Bakkt To The Future For Cryptocurrencies

Takatoshi Nakano wiped another bead of sweat from his brow. With a complexion the color of sand and deep creases carved across his forehead, Nakano, the weather-beaten rice farmer on Japan’s Honshu island is hard at work, harvesting rice from his small plot.

Rice is very nice. (Image by かねのり 三浦 from Pixabay)





Despite the plentiful harvest that season, a look of worry seemed constantly to be drawn onto Nakano’s face, like a parent waiting anxiously for their child to get off the school bus, concerned, but not excessively so.

Because in the 17th century Japan, a good rice harvest wasn’t always a blessing from the Gods — it could well be a curse.

Given Japan’s highly fertile volcanic soils, a good harvest on Nakano’s plot could well mean a good harvest on thousands of other small rice fields scattered across the Japanese islands.

And multiple good harvests meant only one thing — an oversupply of rice and their attendant fall in prices.

Because in the 17th century Japan, the price of rice was determined by what the market would pay when it was ready for sale, it was impossible for a farmer to accurately plan how much they could spend during the planting and growing seasons and know how much they could get for their crop after harvest.

If everyone’s harvest was good, leading to an oversupply in rice, a farmer would ironically get a poor return on their investment and could go bankrupt. If a farmer’s harvest was good, but the rest had a poor harvest, the price of rice would soar and a farmer could make a small fortune.

But the risks during each season were substantial. Does a farmer spend as much as possible (on fertilizer and working the land) in the hopes that his neighbor would not do as well? Or does a farmer put in an average amount of resources so that if rice was in abundance, he never spent that much, to begin with, and miss out on a potential windfall?

Given that during Japan’s Edo period, rice was a staple food source as well as a medium of exchange, the volatility of rice prices often led to shortages and famine, as well as oversupply and profiteering.

Against this backdrop, the world’s first futures market, the Dojima Rice Exchange, located in Osaka, was developed privately and independently, to allow rice farmers to “lock-in” the future price of their product and to hopefully bring some order to the otherwise volatile mix of this staple currency.

Farmers would now be guaranteed a minimum price for their rice and speculators who wanted to take a bet on whether rice would be more or less expensive when the contracts matured and the rice was deliverable, could take a bet either way.

Betting on Bitcoin

So when the Chicago Board of Exchange (CBoE) and the Chicago Mercantile Exchange (CME) first launched their own Bitcoin futures in late 2017, in the thick of the throes of the cryptocurrency bull run, many investors and traders saw that as a signal of institutional involvement in cryptocurrencies, sending the price of Bitcoin and other cryptocurrencies soaring.

But what investors and traders failed to recognize was that the CBoE and CME Bitcoin futures were not for physically deliverable Bitcoin — they were settled in cash.

It’s off to the races. (Image by Clarence Alford from Pixabay)





In other words, the CBoE and CME Bitcoin futures, were nothing more than a naked bet on the direction of Bitcoin, without actually creating an attendant underlying demand for the commodity itself.

So it came as little surprise when interest in these products eventually waned, with CBoE announcing this year that it would no longer offer Bitcoin futures.

To be sure, the CBoE and CME Bitcoin futures were not even really “futures” contracts in the strict sense of the term.

Look The Same, Not The Same

Which is why when the Intercontinental Exchange (ICE), the world’s second-largest exchange group by market value and which also owns the New York Stock Exchange, announced this month that it would be launching Bitcoin futures for trading next month — the market’s response was relatively muted.

Surely we’ve seen this all before, haven’t we?

But the new Bitcoin futures are not of the same complexion as the CBoE and CME products — Bakkt, which was set up specifically to develop infrastructure for institutional trading of digital assets, said this month that it would be launching two Bitcoin futures contract next month, one monthly and the other daily, but unlike the CBoE and CME contracts, the Bakkt contracts will be for physical delivery.

When a signature just won’t do. (Image by Steve Buissinne from repeat Pixabay)





That these futures contracts are for physical delivery of Bitcoin marks a huge step forward in the institutional management and trading of cryptocurrencies, specifically Bitcoin.

Not to sound over-dramatic, but physically deliverable Bitcoin futures contracts, traded on a regulated exchange have the potential to be a gamechanger the way that the Dojima Rice Exchange and Japan’s rice futures launched the industrial age in Japan.

Price Discovery

Up till now, CoinMarketCap.com, a cryptocurrency information website, has served as the defacto source for cryptocurrency prices, including for Bitcoin.

Using opaque algorithms, the unregulated website claims to garner cryptocurrency price information from various sources and amalgamate the sources based on its own proprietary criteria, to present a cryptocurrency price that the website itself believes best represents digital asset prices.

But CoinMarketCap.com itself is no stranger to controversy, with many companies and cryptocurrency exchanges claiming (albeit privately in some cases), that the website has been known to engage in “pay-to-play” tactics, which allows some cryptocurrencies to rank higher than others based on the amount of money spent advertising on the website.

And while such claims are unverified, that such allegations can always be made casts a pall on the integrity of the data churned out by CoinMarketCap.com

With Bakkt’s Bitcoin futures contracts, traders, as well as market participants who actually provide the deliverable Bitcoin, whether they are Bitcoin miners or individuals with large pools of Bitcoin, so-called “whales,” have the opportunity to create a Bitcoin price that is perhaps more reflective of market forces, demand and supply, then CoinMarketCap.com

Bakkt has also said that it expects to see cryptocurrency-focused businesses, specifically cryptocurrency mining firms, use the Bakkt Bitcoin futures to hedge risk, rather than for purely speculative purposes.

In the same way that the foreign exchange markets have an influence on the price we pay to swap one currency for another, Bakkt’s Bitcoin futures may contribute towards Bitcoin price discovery in a far more transparent way than the amalgamated information gleaned from many disparate, unverifiable data sources.

Custody for Your Crypto

Bakkt has confirmed that it will be providing custody for its Bitcoin futures after having obtained a trust license from the New York State Department of Financial Services recently.

Custody of cryptocurrency assets has long been a bugbear of institutional investors as many have been reticent to leave digital assets on unregulated, centralized cryptocurrency exchanges which have a poor track record of hacks, outages, and mismanagement of client assets.

Bakkt’s Bitcoin futures have also received a green light from the Commodity Futures Trading Commission (CFTC) and the futures will list on the ICE Futures U.S. derivatives exchange, with the clearing of the futures being conducted by ICE’s clearinghouse.

Institutional interest in cryptocurrencies has picked up recently, after the meteoric rise of Bitcoin and other cryptocurrencies since the beginning of this year. Bitcoin started the year below US$4,000 and currently trades just below US$10,000 today.

And with negative bond yields and stock markets looking increasingly overpriced, investors, hungry for yield have demonstrated a willingness to consider the hitherto unconsiderable, a foray into the volatile world of cryptocurrencies.

It’s in the vault. (Image by Reimund Bertrams from Pixabay)





Bakkt’s Bitcoin futures could not have come at a better time.

Speaking with the Financial Times, Bakkt’s CEO, Kelly Loeffler, said that ICE had received demand for the leveraged Bitcoin futures from Wall Street clients who would otherwise typically trade commodity, currency and stock index contracts.

And unlike existing Bitcoin futures contracts which track Bitcoin’s price from unregulated data and sources, such as CoinMarketCap.com, the Bakkt Bitcoin futures will be based on actual Bitcoin deliveries to a highly secure warehouse, covered by US$125 million in insurance.

ICE has also backed (no pun intended) Bakkt’s effort, pledging an extra US$35 million to its existing US$68 million guarantee fund, that will act as a backstop to Bakkt’s transactions at ICE’s clearinghouse.

According to Bakkt’s CEO Loeffler,

“The (cryptocurrency) market was really built around retail participants. So stepping back and designing the market around institutional needs will help bring in more sophisticated participants.”

But it’s not just ICE that’s throwing its hat into the ring, in trying to custody cryptocurrencies.

One of the biggest challenges to institutional trading of cryptocurrencies is the fact that a firm’s digital assets typically reside on the unregulated or loosely regulated cryptocurrency exchanges where trading takes place.

Given the vulnerability of cryptocurrency exchanges to hacks or mismanagement of private keys (which control the cryptocurrency stored in a wallet address), institutional traders have been reluctant to trade in cryptocurrencies, despite the potential for profit.

Which is why firms like Fidelity, one of the world’s largest asset managers, is among the institutions that are working on a dedicated cryptocurrency custody service.

American cryptocurrency exchange Coinbase also recently acquired the custody business of digital wallet provider Xapo, in a push into the institutional custody business.

The question of custody is a serious one.

Because it is only when cryptocurrencies can be locked away somewhere safely and their representative elements traded freely on exchanges, that trading activity can genuinely flourish.

Of course, custody also adds to cost — which undermines the otherwise frictionless nature of cryptocurrency transfer, but if the cryptocurrency industry as a whole is to mature, perhaps in the interim at least, some efficiency will need to be sacrificed in the interests of greater participation and inclusion.