the topic of administrator, exchanger and user with bringing definitions and limits of the guidance from FinCEN. It is clear that exchanger must be “business” and must buy and sell convertible virtual currencies to persons. Users who buy goods with convertible virtual currencies are not doing business, Miners who mine and put out their mined token to the network are not required to comply with MSB, because they benefit from the decentralized network and get rewards by contributing. Centralized administrators might be the issuers who have the right to issue and redeem their token, if you issue a token and do not have the right to redeem it then you’re exempt. But this is the most ambiguous guidance regarding the new issuance and this is where it became more ambiguous this week with the FinCEN’s letter. Although apart from having “user” as the most ambiguous definition in FinCEN guidance, administrator is also pretty much vague, because one can argue about the power of the decentralized network and its ability to redeem tokens back. Main concern is that previous guidance although left some ambiguities, was still practicable, this letter has one paragraph that questions one of the exemption, but not imperatively. Letter as well provides enough context not to interpret it as an enforcement but rather a nod to another agency. Now why this incident took my interest is because even a small letter that was addressed to the Senator from one regulatory body could be interpreted in multiple ways, and even though the letter did nothing but brought more ambiguity, its wide interpretation could be less panicky. These small incidents that are caused by small regulatory noises do play a role in the market and their interpretation must be done with a lot of care.

Non-Fungible-Token

Another subject I’m eager to address in this section is the noise around Non-Fungible-Tokens, which gained lot of traction, excitement and support in the form of crypto-kitties. Lot of people provided insights and said that NFT is going to boom. I think we’re pretty early in widespread NFT adoption in consumer grade products (we don’t have any blockchain consumer grade products) and I don’t think that we must veil NFT as collectibles, art ownership and game item ownership. NFT token at its low level is your identity on blockchain, your ticket to the concert or anything that can not be substituted by another asset. I think NFT is not revolutionary, but it is a perfect feature of blockchain assets, its usability just got a little bit shadowed by all the praise for fungible tokens. I think that NFT tokens until they achieve collectible stage, should satisfy identity management on blockchain and maybe lately somebody will as well find application of NFT in fragmenting art. I still see no point in owning 1 cm2 of a painting, it might be relevant for the ownership rights in Kodak One token, but it is not relevant in digitizing ownership of already existing artwork.

I think that NFT is the way to tokenize assets digitally, but first we have to fundamentally address the question of what we want to digitize and what will have a value once digitized. We do not have to rush and tokenize everything, it must not as well have a goal of trade or exchange, NFT must serve a goal first, like certificates, identity and contractual ownership. If we arrive to a point where the sole idea of tokenizing collectibles is to trade then we achieve a) highly liquid market and b) fundamentally not valuable asset. And in case a and b are true then regulators will start questioning how different are the rights attributes to these collectibles, if they are expressed through different contractual rights of holding an asset than these assets are different, but if the market is liquid and assets are easily tradable, if creation of these assets do not hold any other value rather than trade I don’t see why it should not be regulated as financial instrument.

Security Token

First I’ll note that it took a while for Twitter, Google and Facebook to acknowledge that companies purchasing CPC for ICO ads could be interpreted by SEC as Investment Company advertisers, what I find hard to believe is that advertisement prohibition over the internet channels could hit the market as much as analysts would say during the recent weeks. I would like to point that such actions are more of a side-effects of general consensus that most of the tokens raised through ICOs are securities, they are not the drivers.

If you need to register ICO as a security - this is IPO, your security is represented as a token that’s it. One of the most interesting parts of security token can be that the company can raise funds through these tokens, do the due diligence and comply with registration and do not target to deploy underlying blockchain infrastructure at all. We might see established companies trying to supplement “security token” to diversify their capital acquisition plans contributing to the token economy after all. In order to implement this although there will be a need for relevant ATS to exist or current NSE to support trade of the security tokens. TZero plans to have such an environment, to provide a place where investors can buy security tokens. This is a timely thing, seen that most of the large ICO were conducted a year ago and so far none of the security tokens were registered with SEC and were issued through Reg D exemption, making them unregistered securities with obligation of holding for a specific period of time, meaning that by the time tZero is launched these exempted security tokens can circulate on tZero (I’d still leave circulation question open and see how exchange of such securities is regulated, because holder won’t be considered as issuer anymore).

Legal ICO is nothing but an IPO tokenized and administered through a central exchange with prior registration. I will not draw the differences between ICO and IPO, these should be clear to the most by now at the high level at least. I will not as well get into details on the subject matter of when a token is a security and when it is not. I will say that as discussed previously in this paper knowing the nature of the transaction might help (this is something that was supported by Vlad Zamfir as well). If we achieve to have a ledger where we indicate and disclose transaction natures, maybe we can then implement the regulatory triggers that will reflect whatever the market nature of token represents at the moment of transaction, but then as Rosenblum said we’ll need homogenous regulation to accommodate smooth transitions. As good as this might sound, he also said that drawing the lines between these two will be difficult in a fluid market and when you factor tail aspects that follow the nature of transaction (such as taxation) you begin to question if this can work at all.

Deployed Capital (ETF, Interval Funds, Index, IRA, Endowments)

I’ll cover few interesting aspects of how crypto capital can be deployed and what consequences each of these might have. I will omit describing crypto hedge funds that we now have, because hedge fund was the most flexible fund structure to deploy and attract investors in 2016/2017 and because most of the hedge funds are private funds it is hard to assess either their impact on the market or their health.

One of the most interesting investment vehicle so far for crypto is ETF (exchange traded fund). We’ve seen Winklevoss twins struggle to push their ETF through, we’ve seen GBTC trading with exorbitant premiums and we’ve seen reality shares ETF that promises to include blockchain-based digital assets in its portfolio through proprietary revenue-based algorithm on blockchain assets. There was a lot of chatter prior to SEC’s rejection of proposed ETF by Winklevoss, providing insights why investors would buy into the trust with quite logical reasoning for its press time (that said when prices were surging). But SEC rejected Winklevoss ETF on following grounds: lack of regulatory clarity over the assets and liquidity management issues. It is important to understand that the more filings and commentary over rejections from SEC we see, the more regulatory clarity we are getting. ETFs in general are weird investment vehicles for SEC, it was brought up during a speech from SEC commissioner Kara Stein in 2015 where she underlined the abnormal behavior of ETFs during flash crash compared to the overall stock market. Although after SEC’s rejection there were significant moves in the market congressional hearings shed a little bit of light on regulatory sentiment, CFTC approved DCO (Derivatives Clearing Organization) LedgerX that clears bitcoin options, CME and CBOE introduced bitcoin futures contract - that should have given CFTC clearer picture over the spot market trades. These things might positively contribute to future ETF approval.

I see Bitcoin ETF coming soon already, step by step there are regulatory moves that should be paving its way for such product to be listed. For me main concern apart from liquidity and manipulation at this stage would be if at any time of the listing, the demand will be as high as in 2017’s march where we waited for Winklevoss ETF ruling. By the time SEC will grant ETF permission to be listed, retail investors will become more rational (post-bear cycle), CFTC will have clearer picture over the spot market oversight and overall there would be more clarity. I guess that SEC might look into the general rules that applies to ETF trading (which are those of mutual funds with added exceptions or exemptions to facilitate trades). But even though that ETF products might be coming to the market, I think it might be early. Retail and institutional investors who do not want to expose themselves to direct bitcoin custody will opt to purchase ETF. Trust will hold large chunk of underlying digital asset, bitcoin market will become liquid through it, added to this fact that futures contracts are trading as well price discovery can finally stabilize fluctuations. My main concern for early introduction of ETF products falls again under classification issue. Introducing Bitcoin ETF to the market will further anchor its class as that of a commodity and commodity being considered as the most volatile asset, I do not think its introduction will straighten its fluctuating curve and lead to bitcoins adoption as medium of exchange, quite the contrary, it will enhance the “hoarding” phenomenon, locking out cryptocurrencies and further moving prices up without much solid reason behind it.

I would dedicate another discussion to ETF and digital assets, because it is pretty large concept affecting digital assets in serious ways. Above I’ve only covered ETFs with underlying asset that of bitcoin, but if market demand grows for different digital assets we can see ETFs based on ERC20 tokens and other vast array of ETFs.

Apart from ETFs that are traded on exchanges like stocks, I am looking into if there are any interval funds registered with SEC. Interval funds seem to be a good match at this stage, they provide transparency, give access to all types of investors. You can avoid 2-20 fee rates of hedge funds, cater to non-sophisticated investors while preserving specific repurchase schedule to manage your liquidity and at the same time keep offering subscriptions. This kind of investment vehicle seems to be less utilized until recently in U.S although it makes sense to not jump right away at ETF listing but to start with interval funds, it will give SEC a sneak preview into how investors and fund managers react to market fluctuations, what repurchases look alike. This is a compromise between crypto hedge funds and ETFs that we want to see. But it surely provides SEC with some valuable information, I am surprised that I have not seen such implementations yet. Another thing market is seeing right now is a rush of Crypto Index Funds that cater to accredited investors. Coinbase asset management for example that rebalances annually (passive investment) adjusts to coin issuance/inflation and lists tokens per GDAX listing guidelines (under certain limitations). It is a cheaper option (2% management fee and no performance fee) than buying into hedge fund but exposure is limited and less versatile. At this stage, when crypto options are not yet prevalent with broker/dealers, taking a plunge in Crypto Index Fund might seem reasonable. Buying-in into the fund is starting at $10,000. Offer is done through PPM and custody is supposedly managed through Coinbase cold storage system. The offering is made available through Regulation D - overall this is very neat product.

All of the above instruments need to hoard cryptocurrencies either through active or passive management. Passive management funds will lock their assets for a longer period, active will rebalance more often. But it is exactly this activity that will make crypto market appealing to investors during the bull cycles. How locking large sums will project itself on market prices is yet to be seen or how prices will react when funds exit large positions, for this to happen without lot of noise market needs more activity. Another interesting trend that implies locking crypto funds for even longer period was detected last Summer and that is Individual Retirement Account (IRA). Bitcoinira provides IRA to its clients with IRS’ tax deferred status, so if you are eager to hoard your cryptos until you retire you can do so without accruing capital gain tax, until you start withdrawing when you reach you retirement age. Now this is obviously risky and this is obviously a trend coming from younger generation during the bull cycle, but good thing with this is that its long-term capital commitment can withstand bear cycles. This will lock crypto for even longer periods of time and what is interesting here to me personally is that if this trend gathers momentum, will it be able to raise serious questions regarding insurance of these accounts. As of now none are insured by FDIC or SIPC (because classification), but once they become hot and in demand we might be able to see discussion regarding custodianship and insurance to revive pushing clarity in classification if it’s not set by that time. The usage of crypto in IRA is nothing but a positive step for overall health for crypto market. This is although a herd trend and needs to be addressed with the reasoning and counter regulation (disclosures would help). One reason for herding is because tax-breaks and limits compared to 401k are lower in IRA although compound interest of crypto asset itself in IRA can outperform regular 401k). This is an interesting trend because it counters the “tokenize all for the sake of instant-liquidity”. Some things are better kept for what they were created for - longer liquidity and it appears that the young US generation is leveraging that, making IRA products hot.

What is yet to come to the industry are the crypto endowment funds, these might lock up chunk of capital and in bull cycles can be truly useful for the institutions using above principal gains. As of now most endowments serve educational purposes, but it would be interesting to see crypto endowment funds and foundations serving the goals of those unbanked. I assume there’s a long way to that and maybe the next bull cycle will reanimate greed in endowment managers to resort to crypto asset investing. Another hurdle for endowments to participate in crypto is ethical and cultural standpoint, investing in highly risky asset in endowment is a bold statement to its donors that might need rigorous justification from managers.

As a side note, while deploying long-term capital on the market, it will be important to manage proper KYC policy in case we ever transform to fractional reserve banking in crypto space. Consequences to faulty deployment of KYC can be for example surprise U.S. national indebtedness, currently foreigners hold $1 and U.S. hold against it 0.89 cents. Because U.S. puts its investments in higher yield instruments, and foreigners invest their money in secure U.S. instruments, this leads to U.S. getting higher returns on the shorter periods of time. In case there is FRB in crypto and KYC is not properly in place there will be a hard time to figure out the indebtedness of the certain population in crypto. This is far fetched prognosis, but avoiding things like proper KYC can lead to unexpected results for overall economic health. If government doesn’t know its position of indebtedness how should it plan its policies. The longer we deploy the capital to work for us, the bigger the temptation to implement credit product is, which can lead to FRB, and thus role of KYC will come handy, it is not only a tool that we hate to mention and love to avoid, but it is a tool to prevent economic downturns.

Derivatives

Derivatives were introduced as bitcoin futures contracts in 2017 by CME and CBOE, through self-certification process. For some reason it was anticipated that they would jack up prices even further, with anticipated liquidity inflow, but what eventually happened was that with introduction of bitcoin futures prices fell and suddenly confined their movements within 20% band limit that is set on the futures contracts to prevent critical price movements. What it brought as well was the asymmetry of understanding the price. Maybe futures contract enable price discovery but users of cryptocurrency, who are used to track spot prices now had to find ways to find publicly available futures contract expiration dates. I’m doubtful that large portion of bitcoin holders, or those who are eager to enter the market for short-term trade look at the delayed quotations provided by CME and CBOE. This is where the commodity classification of bitcoin should have brought more stability to it and had to be useful, so far after introduction of futures contracts market has been mostly in bear cycle and is still volatile, although it must be noted that no above 20% fluctuations appear to be as frequent as they were before.

Introduction of futures tamed bitcoin prices within the range of $10,000 and was well tested, market didn’t move two and threefold further with futures contracts. But what happened next is confusion, where futures traders need know to find the sources of information that will drive their prices forward. Futures traders look at bitcoin as financial instruments, spot traders look at it (apart from sudden investment gain) as a technological tool, both need to come to terms to understand the asset in one similar way and express their views then.

Crypto has introduced and challenged the asset class paradigm, while CFTC deemed bitcoin as the commodity and commodities are too volatile, building ETF over such a volatile asset in its infancy is a risk. Bitcoin is perceived as the cryptocurrency by many as well, currency being the least volatile of assets is the groundwork for building a transaction, not an ETF right away. Thing is we want from bitcoin both investment instrument and transactionality but with our current form of regulatory and asset class understanding it is not easy. Decreased volatility will enable better adoption on the overall market, with implementation of much better instruments such as proper and affordable shorting, better derivatives as well as better currency ETFs (subject to how bitcoin will be perceived overall).

Being commodity with implied high volatility makes it hard to build better investor products with it. The stability must be brought into the market naturally as it grows. Futures introduction stipulated this through price discovery. But it as well brought another problem that is market psychology of participants. Many of the traders are not well versed in how futures can contribute to the pricing of an asset. Liquidity flow over long-term is not guarantee that price will skyrocket, but nevertheless that was the exact expectation. It is paradoxical for newly initiated traders to look at the tokens, see their price decline from the highs. Paradoxical in the way they love the assets they trade, it made them rich and they start to hate the decreased volatility. Bitcoin price gained some stability in mid-10 thousands for some time, and this is much better for the future of the asset, more stability in bitcoin will make it better medium-of-exchange, it will anchor itself as the stable currency on the market and it will force the regulators to look at it as such and not a commodity. But in order for institutional investors to fulfill their bets an options market needs to be developed, as well by opening bets to non-US players because there are holders of wealth overseas who must have their say in the crypto market.

We have yet to see bitcoin options being offered in a regulated environment, this should further stabilize the market and provide better hedging tools to investors. With LedgerX being DCO, it seems possible that we’ll see wider and more accessible options trading coming this year. As of this moment your trades on LedgerX must be collateralized at 1:1 ratio, this way avoiding credit risk. You will be able to write an option (put/call, covered not naked) and sell it. It will be interesting to see how options will behave, are they going to be left non-executed, expired, are they going to be sold or executed?

Another aspect of derivatives is tail-classification, for example Coinbase considered Bitcoin Cash as derivative of Bitcoin and listed it on the grounds that fork was considered derivative of the main chain, same goes to the Ethereum Classic. This is neat reasoning to list any forked asset, but forks might start to differ widely from their main blockchain and this formula might not be applicable to each and every forked blockchain. But I have to admit that this made a lot of sense and gave flexibility to Coinbase to enhance its digital asset listing.

Now I invite you to look at weird history of derivatives regulation. Onions are the only agricultural product that was delisted from commodity futures in late 50s due to what was then called Great Chicago Onion Ring, where onion traders manipulated the market by owning almost all onions, dictating the price of the contracts, shorting them and then finally dumping the market with their onions to realize gains on short positions.

CFTC removed onion but what did they implement as measure to prevent this from happening to other commodities, still is a question to me. This does not seem as a preventive comment but as a remedy to the manipulation. Various researches were conducted after this event happened to see how commodity futures contract affected asset’s volatility. Results were unfortunately divided with some saying that with delisting onion futures, the onion prices were less volatile while others concluded that onion prices were less volatility when contracts were trading on the futures exchange. During the hearings, the Commodity Exchange Authority stated that it was the perishable nature of onion which made them vulnerable to price swings. Now bitcoin is not perishable, but the nature of bitcoin, private cryptography (secrecy) and small market (compared to other markets) makes it more susceptible for someone to corner the market. Now this is a feature of commodity (perishable plays a role), while in interconnected system with medium of exchange this could not happen. Today you might not be able to do it so publicly and you would not hold 98% of bitcoin, but by observing the volume and circulating supply, you can take the futures position with substantial power, enter and exit your positions and definitely affect the market intentionally or unintentionally.

Look out, onions are not the only exception, so are the the futures contracts for movie receipts from overseas. Prior to Dodd-Frank Act being passed two exchanges were ready to list DBOR (Domestic Box Office Receipts) contracts on futures exchanges. Hardly lobbied by Majors, MPAA and producers, senate banned listing of those contracts. Although this would highly benefit some unpredictable Hollywood box offices, producers became nervous that they would be prone to manipulation and insider trading from this product. Please take a note of the power of lobbying here as well.

Proof-of-Stake triggers new regulations

While everybody is interested in how Proof-of-Stake will work out, I have not yet seen a regulatory opinion over this type of consensus. PoS would trigger another regulatory sentiment towards the cryptocurrencies. As of now prevailing regulatory philosophy is that of an investor protection but in case of Proof-of-Stake we will move into the Regulation E and Regulation DD, where philosophy will be bank-thinking based, thus focused on soundness and safety of the deposit funds.

These two regulating arms are very different and require different mindset, while one regulates investments, the other regulates soundness of deposits. Once we move towards these waters we will see more of Feds enforcement and we might start to see discussion between Federal Reserve and other federal agencies debating whether bitcoin is a currency or not. Because once we move to PoS and substantial funds are deployed in order to mine blocks, we will have to admit that we moved away from security and commodity debates towards deposit debates. This will require thorough analysis of Federal Reserve’s opinion but this will definitely usher crypto regulations towards a new direction. And what is even more interesting it will decouple Ethereum from Bitcoin because not only there will be difference by consensus, there will be difference by regulatory treatment.

technology, finance, lawGiorgi Gurgenidze