Cryptocurrency hopefuls want to believe that Wall Street is just another eager investor, ready to pump money into the growing crypto market and enjoy the same returns that retail traders have seen every time the value of cryptocurrency has skyrocketed. But that projection misses the mark in two ways: first, Wall Street is already neck-deep in the cryptocurrency market; and second, the last thing Wall Street intends to do is pump the precarious market with its own capital.
Institutional finance has had many opportunities to make money in the cryptocurrency space. But, as its influence spreads, the cryptocurrency market is transforming into something new. Whether intentionally (or as a byproduct of its own flaws), Wall Street could slowly be killing cryptocurrency.
How Could Wall Street Kill Cryptocurrency?
The short answer is hypothecation. In short, hypothecation is when a firm that owns equity shares in a company signs those shares away to a lender as collateral. For example, suppose that Fund A needs $100 million. Broker B agrees to lend Fund A the money in exchange for $100 million worth of the securities that they (Fund A) owns. This type of transaction is referred to as hypothecation. Rehypothecation occurs when Broker B reuses the assets they got from Fund A as collateral for its own business operations. In the traditional financial world, this is easy to do for a few reasons.
The first is that shares are not settled physically. Rather, they are written as certificates of ownership. This makes it easy to pass them along as an ‘IOU.’ Another reason is that accounting and tax laws allow the same asset to be attributed to different parties (as long each party records a different amount of debt on their balance sheets). Though counter-party risk increases significantly with a system like this, it’s necessary to grant increased flexibility to banks and brokers.
Why This Matters for Cryptocurrency
Now, consider that although many major cryptocurrencies claim to rely on a hard-coded proof-of-work (PoW) or proof-of-stake (PoS) system, they are actually traded on centralized exchanges. If a bitcoin were to be rehypothecated six times as brokers and exchanges trade debt and collateral, who gets to claim custodianship in the event that it’s needed? Who actually owns the cryptocurrency at the end of the day if multiple parties know the private key (or if no one does)? Consider that cryptocurrency enthusiasts live by this mantra: “If you don’t own your private key, you don’t own your bitcoins.”
If a broker goes bust and someone needs to pay up, or if a hard fork occurs and someone needs to vote with their ‘stake,’ it’s unclear who actually owns the bitcoin because, at this point, the collateral chain is so long. Regardless, this complex model of transient ownership simply doesn’t work when it comes to ledger-based assets because it may result in multiple parties expecting remuneration at the same time. The chance of a meltdown in this scenario could be devastating.
How Wall Street Could Make Bitcoin More Stable
In the past, bitcoin was traded exclusively on fiat exchanges. This meant that users could only buy or sell; there was no way to short bitcoin and there were no futures or derivatives based on the cryptocurrency. All purchases were settled in bitcoin; anyone who bought a coin effectively removed it from the market. Bitcoin’s limited supply and deflationary nature made it easy for the price to rise exponentially, as more people bought and fewer people sold because they expected greater returns the longer they held on to the currency.
This naturally contributed to volatility because the market was directly exposed to the forces of supply and demand. Mass fear of missing out could send bitcoin’s price soaring, while the same fear could bring it back down just as quickly. Wall Street’s introduction of bitcoin futures to its own brokers and exchanges significantly reduced volatility, simply because futures allow people to speculate on bitcoin’s downside as well as its upside.
This balances the market and makes it just as profitable to suppress bitcoin as it is to pump it. Additionally, with instruments that merely mimic bitcoin’s price and aren’t cryptocurrencies themselves, the supply and demand factor is less relevant. Bitcoin’s spikes and swings become much less pronounced. High-frequency trading bots also now populate crypto markets, which further reduces their once impressive instability. Sophisticated bot programs like those employed by Wall Street can still be extremely profitable in low-volatility environments. Volatility is part of the reason that bitcoin is so popular and profitable for the average trader, and without it, the asset really has no fundamental or unique value to the masses.
Why Investors Want a Bitcoin ETF
A Bitcoin ETF represents the real pipedream for crypto enthusiasts for two major reasons: first, ETFs are settled in an underlying asset; and second, they’re plugged into the traditional financial market via brokers. With an ETF, bitcoin would become more accessible to retail investors who still don’t have the patience or wherewithal to buy bitcoin on cryptocurrency exchanges or operate a blockchain wallet. Simply put, it’s the secret ingredient for mass adoption.
Those bullish on a bitcoin ETF saw a glimmer of hope in October 2021 when trading began on the NYSE of the ProShares Bitcoin Strategy ETF (BITO).1 This ETF isn’t directly tied to bitcoin and instead tracks Chicago Mercantile Exchange (CME) bitcoin futures—the contracts that speculate on the future price of bitcoin.2
On the other hand, ETFs that are directly tied to Bitcoin from several firms have been flat-out denied—including from early bitcoin investors Cameron Winklevoss and Tyler Winklevoss—or have not yet received approval from the SEC.3
Even though there are avenues for profit in crypto, and the field has enjoyed an increase in popularity in recent years, the future of cryptocurrency’s relationship to Wall Street and the greater investing public contains many uncertainties.
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