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Beverly Chandler

Bitcoin and Ethereum challenge the capital markets


Supporters believe digital currencies are developing capital market layers. Beverly Chandler investigates.

An example of innovation combined with nostalgia is the arrival in the UK of the new pound coin, its design based on the much-loved threepenny bit, a twelve-sided coin that was in use in the UK from 1547 to 1971. 

It’s a bit of a leap from the threepenny bit to the bit as in a binary digit, a unit of information in computing, and the bit in the digital currency bitcoin, but there is something oddly romantic and nostalgic about the world’s most modern currencies.

Bitcoin is the best known of the digital – or crypto – currencies, first named in a paper in 2008 and launched in 2009 by a mysterious and anonymous figure who goes under the name of Satoshi Nakamoto. 

For all its mythical origins, bitcoin now has a market cap of around USD17 billion and a value of around USD1,100 per coin, with Nakamoto’s personal bitcoin holding rumoured to be worth in excess of USD1 billion.

A hint of a noble quest in the bitcoin story comes in the activities of bitcoin miners, charged with releasing new bitcoins through a competition in which users offer their computing power to verify and record bitcoin transactions into the blockchain.

The blockchain is the ledger, the register of bitcoins recorded in a distributed database. To achieve independent verification of the chain of ownership of every bitcoin each network node stores its own copy of the blockchain.

This technology lies behind what many see as the key strength of bitcoin, that it has no one central governing body which controls it and everyone who is involved in it has some degree of control over it.

Bitcoin mines are situated all over the world, but the largest are distinguished by banks of huge computers whirring away resolving increasingly difficult puzzles in order to release more bitcoins (and their ability to charge transaction fees) into the world. 

On a more prosaic note, because of the heat caused by all the whirring computers, the energy costs have threatened to impact on the profitability of the bitcoin transaction fees. 

The result is that the mines are increasingly found in obscure parts of the globe, far from the usual financial centres, where they can be cooled by Arctic air – Iceland – or powered by hydro-electrics, Tibet.

And, with bitcoin, all this questing and solving of puzzles is a race to a fixed goal. There are a finite number of bitcoins available – no quantitative easing for this currency – and the total stands at 21 million bitcoins. 

The network releases a new block of bitcoins every 10 minutes until all 21 million are released, with the blocks getting smaller as time goes on. If the miners in the network take more than 10 minutes to guess the correct code, the puzzles get easier, if the reverse happens the puzzle becomes harder. 

Inevitably, the puzzles are becoming harder as more miners raise the stakes in trying to solve them. More difficult puzzles lead to fewer bitcoin releases, capacity constraints and rises in valuations, but also rises in transaction charges – some observers predict bitcoins will become prohibitively expensive to use going forward.

Bitcoin’s leading broker/dealer Coinbase announced in a ‘spring cleaning’ blog in March that it would discontinue paying network transaction fees for on-chain transactions. 

They wrote: “Network transaction fees do not go to Coinbase, they go to the miners of the bitcoin and Ethereum networks. Since our inception, we have been paying network fees on behalf of our customers to help support the growth of the bitcoin and Ethereum networks. We now have over 6 million users worldwide, and this has become a significant cost. Fees will be assigned dynamically based on the current network conditions and will be paid by customers when they send an on-chain transaction. Transactions between Coinbase accounts will continue to be off-chain and free.”

One solution to the issue of rising transaction costs is a proposed ‘forking event’, a hard fork which would divide bitcoin into two separate pools of assets and power. March saw a group of nearly 20 bitcoin exchanges release contingency plans in the event that the bitcoin network splits in two, creating two competing currencies.

Mike Venuto is co-founder and CIO of Toroso Investments, an asset management firm with direct assets of over USD100 million and which advises on over USD1 billion. He has taken a particular interest in bitcoins and the recent applications to include them in an ETF. 

Commenting on the potential fork, he says: “The bitcoin blockchain is owned by the world. If the crowd wants the fork, it’s a crowd-sourced infrastructure so it’ll happen.”

Bitcoin enthusiasts estimate that in its current form the last bitcoin will have been mined by 2140 at the current rate of mining and estimates for the final top price for a bitcoin vary from several million dollars to USD5,000.

Investors who have been in bitcoin since the outset have enjoyed extraordinary returns. 

Ryan Radloff is head of investor relations with USD50 million Global Advisors which runs GABI, a bitcoin fund, a bitcoin platform and offers bitcoin exchange traded notes (ETNs).  

The Global Advisors ETN comes through their subsidiary, XBT Provider AB, based in Stockholm, and is based on the average price of bitcoin drawn from the top three exchanges. The firm has now hired a veteran of the ETF industry, Laurent Kssis, in their plans to accelerate growth in the XBT Provider AB business.

With all the secrecy and the questing, many observers question what drives the continued rise in the value of the bitcoin, as early days were marked by links to the ‘dark web’.

Bitcoin is pseudo anonymous – partially anonymous – so while you can see where every bitcoin is going on the blockchain, you don’t know who owns it. This has posed significant problems in the past.

Radloff says: “Bitcoin had similar, humble beginnings as the internet, both started in areas that were not mainstream, and associated with ‘dark web’ activities like drugs and the sex industry, however both innovations have grown out of their ‘rocky starts’, to become very useful technologies to civilisation.” 

There have also been concerns that the bitcoin price is being affected by its huge take up in China, where monetary restrictions are driving investors to shadow banking and to the digital currency world, and the authorities have had to address ‘know your client’ problems on the Chinese exchanges and resolve fake order books. 

Bitcoin enthusiasts believe that while the Chinese activities had a temporary impact on bitcoin liquidity, the heart of bitcoin price rises lies in increasing demand for the coin as a real store of value. 

“Bitcoin is being used much more in a professional capacity,” says one. “You can buy a Tesla with bitcoin.” Or a coffee in a café in Oxford or use a bitcoin ATM in Las Vegas.

Firms such as Radloff’s believe that all of this is a sign that the digital currency is evolving. 

“A capital markets layer is starting to emerge with futures, swaps, derivatives and unique arbitrage opportunities which we can take advantage of,” he says. “We had 71 per cent returns in our fund for our investors in 2016 with fluctuations on a month to month basis lower than what you would see owning the underlying, so family offices will be long bitcoin through the platform and then diversify by being long in GABI. 

“GABI provides a professional management approach to the risks associated with bitcoin, both direct investment into bitcoin and we are also set up to take advantage of arbitrage opportunities in the bitcoin markets.” The US regulatory body, the SEC, appears not to agree that bitcoin is ready for the main stage, having recently knocked back a bid from the US’s Winklevoss Capital to launch a bitcoin ETF, COIN, and a second bid from Solid X to launch one on the New York Stock Exchange. 

The SEC ruled that a proposal to allow the Bats BZX Exchange to list and trade shares of the Winklevoss Bitcoin Trust should be turned down. “The Commission is disapproving this proposed rule change because it does not find the proposal to be consistent with Section 6(b)(5) of the Exchange Act, which requires, among other things, that the rules of a national securities exchange be designed to prevent fraudulent and manipulative acts and practices and to protect investors and the public interest.”

Further, the SEC commented that it believed that the significant markets for bitcoin are unregulated. 

Townsend Lansing, head of ETCs at ETF Securities says: “There is no potential for a bitcoin ETF in the US any more in the near future. The SEC rejected the Winklevoss ETF in a way that strongly indicates that they won’t be approving any bitcoin ETF for some time and won’t until there is a properly regulated and liquid exchange for bitcoins.”

However, outside the US, things might be different. Lansing says: “Elsewhere, bitcoins ETFs are possible, but they might encounter the same issues as with the SEC. The area is incredibly complex and I am not sure that the asset is quite ready to be used in an ETF format.”

Meanwhile, in the US another contender for the bitcoin ETF business remains in the ring, Grayscale, which is going about it in an entirely different way. Both of the earlier applications for ETFs, COIN and Solid X, were based on ‘33 Act ETF legislation, while Grayscale has filed under the Jumpstart Our Business Startups Act of 2012 (the ‘JOBS Act’). This version, which takes their existing bitcoin investment trust and converts it into an intraday trading ETF has, potentially, a huge impact for bitcoin.

Toroso Investments’ Mike Venuto says: “The demand an ETF could create is scary. Unlike any other asset in the world this is finite – if we run out of dollars and pounds, we print more; if the gold supply is low, we mine more; if we run out of oil, we pump more.”

He also warns that the effect a bitcoin ETF may have on bitcoin itself, might not be the one intended.

“I think that a bitcoin ETF would likely raise the value of bitcoin but increase speculation and I don’t think this should be a speculative asset because it has value for its utilisation. From the point of view of its benefit to bitcoin, an ETF could be dangerous, but as an investor it makes it easier to access.”

However, Venuto predicts there will be a bitcoin ETF within the next 18 months to two years as firms watch and follow the ‘road map’ the SEC is laying out as it turns down applications and, in so doing, defines its requirements.

And there are very faint signs that institutional investors are beginning to take an interest in cryptocurrencies. Rupert Osborne is Deputy Head of FX and Futures Dealing, IG Group which makes markets in bitcoin. Osborne says: “From our client base, there may be some institutional clients out there. What I hear in the bitcoin market is that since the ETFs have been stopped in the US, there has been more of an interest in institutional products and I am sure there will be an ETF in London or China at some point – I am sure there is a lot of institutional demand out there.”

He continues: “It’s a fragmented market so it’s hard to tell if exchange prices are accurate when there is so much volatility. When the SEC blocked the Winklevoss trust there were huge differences in prices across the exchanges as people were trying to get in and out of positions.

“It’s not an efficient market at the moment. The arbitragers are already there, but there is not a huge amount of liquidity so if someone turned up with millions, they would bring the prices into line quickly without making too much money. In the future, there will be consolidation in the exchanges and if they get regulated in reputable jurisdictions over time it will be more efficient.”

Meanwhile, the blockchain technology that supports bitcoins has developed a life of its own as companies as diverse as Northern Trust and IBM have launched an application for the private equity market or the activities of Deutsche Bundesbank and Deutsche Börse, who have jointly launched a functional prototype for the blockchain technology-based settlement of securities. Their prototype is designed to provide the technical functionality for the settlement of securities in delivery-versus-payment mode for centrally-issued digital coins, as well as the pure transfer of either digital coins or digital securities alone.

A recent survey from Outlier Ventures’ Blockchain Ecosystem Tracker which tracks over 1200 listed blockchain start-ups, led to Frost & Sullivan and Outlier Ventures evaluating the market and mapping 130 blockchain start-ups into their key activity areas. Investment in 2016 reached an all-time high of over USD500 million, bringing total investment in blockchain technology start-ups to USD1.5 billion, the firm says.

Commenting on the blockchain activity, a bitcoin enthusiast says: “We love the free advertising of all the blockchain companies, but most are failing to understand the innovation in the technology. The real innovation here is decentralised digital money: no one has to ask permission anymore to store, send and access value.”

And, of course, one digital currency isn’t nearly enough. The Swiss model Ethereum (another Game of Thrones’ name, if ever there was one) launched in 2015 and has a capitalisation of USD1 billion. Pre-sale it was launched in bitcoin but differs by having no limit to the amount of currency that can be issued. 

Our bitcoin enthusiast says: “I’m a big fan but the issue is that it’s an investable asset with no capped money supply so it’s difficult for me to put my head around and tell somebody to invest in when I don’t know what the end goal is.”

Ethereum is based on smart contracts or highly programmable digital money. The Ethereum site explains that applications run as programmed without any possibility of downtime, censorship, fraud or third party interference. The apps run on a blockchain and without a middle man or counterparty risk.

Venuto says: “The desire for Ethereum is about having a more utilisable version of bitcoin to attach an asset to but a big drawback, that I think will be its undoing, is that it’s a closed system. You are paying the foundation and hoping they will do something good with that money.” 

Ethereum has also achieved some critical mass. Dutch bank ING Bank, working with financial technology innovation company R3 CEV, recently trialled five block chain technologies, including Ethereum, in parallel in the first test of its kind. This seems to fit with Venuto’s views on Ethereum. “With Ethereum, they’re trying to make the value more about how it is used for transactions and less about a deflationary asset,” he says.

The jury has to be firmly out as to whether bitcoin offers much to the institutional investor at the moment, but as a disruptor and cause of new thinking in investment, it is working pretty efficiently. Perhaps the thing to remember is that the many sided new British pound coin, based on the original many sided threepenny bit, has been designed specifically to increase security in the British coinage. 

The Royal Mint launched it flagging it definitively as: “The most secure coin in the world.” Maybe now, as it was then, security lies in the edges. 

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