Digital Evolutions : The Coming Of Age of Digital Currency Trading Technology
There has been a great deal of discussion in mainstream and specialist media in the past months of the coming of age of digital currencies, both positive and negative. As a recent initiate to the digital currency world, I am taking a perspective from the traditional viewpoint of trading and exchanges and how the space could potentially evolve.
As it stands, the market cap of Bitcoin is somewhere in the region of 6 to 7 billion dollars. Recent price volatility has made this number hard to state with any degree of accuracy, however the bottom line is that the adoption and evolution of digital currencies has started to gain traction not only within the technology arena but also among more traditional spheres as the pace of adoption grows and interest expands.
In 2013, the main focus on Bitcoin and alternative currencies was around the use of an alternative currency to facilitate the transfer of money outside of the traditional banking channels. Large amounts of venture capital have been committed to establishing payment providers and technology providers who facilitate integration with the blockchain environment. Towards the end of the year, a number of ventures also started to look at the intersection between Wall Street and this space, to allow the trading of digital currencies with fiat currencies. Spot trading is already well established, on exchanges such as Bitstamp, BTC-e and several venues in China. A cursory look at ZeroBlock and BitcoinWisdom will show the number of these exchanges as well as the diversity of prices they offer. Mature financial markets do not offer this huge ‘spread’ simply because the liquidity and transparency that drives them means that the vast majority of arbitrage opportunities have dwindled to levels where the cost and effort involved is simply too great to make it worthwhile. Michael Lewis’ Flashboys documents the lengths that modern High Frequency Traders will go to to gain an advantage, even if it means carving through a mountain to ensure the straightest point-to-point connection via optical fibre.
Bitcoin exchanges on the other hand are still primarily venues for buying and selling bitcoin that have been acquired by miners and a smaller subset of retailers, as well as catering to altcoin miners who look to trade their alternative coins for the more established Bitcoin, presumably to be able in turn to cash in on their mining activities or simply spend Bitcoin via the nascent retail channels. The credibility and reputability of these exchanges is constantly in question, and a cursory check of the various exchanges will not reveal any substantially useful information about the people backing them, the security of their operations or indeed the motives for maintaining the exchange in the first place. This is still a very wild west environment, where anything goes and there is very little recourse to the average retail investor should anything go wrong.
This year has seen an evolution with newer exchanges attempting to address this and move into the space where traditional FX and digital currencies are traded, targeting institutions that would look to capitalize on the differentials as well as offer larger institutions the opportunity to hedge their digital currency exposure with fiat currencies. Think of PayPal, a global operator of payments that manages currencies for transactions the world over. At some point, PayPal has to put this money in the bank, and their interface to Wall Street to hedge these currencies acquired the world over is a huge source of flow for the lucky banks that get to run the business.
For digital exchanges, venues such as Kraken, itBit, Vaurum and Atlas are looking to capitalise on the intersection between digital payments and financial institutions, and they have tailored their approach to appease the ongoing concerns that institutions and Wall Street have with the lack of regulatory coverage and riskiness of digital currencies. There are also exchanges such as Bitmex, btc.sx, icbit and hitbit that have launched to offer additional trading opportunities for Bitcoin by offering leverage and traditional instruments such as derivatives and options. This week, a new exchange called the San Francisco Open Exchange (sf-ox) has launched promising to offer arbitrage opportunities between different digital exchanges and by incorporating aggressively named algorithms designed to seek out and capitalize on price differences.
All these exchanges have taken different approaches to how they could potentially attract liquidity and address the concerns of the institutional world, and all have similar challenges in managing the risk implied by offering leveraged products to traders who can potentially deposit digital funds, make a trade and then subsequently withdraw their funds rapidly without any form of protection for themselves, the exchange they are trading on or the other market participants.
Traditional exchanges offer trading facilities through memberships, who manage counter-party risk through deposits, default fund contributions and initial and variation margins on every product traded. These exchanges are secure, gated arenas where connectivity is via leased lines and private networks that are permitted only to those who have established their credentials and can demonstrate sufficient knowledge of financial markets as well as having the necessary funding to be able to participate without negatively impacting the operation and viability of the whole market. Last and definitely not least, most traditional exchanges are of significant national and global importance, and usually have implicit government support to bail them out if all else fails.
Digital currency exchanges on the other hand have to manage the risk entirely by themselves, and in addition deal with complexity of having an unregulated product, limited knowledge of the end customer and the need to manage the potential liabilities of operating in the various regulatory environments in which they find themselves operating. All of this in an environment where hacking and computer security is a primary concern, which rises exponentially the more a particular digital currency is traded on the exchange. Some exchanges do this by seeking regulatory approval, others operate entirely in the almost entirely anonymous environment of digital currencies and refuse to offer fiat currency deposits and withdrawals. Balancing this is a delicate task, as regulatory scrutiny is an anathema to traditional digital currency proponents, yet attracting serious institutional liquidity and interest will only be possible by offering some form of guarantee that funds traded will not simply vanish into thin air without any recourse or possibility of restitution.
As an observer in this space, one of the most impressive things has been the degree to which the way these new exchanges have been able to rapidly update their platforms and deploy to a customer base that is completely global, on a market operating 24x7 with a potentially unlimited number of participants. This is a far cry from the traditional world where exchanges are physically tied to a specific country, and access is tightly controlled through a network of participating member firms, regulated by a specific domicile and run for profit that is derived primarily from reselling market-data and access to the connectivity offered by the exchange. The Internet has definitely disrupted this particular model and advances in modern-day technology have shown that the barriers to entry have crumbled as entrepreneurs take the knowledge of how traditional exchange systems and trading platforms work and rapidly prototype them on a world stage.
Regulation, as well as the fickleness of market participants as they search for the best liquidity, will ultimately drive the success of the exchanges who will be able to carve out a stable position in the future. Markets, whether spot or derivatives ones, will ultimately only survive if they learn from and follow the rules that have governed the success of all earlier market places. The level of innovation in this space and the degree to which they can outsmart the competition while maintaining the reputation, security and stability of their own venues will be the ultimate judge in this arena. A degree of maturity is still lacking, and the transition from a purely gambling, speculative venue to one which has the trust and faith of all participants in the market is still a few years away from reality.
As some panelists commented at this year’s Coinsummit in London, 7 billion dollars is still only the equivalent of a single mid-cap company on the NYSE. The liquidity of the contracts and ability to exchange these is far from being mature enough, so the future viability of all of these exchanges is still very much in question. However the Bitcoin platform has much to offer not only in the digital currency space but also as a means to challenge the incumbents in the payments space. Legacy banking systems rely heavily on interconnectedness through established players such as SWIFT and Markit, and Bitcoin and subsequent developments on the platform have the ability to substantially disrupt these if greater adoption and understanding of the mechanics behind digital currencies takes off. Traditional Wall Street technology teams as well as existing exchanges are only starting to realise the potential for their normal ways of doing business, and the scope for further innovation once this has been realized is still potentially huge.
Hedge funds and other professional investors currently only tread lightly in the digital currency world, hampered by their own desire for security and risk management as well as the need to manage their customers’ funds securely without undue risk and the need to stay within the confines of their legal environment. The launch of the Winklevoss Bitcoin ETF may well change this perception, as the need to make markets and ensure liquidity could help bridge the gap between the retail market who want to participate and the financial institutions who wish to back this liquidity.
Of course, as one seasoned professional futures trader pointed out to me, if there is a tipping point at which institutions become heavily involved, the amount of money, knowledge and aggressiveness they bring to the game will also be a huge threat to incumbents who have already started to play in these waters. They may well find themselves outgunned to the point where they lose liquidity and wither away, or simply be absorbed into the existing banking and exchange infrastructure through acquisition to operate as dark pools or similar execution venues.
What is certain is that the current digital currency space and how new entrants are able to quickly bring new products and offerings to the fore is definitely an exciting one. In the future Bitcoin may cease to exist, but the manner and pace with which the global technology arena is developing, evolving and learning is definitely a lesson for all players in the trading and exchange space. Eventually the most exciting space to be in will be among the providers and enablers of the financial technology that supports these innovations, the “plumbing” so to speak; who see the opportunities and are able to bridge the digital and physical worlds with solutions to build a brighter and more interconnected world for everyone involved in financial markets.