Bitcoin Financialization: Hype or Peril?

Caitlin Long recently wrote a three-part series about the incipient financialization of bitcoin. I think that this is an especially important issue to discuss, and I worry that too few people in both the bitcoin and Wall Street communities fully understand the problems that bitcoin financialization could generate.

First, her three articles can be found at the following links:

• ICOs Were 45% of IPOs in Q2 2018, as Cryptos Disrupt Investment Banks
• Is Financialization a Double-Edged Sword for Bitcoin and Cryptocurrencies?
• Racing to Fix Wall Street: ICE, Cryptocurrencies And Enterprise Blockchain

There is also a summary of these three articles, available here. Finally, podcast host Laura Shin interviewed Caitlin about this issue, which is available here. I recommend that you read these four articles and listen to the podcast, as they give a lot of background about this issue.

Wall Street sees vast new possibilities in bitcoin. It will create bitcoin-derived derivatives, which make off-chain claims on bitcoin out of thin air. It turns out that this has profound implications both for Wall Street and bitcoin bulls.

What is Financialization?

“Financialization” describes the process by which the economic exchange of value between parties is mediated with financial instruments, including derivatives like options, forwards, futures, swaps, etc.

Advocates of financialization claim that it creates more liquidity, gives investors, traders, and buyers and sellers more options to exchange with each other, and allows investment managers to adequately hedge exposure to various risks.

Critics of financialization claim that it makes complicated financial markets even more opaque, leaves most of the profits to the experts rather than the end users, and sells complicated investment schemes to unsophisticated pension funds, local governments, and other parties ill-equipped to accurately parse the risks associated with these instruments.

The Size of the Derivatives Markets

One of the interesting things about derivatives markets is that the notional value of outstanding derivatives are often many times the value of the assets from which the derivatives were created. The Bank of International Settlements notes that the notional amount of outstanding OTC derivatives contracts at the end of June 2017 was $542 trillion. Real estate, for comparison, is a $215 trillion asset class globally.

In traditional finance, this isn’t necessarily a problem. However, it is a problem with bitcoin because if the notional value of bitcoin-derived derivatives is greater than the market value of the extant bitcoin, then bitcoin’s algorithmic scarcity is undermined. All of the sudden, hundreds of billions of dollars worth of derivative claims on bitcoin will occur off-chain, in opaque Wall Street systems. No longer will you be able to explore all bitcoin-related transactions through a block explorer.

What are the Consequences?

Given this, if a large enough group of bitcoin users band together and choose to fork bitcoin, the financial institutions trading bitcoin-derived derivatives may suddenly find themselves trading derivatives tied to a worthless cryptocurrency.

Think of it this way: if Wall Street goes full bore on bitcoin, and trades them and makes derivatives based on them, which can be settled in bitcoin, as opposed to cash-settled derivatives, then what happens if bitcoin is forked, and Wall Street is left holding the toxic bitcoin? Quoting Caitlin:

Anyone exposed to fractionally-reserved bitcoins — again, these are off-chain substitutes for bitcoin that aren’t 100% digitally-escrowed by real bitcoins on-chain — are at major risk to a fork of the chain. In such a scenario, any party that rehypothecated, naked shorted, or has any other type of uncovered liability…is vulnerable to go broke….Because such a firm would still owe the liability but have little asset value, since asset value would migrate to the forked coin and no off-chain substitutes would receive any of the forked coins.”

Remember, these bitcoin derivatives are off-chain claims on bitcoin. But forks affect on-chain transactions. When bitcoin cash forked from bitcoin, people who held bitcoin in their wallets received some amount of bitcoin cash. But, had there been a robust off-chain derivatives market at the time of the bitcoin cash fork, none of the derivatives owners would have received any benefit.

Now, the fork of bitcoin into bitcoin cash did not prove to be fatal to bitcoin. But it’s not hard to imagine a scenario where hardcore HODLers, who have significant leverage in the bitcoin network, see the rise of off-chain derivative claims to bitcoin, and in a fit of ideological pique, decide to fork bitcoin into a new, derivative-less bitcoin alternative. And then Wall Street would be left holding the bag, unable to settle its claims.

At this point, Wall Street partisans will make the argument that Wall Street has trillion-dollar balance sheets, which it could use to exert leverage over the bitcoin network. But this kind of argument misapprehends why bitcoin is a secure network. Bitcoin is not a secure network merely because its value is greater than $100 billion, but, rather, it is secure because it has many thousands of participants. Wall Street can’t force longtime HODLers to sell their bitcoin to Wall Street institutions. Therefore, Wall Street’s ability to control the bitcoin network, and so any fork that arises from it, is severely constrained. Given this constraint, Wall Street would do well to understand the risks inherent in forks.

In her podcast interview with Laura Shin, Caitlin notes that regulators have asked for industry input about bitcoin derivatives markets. And they have received responses from traditional financial institutions. But they have as yet to receive any responses from people in the cryptocurrency community, who understand how blockchains work, why bitcoin is secure, and why off-chain derivatives claims pose so much danger to the issuing institutions.