The killer app is trading
Consensus 2018, a week-long conference put on by CoinDesk, took over New York last week. In scenes straight out of “The Wolf of Wall Street,” Snoop Dogg performed in a Meatpacking District club, a $3m yacht party was held for an app that is launching in July, and Lambos (the lingua franca of crypto) revved their engines in Midtown Manhattan.
Even though the conference was branded as “Blockchain Week,” you did not hear a whole lot of news about blockchain technologies coming out of the conference itself. This was not the case back when the conference consisted of 400 starry-eyed crypto-enthusiasts. However, in 2018, the conference had a decidedly grown up feel, with 8,000 people in attendance and panels dominated by executives from corporate America and Wall Street.
I was struck by the contrast of opinions in the aftermath of the event. Crypto-enthusiasts were downbeat about the number of “suits” at the conference, with some even questioning remaining in the space. On the other hand, Wall Street attendees were euphoric. Every Wall Street bank was in attendance. All the major Chicago proprietary trading firms were talking up the scale of the opportunity. The buzz of the conference was about new assets to trade on crypto exchanges, SEC-regulated alternative trading systems (ATSs) to trade ICOs, and prime services for the buy side.
“Wall Street is done” is something you used to hear a lot in the crypto community. The crypto-maximalists believe the power of the blockchain would single-handily replace all of Wall Street, ushering in a new crypto-utopia (probably in Seasteading communities). The reality could not be further from the truth. Wall Street is ascendant and is coming to dominate the entire cryptocurrency ecosystem. As we will explore here, the reason is that cryptocurrencies are the perfect trading instrument, although not for the reasons crypto-enthusiasts would have you believe.
Bitcoin is the future of money (2008)
Bitcoin (BTC) was born out of the financial crisis, with libertarians mad-on-the-internet about central banks printing money to stave off a second Great Depression. Bitcoin promised a currency that was uncontrollable by any single government due to its decentralized nature. Anyone, anywhere in the world could send bitcoin to someone else without the permission of any government or the services of any bank. That transaction could happen near-instantly and for much less than a bank would charge.
Early proponents of bitcoin were technology folk, who were excited about the benefits of the technology – faster, cheaper, decentralized, but did not fully understand that money has three essential properties. First, money is a medium of exchange that facilitates the sale of goods and services, replacing the inefficiencies of a barter system. Second, money is a unit of an account which allows users to set the prices of goods and services. Third, money is a store of value which can be reliably saved to be used later as a medium of exchange.
Bitcoin (and other cryptos) turn out to be pretty terrible at all three. A currency that goes up 20x over the course of a year and then falls 70 percent is not a store of value. The dollar has lost 16.4 percent of its value due to inflation in the time that bitcoin has existed. More important, the Federal Reserve manages inflation at a target rate with a variety of tools at its disposal. Without confidence as a store of value, it is impossible for companies to set the prices of goods and services in bitcoin. Without a stable unit of account, bitcoin can never develop as a medium of exchange, as it will be spent immediately or hoarded for speculation.
The earliest crypto companies were largely focused around “digital wallets” to simplify the storage and spending of cryptocurrencies. Today, no one really takes crypto seriously as the future of currency. Coinbase started out as a wallet company but pivoted to an exchange model that facilitates the trading of crypto/dollar and crypto/crypto pairs. Stripe abandoned support earlier this year for accepting cryptocurrency payments. The number of transactions done in cryptocurrencies is tiny and shrinking.
RIP crypto as the future of money, 2008–2013.
Decentralized applications will take over the world (2014)
While Bitcoin was going vertical at the end of 2013 (rising from $100 to more than $1,000), a lot of people started to think about applying the blockchain to other types of applications. The first attempts at this were by bank consortiums looking to modernize the back office of Wall Street. These consortiums, while well-funded, have largely failed to deliver anything of note, as we covered in Trading Places last year.
The next round of innovation came in Ethereum’s launch in 2015, which allowed code (“smart contracts”) to be run directly on the blockchain. Just as bitcoin made it possible to transfer money without central banks, Ethereum would allow you to run applications without a company controlling the code or data.
But, after a few years, only two applications have found acceptance. Cryptokitties is kind of like Pokemon on the blockchain. You collect, breed, and trade digital kittens. Very cool (I guess?) but not exactly the decentralized application revolution that we were promised. Smart contracts are hard to program for, often buggy and prone to hacks.
The other application (really a category of applications) is Initial Coin Offerings (“ICOs”), which allow the sale of tokens on the Ethereum network. These tokens can theoretically represent anything (like a Cryptokitty), but more likely are used to sell a financial interest in a common enterprise. ICOs have attracted the attention of the SEC and as such have been forced to go legitimate and operate through the traditional channels of Wall Street. As you might expect, this has damped much of the enthusiasm among enthusiasts about the future of decentralized companies.
RIP crypto as the future of applications, 2014–2017.
Regulated and centralized trading (2018)
While crypto has not delivered on the utopian vision of its founders, it has delivered something that should delight everyone else trading it: A new asset class that is infinitely replicable, untethered to real-world companies or assets, extremely volatile, and requires the same gatekeepers as every other asset class.
In traditional finance, trading instruments are based on real-world assets (even CDOs!). Stocks represent ownership of a company’s equity, bonds represent an obligation of a company, commodity futures represent a claim on the future delivery of a commodity, etc. There are only so many companies that IPO a year. With crypto, creating a new trading instrument only requires a bit of new code and enough miner interest. There are at least 667 forks of the bitcoin codebase. Bitcoin, Bitcoin Cash, Litecoin, ZCash, Bitcoin Gold, Bitcoin Diamond, Dogecoin, Bitcoin Private are among the top 50 coins.
The lack of relationship to real-world fundamentals means that the true value of a crypto assets is impossible to determine (e.g., as opposed to price/earnings ratio of a stock), but the price is readily apparent by the balance of supply and demand in the market. This is a trader’s paradise! As a former trader, I did not know whether Treasury yields were going up or down a year from now (or even hours from now), but I could make a two-sided market to any counterparty on the street because I had a ton of information about who wanted to buy or sell.
Far from being disintermediated, Wall Street is at the center of the new wave in interest in crypto. Liquidity in the crypto markets is powered by the same high-frequency trading firms that are dominant in equities, US Treasuries, futures, and every other liquid asset class. Jump, the largest trader of US Treasuries, has a trading team of 22 people working on crypto, according to a source familiar with the matter. That team is larger than any other single trading team (of which there are approximately two dozen) in the company. Hudson River Trading, Tower Research, and XR Trading all have large automated trading initiatives on the retail exchanges. (Notably absent from the list is Virtu.)
DRW, a huge market maker in futures and fixed income, now trades 30 coins around the clock. Does DRW use fancy new tools and smart contracts to settle on the blockchain? Nope. The crypto trading desk does not look much different than a commodities trading desk: trades are negotiated through Skype, confirmations are sent by email, and the back-office handles end-of-day settlement by sending and receiving wires.
The banks were slow to catch on, but they are now entering the market in force. Hedge funds and asset managers are not going to maintain a secure hardware wallet — they are going to trade through a firm like Goldman Sachs that will extend them credit, offer them research and technology, and clear and settle trades using the firm’s traditional back-office systems. Goldman Sachs has been public about entering the market this summer, but JPMorgan, Barclays, and others have all signaled interest in getting a crypto desk up and running by the end of the year.
Meanwhile, the retail exchanges have started to focus on institutions. Coinbase announced last week a suite of institutional tools including custodianship, low-latency trading, market making, and prime services. Gemini offers co-location in NY5, close to where banks maintain their foreign exchange trading systems, and order entry through FIX, which is a messaging protocol standard in finance. Exchanges such as Nasdaq and NYSE have said they are interested in participating when the regulatory regime is better defined.
With SEC scrutiny, ICOs have been forced to professionalize. White shoe law firms, the Big Four accounting groups, FINRA-registered bank broker-dealers, and SEC-regulated ATSs, have all entered the market to bless these ICOs as legitimate private placement offerings. And while this is all very exciting for finance professionals, it is far from a future free of gatekeepers that crypto-enthusiasts envisioned.
Wall Street is now driving the future of cryptocurrencies, 2018 – ____.
Wall Street will take it from here
Uncensored money and distributed applications were great concepts but have found success in few real-world applications. However, the blockchain has found its killer app and it is trading. There are a few new players in the market (notably, the crypto exchanges), but for the most part crypto is fitting into the existing world of the capital markets.
It could just be the greatest financial instrument ever known to man.