Views on the Financialization of Cryptocurrencies

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Wharton FinTech

6 min readFeb 12, 2019

This piece is in discussion to an excellent article written in July 2018: “Is Financialization A Double-Edged Sword For Bitcoin And Cryptocurrencies?” by Caitlin Long, 22-year Wall Street veteran, co-founder of Wyoming Blockchain Coalition and ex-Chairman of Symbiont.

In her article, Caitlin Long first distinguishes between cryptocurrencies and other kinds of assets. She emphasizes that cryptocurrencies are equity-based assets with no counterparties (similar to land and physical commodities); unlike other assets we are more familiar with (such as shares and deposits) which are debt-based assets — meaning that the assets we own are simultaneously also someone else’s liabilities. Crucially, she points out that the financial system can “easily financialize” debt-based assets since the system itself holds title to the asset (and when you buy it you own only an IOU). Further, leverage is permitted by financial regulation. By extension, then, equity-based assets are not easy to financialize, since the financial system does not control title to these assets and owners must be willing to pledge them before a debt claim can be created.

I discuss my views below, drawing from my experience in facilitating markets and trading physical commodities from the platform of a top financial institution. Physical commodities are an asset class Caitlin Long and others determine as most similar to cryptocurrencies.

For the sake of this discussion, let us define “financialization of cryptocurrencies” as the vastly expanded role of financial motives, financial markets, financial actors and financial institutions in cryptocurrency markets (Casey, 2011). Caitlin Long offers two things that happen as an asset class is financialized: 1. it becomes “investable by large institutional investors”; 2. leverage — the issuance of more assets “out of thin air” or creation of more claims to the assets than there are assets. This is an interesting discussion because, clearly, there are some features of financialization that are beneficial and features that should be treated with caution.

Main benefits from financialization

The most obvious benefit from financialization would be the network effects created due to the additional holders of the cryptocurrency. This is a benefit that lends itself strongly to cryptocurrencies specifically. Since cryptocurrencies (like bitcoin, litecoin, and ether) rely on a proof-of-work consensus mechanism, the increase in actors in the space essentially contributes computing resources to the network, in turn generating a self-multiplying effect of making the cryptocurrency itself more secure, decentralized, and resistant to attack. This is what Trace Mayer refers to as the 6th network effect of cryptocurrency. However, it must be noted that the positive effects occur mainly only when financial actors directly or indirectly (through exchange) purchase the crypto-asset itself — this is the only way that processing resources are brought back to the network.

Another benefit would be the fact that prices would move closer to true fundamentals, i.e. financialization and the creation of 2-way markets would facilitate price discovery. Prior to December 2017, it was not possible to short-sell or to bet on the decline of bitcoin prices, and so speculative demand for bitcoin came only “from the optimists”. With cash-settled BTC futures eventually offered on the CBOE and CME, pessimists could short-sell or bet. What we saw was ensuing price declines in the asset, as pessimist demand came into the market. It must be pointed out that this cycle of high prices followed by a correction once futures are introduced is not atypical, but a typical occurrence and pattern observed in other asset classes once futures are introduced. Caitlin Long’s key argument against financialization is that leverage creates more claims than there are corresponding assets. Coupled with the fact that cryptocurrencies have a higher proportion of “HODLers”rather than speculators, leverage could risk creating a bubble with disastrous consequences once it bursts. The concern is ultimately about increased volatility in prices and contributing to the creation of asset bubbles. Here, we are not refuting the point, but offering the viewpoint that in the longer run, the construction of two-way markets accessible to various actors enables fundamental demand and supply factors to be reflected.

A parallel to be drawn with physical commodities markets

Physical Copper Cathodes ready for trading

It might be useful to draw a parallel with physical commodities (another kind of equity-based asset class) and see what happened as that asset class was financialized.

We find the consistent view from a variety of research (listed in References below) that there is no conclusive evidence that long-term commodities prices are closely influenced by financial market participants and their involvement in those asset classes. Falkowski in his paper “Financialization of Commodities” (2012) argues that it is difficult to draw a precise line between financial and fundamental factors in affecting price volatility. Comparing price changes in exchange traded commodities (Crude oil, soybean, copper, coffee etc.) vs non-exchange traded commodities (tea, poultry, sunflower oil, cadmium, rhodium etc.) from 2001–2008 leading up to the commodities price boom, showed that non-exchange trade commodities prices increased more than those open to financial speculation. If the instruments of financialization caused a price bubble in commodity prices, why did prices increase substantially more in markets without any fund activity? While the research does not provide any conclusive evidence, it does encourage caution in the blanket statement that financializing an asset class is responsible for the creation of asset bubbles.

In addition, there are also ways the presence of financial investors could stabilize the market. For example, passive long-only investors who systematically rebalance their portfolios provide stabilizing anti-momentum roles, market activity of long-short active investors who do fundamental research and reduce extreme volatility resulting from sudden realization of supply/demand imbalances, traders using their knowledge of new private information to judge prices. Considering the reasons above, I would thus hesitate to conclude that the financialization of cryptocurrencies is necessarily dangerous.

There are other more nuanced arguments that come to mind when the topic of financialization is broached. In his book “Blockchain and the New Architecture of Trust”, Professor Kevin Werbach of the Wharton School explains (and wisely so) that blockchain represents a new architecture of trust, distinct from three previously existing ones: peer-to-peer, leviathan and intermediary trust. In some sense, that is why blockchain is truly unique and revolutionary as a technological innovation. Quoting from the book,

“The blockchain replaces trust in individuals or institutions with trust across a system as a whole. Trust in the conventional financial system means faith in individual actors such as banks or regulators. With the blockchain, by contrast, no distinct party — not miners, those running blockchain nodes, creators of the code, or user — is necessarily trusted.”

(Notice here how blockchain is immediately juxtaposed against how the “conventional financial system” works). It seems ironic that we are here to discuss how the “conventional financial system” is going to affect cryptocurrencies.

In addition, I would like to venture the below thoughts as extensions to our discussion:

Is a certain level of centralization necessary for decentralization to move forward (or are we doing something truly disastrous)?
Can some elements of our conventional architectures of trust (through financialization) be beneficial to the decentralized architecture of trust blockchain has brought about?
In the eyes of the code and protocol, are all holders of cryptocurrencies equal (or are “HODLers” better than financial speculators)? Who are we to discriminate?

Some may look to the Internet and the increasing centralization of it as commercialization came about. Some of the best applications of the Internet (Facebook, Google, Twitter etc.) are centralized applications built on an originally-intentioned decentralized technology. Arguably, some centralization enabled the Internet to become truly revolutionary. It may have never taken off otherwise.

My final view is thus two-fold: first, financialization of cryptocurrencies will happen. In very recent times, we have seen the emergence of the ICE (Bakkt) Bitcoin physically-settled futures. We are seeing startups like Celsius (of Alex Mashinsky, no less) and SALT Lending who are keen to allow cryptocurrency holders to use their assets as collateral and to start earning interest. The tide of financialization is inevitable. Second, given the inevitability, the more important question is how can we prepare for it, in a way that minimizes the dangers of leverage, such that the benefits of price discovery and added security can be accrued. This calls into informed and nuanced policy-making and regulation. In some way therefore, the age-old leviathan architecture of trust is required to protect this budding technology so that it can bloom.

Thank you to the following resources, and guidance of Professor Kevin Werbach of The Wharton School and David Crosbie of Penn Engineering:

Views on the Financialization of Cryptocurrencies

Main benefits from financialization

A parallel to be drawn with physical commodities markets

Written by duckiehan