As an intermediary-friendly exchange that has adopted familiar building blocks from traditional commodity markets and brought conventionality to the crypto space, we believe that the gold markets are a useful precedent for digital assets. In an earlier post, we compared end-users and miners of digital assets to hedgers in traditional commodity markets. Similar to other commodities, when seeking to sell their digital assets in exchange for legal tender, digital asset owners face market risk related to price volatility, and liquidity risk related to finding ready counter-parties with offsetting interests. Miners need a way to manage the risk of holding their long positions in the market.
This is a nearly identical use case to a traditional physical commodities producer, e.g. a gold miner, that uses futures contracts to lock a price at the present for the future sale of the commodity. The producer foregoes the potential upside if the commodity increases in price beyond the settlement price of the futures contract, but is also protected on the downside if the price falls. Below we take an in-depth look at the gold market, how it compares to the digital asset space and how it provides a useful precedent for us as we develop this new marketplace.
Physical Gold’s Market Structure
The current crypto asset market structure is in many ways similar to that of the precious metals market structure, which offers valuable insight as we build a conventional market for digital asset investors. For example, precious metals owners can face challenges in converting assets to legal tender similar to miners who acquire coins through the act of mining. Physical gold is the most prominent example. It trades in an over-the-counter (OTC) market that can be subdivided into a number of sub-segments: the interdealer wholesale market, the retail dealer-to-consumer market, and the industrial producer-dealer-manufacturer market. The physical cash market does not fall under CFTC jurisdiction, except in cases of market manipulation and fraud, but futures on the physical gold are under CFTC’s jurisdiction. Some aspects of cryptocurrencies do fall under CFTC jurisdiction, similar to how some aspects of the cash gold market in the United States fall under FinCEN rules in accordance with the Code of Federal Regulations (31 CFR § 1027.100(b)). For the purposes of this blog we will focus on the U.S. consumer retail dealer-to-consumer market for gold.
Similar to the technical aspects of bitcoin and Ethereum, for example, the process of mining and refining gold are extremely technical in nature and most of the end purchasers are unlikely to have expertise in the underlying processes, including any risks associated therewith. There are environmental and labor considerations in the underlying supply chain as well. Where and how gold is stored varies according to the preference of the owner: commercial vaults, sovereign vaults, personal safes, safety deposit boxes etc. with associated varying degrees of control over the asset by the final beneficiary — full control where the owner holds the gold in his/her physical possession, or intermediated control where the owner has chosen to store the gold in a commercial or sovereign vault, for example. The value of gold is set by the market (with the COMEX futures contracts and/or LBMA fix as the predominant reference prices) but can vary widely from one dealer and/or storage location to the next. The quality, reliability, safety, liquidity and location of storage facilities can impact how the market values the gold held there. For example, two 100oz COMEX good delivery bars of identical weight and purity may have different values if one is held in Chicago and the other in Singapore.
There are echoes of this in the crypto asset market too. Crypto assets can be custodied — defined by whom and by what means private keys are recorded, secured and managed, and where ownership records are maintained. There are a variety of means and locations with varying degrees of control and security. Private keys can be recorded in different ways where the owner exercises a greater or lesser degree of control. For example, an owner can maintain full control by holding private keys themselves in their physical possession, such as in a person’s biological memory, on a piece of paper, in a file on a computer, or using a hardware wallet. Alternatively, an owner can rely on a third-party to manage private keys. Further, private keys can be secured in a variety of ways including via technical, physical, and operational means. For example, private keys can be “sharded” such that the key is divided up into several pieces, with each piece distributed/secured separately. Each shard by itself is useless, meaning multiple shards must be assembled to reconstruct the private key. This can address single points of failure and enable operational checks and balances. Finally, ownership records can be managed directly on a given blockchain, or in internal books and records system “off-chain”. The quality, reliability, and safety of a crypto storage facility, like a gold storage facility, is driven in large part by the security and operational controls it has implemented.
As with the gold market, the liquidity and price of fungible underlying crypto assets can also vary by location. The widest differential can be found between geographical regions. For example, on Zimbabwe’s leading digital currency exchange Golix, bitcoin traded at a 30 to 40% premium to the international market price in 2018. That was because there was more demand for bitcoin in Zimbabwe due to its dire economic situation but fewer options to purchase the digital currency than in other countries. Hence, the price traded higher in the Southern African nation. Substantial price differentials can also often be witnessed when comparing Korean exchanges and U.S. exchanges. For example, during the peak of 2017, the regularly higher prices for cryptocurrencies in South Korea driven by strong local demand have led traders to dub this price differential the “kimchi premium”.
Having said that, cryptocurrency price differentials also exist on exchanges based in the same jurisdiction and these can be more easily exploited than trading across borders as there is no added currency risk when cashing out into fiat currency. Cryptocurrency prices vary across exchanges due to differences in liquidity, a lack of international price referencing standards, and the inefficiency of making fund transfers between exchanges. Moreover, prices on some exchanges, e.g. Bitfinex, might be higher due to the fact that it is expensive or impossible to withdraw fiat from the exchange, for example because the exchange does not have access to the banking system. In such cases this may increase demand for a cryptocurrency such as bitcoin, or a stablecoin such as USDT, the more liquid cryptocurrencies that can be moved to other exchanges that do have access to the banking system, and either traded or tendered for fiat which can then be withdrawn. This demand can drive the price of these “conversion” currencies and result in arbitrage opportunities for sophisticated traders.
The varying liquidity and prices of fungible underlying crypto assets can also occur for similar reasons such as the reputation and credit risk of the facility/platform, operational cost and speed relating to the deposit/withdrawal of assets, and the number of customers and potential counterparties with access and volume/value of assets stored/traded there, which may contribute to the availability of liquidity.
In the gold market, there is no guarantee of the price at which an owner of physical gold can convert their assets to legal tender or, in fact, that they can convert to legal tender at all. An owner may seek to compare prices by requesting quotes from a number of dealers, but this can be a time consuming and labor intensive process. In practice, most dealers will quote a price as an offset to the futures contract, which helps to create a degree of transparency. Dealers are able to quote more firmly, and at narrower spreads, because the futures contracts enable them to hedge their risk. Crypto owners may face similar structural challenges in converting their crypto assets to legal tender. The efficiency that futures contracts bring to the gold market enables gold owners to convert their assets into legal tender more efficiently and at better prices than may otherwise be available in the absence of the futures contract. Regulated futures markets can be similarly expected to benefit the digital asset market.
Market and Regulatory Similarities
Neither gold nor digital currency are the creation of governmental laws and regulations. This is a key factor that differentiates each asset from securities. Also, both gold and digital assets, like traditional commodity markets, benefit from the use of central limit order books. Traders are incentivized to place orders to these systems, thereby enhancing market liquidity, price discovery, and risk management functions of the markets, particularly during periods of market stress.
There are even similar uncertainties or unknowns related to the gold and digital asset markets. Gold futures contract specifications do not take into account the underlying technologies and processes for the mining, manufacturing, transporting and storing of gold beyond those related explicitly to the storage of gold deemed as good delivery to satisfy the requirements of the futures contract settlement. Similarly, it is unclear whether a futures contract on digital assets ought to consider the technical aspects of mining and storing the asset beyond whether the asset is stored in a facility that meets acceptable security and settlement requirements for the futures contracts, such as a CFTC registered derivatives clearing organization (DCO).
Similar to other commodities and assets that are not legal tender, when owners of digital assets look to sell their digital assets in exchange for legal tender, they face market risk related to price volatility, and liquidity risk related to finding ready counter-parties with offsetting interest. This is nearly identical to the challenges traditional physical commodities producers, for example a gold miner, faces when he enters into a futures position. Futures contracts help miners and producers lock in a price at the present time for the future sale of the commodity. It is the process of forgoing the potential upside if the commodity increases in price beyond the settlement price of the futures contract, but it is also protection from downside price risk.
Turning to the gold markets presents significant learning opportunities for ErisX as we adopt building blocks from traditional commodity markets and apply them to digital assets. For more information about our familiar infrastructure and regulated marketplace for digital assets, please email email@example.com.