Is the Crypto Space Really Ready for Its Wall Street Close-Up?

What ‘financialization’ means for Bitcoin, Ethereum and others

Wall Street bank Goldman Sachs made big news in December 2017 when it announced plans to launch its own crypto trading desk.

It happened right in the middle of the big Bitcoin run-up at the end of the year and immediately caused prices to spike even further.

This was it. Validation. Official recognition from Wall Street that cryptoassets have true value and are here to stay. The bank said they planned to get the business up and running by the summer and started hiring right away.

Then… nothing.

June came and went. Then July. And August.

But then in September, an update. Goldman said it would “indefinitely postpone” the crypto trading desk plan due to the “uncertain legal and regulatory footing that the industry is currently muddling through.”

Bad news. Just like that, all that validation for the space went out the window.

Or did it?

For a long time, the idea of Wall Street coming to crypto was seen as the dream scenario. The idea being that it would attract big money to the space, drive up the price of Bitcoin, and then everyone would get rich.

But it’s more complicated than that. In fact, it’s always been more complicated, but too many traders have been blinded by the promise of quick riches that they’re ignoring what a “Wall Street of Crypto” would really look like and mean for the industry.

Is it really a good thing that major banks and other financial institutions are moving into the cryptocurrency space?

Financialization comes to crypto

Everybody’s been waiting for it. Everybody seems to like want it.

It’s all the traders can talk about.

But why? Who really wants this to happen? And, maybe more importantly, who doesn’t?

The truth is, whether the financialization of cryptoassets — that is, turning crypto assets like Bitcoin into financial assets that can be traded and held like traditional bank assets — is good or bad depends on which side of the issue you’re on. Traders might love it; investors might hate it; developers might not care.

It just depends.

As an investment, Bitcoin has been the best performing asset for the last several years. It’s crushed every return out there, and it isn’t even all that close. But on the banking side there are still a lot of questions around the idea that Bitcoin will replace the dollar as the world’s reserve currency. And then politics. What role do central banks play in all of this? Are they going to allow cryptoassets to step up like this?

But Wall Street is interested in Bitcoin despite all of these questions.

Why? Because they see the opportunity in cryptoassets. They can see the upside.

And why not? We all want to make money from our investments.

But the “incumbent system” — Wall Street, the Fed, the banking system, etc — has been stuck on the sidelines for a long time. They’ve been sitting back watching Bitcoin and other cryptoassets appreciate over the last couple of years and they want in.

They’re “the man,” and they can’t just sit back and watch other people pocket gains without taking a piece for themselves.

Because at most financial institutions their whole job, the way they make money, is by showing off positive returns and getting more and more people to bring them money to invest for them.

The S&P 500 returned almost 19% in 2017, making it one of the best years in Wall Street history.

Bitcoin, on the other hand, returned more than 1,300%.

The solutions for the banks and other institutions then is to financialize these cryptos, taking Bitcoin to start and turning it into a financial product that they can access and trade.

What They Really Want To Do

Basically what they want to do is to create a leverage-based asset with Bitcoin as the underlying asset. This isn’t a new idea. It’s what Wall Street does all the time. It’s what it did with mortgages. It’s what they did with pensions. It’s what they did with ETFs.

But to really understand what’s going on here, let’s first dig into how the system works. How it’s worked for decades.

To do that, we need to go back to the beginning.

Our entire financial system is built on debt. Since 1971, when the U.S. left the gold standard, everything involving U.S. currency has been built on debt.

That opened the door to financialization, which Wall Street has done in two different ways over the years: debt-based assets and equity-based assets. Debt-based assets are based on underlying debt holdings, while equity-based assets are based on equity holdings, or real shares in a company.

Not surprisingly, at least to me, is that it’s the debt-based assets that Wall Street really loves. That’s what they always want, because they can better control it. Their profit or loss isn’t based on the ups and downs of some company, but instead they can write their upside into the deal by controlling the debt and setting their own terms.

Here’s the twist: A debt-based asset is it can be both an asset and a liability at the same time. That’s key to understanding this type of financialization.

Owning a debt asset basically means that somebody owes a debt to me, as the holder of that asset. So we’re calling it an “asset” even though I don’t actually hold it.

That’s what creates counterparty risk for these types of holdings. If somebody owes an asset to me, then they’re my counterparty. I’m at risk because if they default then I lose.

It’s like with stocks.

Maybe I owns shares of Apple or Facebook through my brokerage account. I don’t really own them, though. My brokerage owes them to me. What I really have is an IOU that my brokerage will pay me for my shares when I want to sell them.

They’re my counterparty.

And that’s a risk for me.

At the end of the day, all any of us have are IOUs. That’s how the whole system works.

all any of us have are IOUs

But equity-based assets are different. They are assets that Wall Street doesn’t like because they can’t financialize them.

One example of an equity-based asset is crypto. If I own cryptocurrency then I own the key to it. It’s in my account and no one else can access it. It’s mine. There’s no counterparty.

That’s equity. There is no IOU there.

Bitcoin was created not to have counterparty risk. So I can control the keys and I can own it.

Other types of equity assets include land, physical commodities like gold or silver, personal property, etc. Anything that you can have in your possession is an equity-based assets.

What does this mean for Wall Street and crypto? What the banks want to do is take the equity asset that is crypto and turn it into a debt asset. When that happens, they’ll hold the title to the debt, they’ll hold the security (the cryptoasset) and then they’ll pledge it out to investors.

Crypto will be an asset to them and a debt to the investor (like me).

Then they can use that IOU and loan it to another bank. And that bank can loan it to another bank, and another, and another. These IOUs will just start piling up on my debt.

This is Part 1 of a 3 part series.

Check out Parts 2 and 3

Part 2: Is the financialization of Bitcoin a Good Thing?
Part 3: How Bitcoin and we can protect ourselves from this

Studying history to predict the future, trend hunter, fundamental analyst, speaker, adventurer