Regulated Financial Exchanges and the Crypto Brethren in their Shadow – Traders Magazine
This first appeared in a blog by Brett Ladendorf
Has Crypto Survived the First Minsky Moment?
A Minsky Moment is defined as a market collapse brought on by reckless or excessive speculative activity. Investor sentiment is considered one-sided for a longer period leading to myopic markets where bullish sentiment becomes unsustainable. Volatility usually ensues. Cross market asset correlations trend towards 1. Many over levered entities holding such inflated assets fail. It is during these times when market infrastructures such as financial exchanges are tested, and new asset classes undergo additional scrutiny. Cryptocurrencies may have swooned along with equities and other risk assets in March but the strength of the financial plumbing in digital assets has since only strengthened.
Ensuring Continuity at an Exchange
The week of April 20th will not soon be forgotten by crude oil traders. When the May 2020 futures contract fell flat on its financial face Monday morning that week, the world paused to reflect on the implications of a negative print. While some scratched their heads, those familiar with the concept of super contango trudged on. Futures contract clearance did not skip a beat. Counterparties posted collateral. Those that did not or had accounts go debit took hits, but trades continued. Natural longs continued to transfer risk using the months further along the curve. The ecosystem of derivatives exchanges, built over many decades, ensured market integrity in the face of yet another Minsky moment. Risk transfer markets in traditional physical and financially settled derivatives markets demonstrated remarkable resilience. A similar system is emerging in the digital asset markets. There the first major test ran its course.
Traders come to regulated financial exchanges for price discovery, liquidity, and durability. The first two of these are self-explanatory but all three are interrelated. The third, durability, is associated with positive terms such as efficacy and credibility. Participants know that a regulated exchange has reliable processes such as clearing and settlement. They can expect to receive notifications on changes in margin and the expiration of contracts. There are reasonable expectations for the honoring of contractual agreements because of a centrally cleared process. This durability has as much to do with efficacy and credibility as it does for continuity of operations during times of elevated volatility or a loss of liquidity during a flash crash. A major issue at crypto exchanges, both spot and derivative, is the assurance that any one of them will endure continuously because most operate 24 hours a day, 7 days a week. The risk of loss of custody is high should a hacking entity force a shutdown or steal wallets offered on exchange. The risk of a crash is high on any one exchange if market makers lose funding or step off platforms if asset volatility crowds out marginal providers of liquidity.
On a regulated futures or cash equity exchange, the risk of asset theft through a hack or a busting of a qualified custodian is infinitesimally low.
Standard agreements on pricing is an important component to exchange durability. For the CME Group, a regulated derivatives exchange, the operators use the Bitcoin Reference Rate or BRR, to price the exchange traded futures contract. Reference rates are commonly used by financial exchanges to aggregate various interest rates for the pricing for futures contracts. The thought process behind and justifications for the calculations runs deep for these reference rates. The confidence of traders in the representation of these rates contributes to the deep liquidity of to such contracts like Eurodollars and Fed Funds. Continuity and representation are intertwined to deliver a powerful network effort for traders, market makers and other risk professionals who can support the liquidity of current contracts and whose support is so critical to the launch newer contracts like that of ICE and CME Bitcoin futures and options.
With some Macroeconomic Policies comes Demand for Dollars and Digital
Digital assets and crypto currencies are revolutionizing the way stores of value are created and protected. They can be a tool for people to protect their wealth from the inflationary threats of monetary policy that is accommodative or unhinged. A long-term bitcoin holder, aka a “HOLDER” aims to mitigate inflation risk because she feels central bank monetary policy is too loose or that a country’s fiscal policy is off the rails. Recent events in Lebanon, for example, have shown civil unrest in a country where a local currency has been pegged to the dollar since 1997. U.S. dollars there have become scarce, wreaking havoc on the country’s economy. Citizens and businesses are having trouble paying their liabilities in dollars because of this scarcity. There are reports that transactions of BTC / Lebanese pounds mirror the synthetic peg of 1,500 pounds to 1 USD. This resolution through triangulation is not new.
The deteriorating macroeconomic situation in Lebanon and in other countries like Venezuela is complex. One of the necessities of money functioning as medium of exchange anywhere is stability. Neither of these countries have stable currencies. As a result, banks, corporations, citizens and even the government must transact in reserve currencies or other mediums as trading partners and foreign investors refuse payment in their local currency. Effectively maintaining stores of value with fiat in such situations becomes exceedingly difficult so these entities use other means for keeping engaged with trading partners. Triangulation, an often unseen yet critical process carried out in the foreign exchange markets, allows for the Lebanese to evaluate their purchase of bitcoins with local currency when dollars are not available. Citizens and business operating in destabilized economic regimes often have no other means to trade than through alternative stores of value such as commodities priced in dollars or bitcoin. Inflated paper reserves with continuous declines in value relative to goods and services offered outside the country are constrained without triangulation. A Lebanese food importer or a Venezuelan oil company that can secure cryptocurrency like bitcoin will have a better opportunity to not only trade bilaterally but better understand the value of their goods transacted by converting barrels of oil into dollars and dollars into bitcoin.
The universal belief in preservation of value extends across borders. People want their money, whether earned through labor provision, active speculation, or passive investments, to be a lasting store of value. Market volatility tests mediums of exchange over time and through cycles. The 2020 coronavirus outbreak, an extreme exogenous shock that dealt a harsh bout of volatility in the global asset markets, is testing cryptos and the platforms they trade across. Exchanging currencies between fiat and fiat and between fiat and digital incur frictional costs and principal risk for holders. Traders and investors should not have to worry about thefts, but outages and cybersecurity risks pose a threat to almost any platform that is electronic and connected to the Internet. Many exchanges are unreachable by or forbidden to U.S. based investors. For those global citizens who can access them, where digital-to-digital transactions occur, continuity will remain a key to trader confidence in the ecosystem. Although in-kind fiat transactions in the FOREX markets dwarf crypto currency spot markets, the durability of these spot digital asset market exchanges will be watched closely by traders and regulators.
Listed derivatives exchanges offer the standard for risk transfer continuity. Volatility in the cash and derivatives markets has shaken the margining and clearing processes yet they have endured through the crashes of October 1987, of October 2008, and of March 2020. They have had over a hundred years to model their place in the ecosystem of asset markets. In-kind spot market transactions may have no need for a central intermediary in crypto. But if a HODLER chooses to discover relative value, whether a bitcoin buys 100 or 500 barrels of oil, the exchanges can and will fill that role.
The views represented in this commentary are those of its author and do not reflect the opinion of Traders Magazine, Markets Media Group or its staff. Traders Magazine welcomes reader feedback on this column and on all issues relevant to the institutional trading community.