Institutional interest in bitcoin surges as trading products mature

Wall Street’s interest in bitcoin is growing quickly, aided by a raft of new tools and instruments designed to make trading of the digital currency easier and more familiar to investment professionals. A year ago, most traders and institutional money managers were highly skeptical about digital currency, if they knew about it at all, and viewed it almost exclusively through the prism of bitcoin’s well-publicized failures like Mt. Gox and Silk Road. 

That was then. Fast forward twelve months, and despite bitcoin’s falling price and the continued regulatory debate, most buy-side denizens are not only informed about the basics of Bitcoin, but they’re increasingly interested in learning how it can complement their existing portfolio strategy as an uncorrelated, high-alpha asset class.

Several factors are responsible for driving this transformation. First, rapidly growing commercial and institutional appetite for bitcoin exposure has highlighted the need for financial products and services able to handle large positions, hedge risks and take advantage of bitcoin’s ample price volatility. Secondly, the Bitcoin ecosystem has become a venture-capital darling, with at least $295 million raised by startups since the start of the year (a record $96.5 million in October alone) and some $105 million raised in 2013.

Some of the biggest names in next-big-thing VC investing, like Andreessen Horowitz and Tim Draper, are placing big bets on digital currency. This influx of capital has enabled a large number of companies to develop software and platforms that replicate the trading experience familiar to most on Wall Street. Indeed, a number of applications are now available to track, chart, and analyze bitcoin as a financial instrument, not just as a unit of account. In turn, this has brought bitcoin out of the shadows and put it onto the trading desk in much the same manner as equity, fixed-income, commodity and derivative instruments. Even Bloomberg LP and Thomson Reuters have taken notice, and now include bitcoin pricing data & charts on their institutional trading platforms.

Furthermore, bitcoin’s relatively low liquidity and high volatility have highlighted the need for more sophisticated hedging and trading tools. Robust margin capabilities, high-frequency trading algorithms, and derivative contracts have all been developed in the past year designed to both protect investors as well as provide ways to speculate on swings in bitcoin’s price. And perhaps most interesting to long-term observers of the digital currency ecosystem, these tools are increasingly being developed by Wall Street trading veterans interested in exploring bitcoin, as opposed to bitcoin technologists trying to build trading applications. The difference is subtle, but significant.

Volatility has been both a blessing and a curse for Bitcoin. While wide swings in the price of bitcoin against fiat currencies obviously offers a lot of potential to nimble traders, until recently there was a dearth of alternatives to merely trading in and out of this asset class. With the advent of the first generation of bona-fide derivative instruments able to provide both additional liquidity and a suite of tools to hedge risk beyond simply closing positions. Issues around clearing, settlement, borrowing and global market making notwithstanding, Wall Street’s interest has accordingly skyrocketed.

Innovation has been rapid, even by Bitcoin standards. Major bitcoin exchanges like Bitstamp, Bitfinex, OKCoin and Huboi have led the way in developing margin, swaps, limited futures and options trading, short selling and familiar trading tools like stop-loss and trailing stop orders. They’ve also created platforms to buy and sell bitcoin mining capability, known as hashing power, essentially turning the mining side of the Bitcoin ecosystem into a tradable instrument.

Meanwhile, Bitcoin’s fractured network of exchanges, each with their own inside market, makes pricing relatively inefficient at best and arbitrage opportunities large, both of which make it a perfect candidate for the automated trading scripts increasingly available open-source, for rent, or from exchanges. Concurrently, powerful institutional trading platforms like Zeroblock, Tradeblock, Coinsetter and Vaurum have developed products that provide market data, low latency trade execution, broad liquidity sourcing, and elements unique to bitcoin ownership, like secure storage.

Swaps and non-deliverable forwards have received particular attention lately. By settling in cash, they allow investors to gain synthetic exposure to bitcoin without owning it directly. Trading exchange Bitfinex has offered swaps for some time, while SolidX, a New York-based startup that recently raised $3 million in VC funding and was founded by prop trading and hedge-fund professionals, has developed an ISDA-compliant total-return swap that delivers the dollar return on bitcoin over a set period. Meanwhile, New Jersey-based Tera Exchange has received CFTC approval to operate as a swaps execution facility, providing the first regulated platform for swap participants and their counterparties. Another New York startup, LedgerX, is backed by Google Ventures and counts former CFTC Chairman James Newsome among its board members. The company, which has applied for registration with the CFTC as a both a swap execution facility and a derivatives clearing organization, intends to list physically-settled bitcoin option contracts on the first fully-regulated derivatives exchange.

Other familiar instruments are making their way into the bitcoin ecosystem. First Global Credit has developed a Contract for Difference platform that allows users to use bitcoin balances as collateral against investments in a number of global equity markets, while Singapore-based Coinarch has launched what is essentially an out-of-the-money put option that settles in cash should the option expire above the strike, and in bitcoin at the strike price should it expire below it.

Unsurprisingly, the surge in derivative activity is encouraging securities regulators to get up to speed. In early October, the CFTC’s Global Markets Advisory Committee held public hearings to look at overall regulation of bitcoin derivative markets, and the results were encouraging. Unlike many other agencies, the CFTC appears to be approaching bitcoin with an eye to understanding the potential benefits while also devising an appropriate regulatory framework in which bitcoin can operate. According to CFTC commissioner Mark Metjen, more than 5,000 worldwide logged on to view the hearing’s webcast, by far the largest online audience ever recorded for a CFTC hearing.

The development of sophisticated trading tools and liquid derivative instruments has long been considered key to widespread adoption of bitcoin by Wall Street. As these products develop, so will the ability to speculate on and/or hedge price volatility and counterparty risk, which along with greater regulatory oversight, will bring in institutions that have so far been uncomfortable with or unable to engage bitcoin in the past. One thing is for sure – the days of Wall Street dismissing bitcoin out of hand are rapidly becoming history. 

About the Author

Steven Lord is Managing Editor of FINalternatives.com and the founder of Modern Money Group. He has studied bitcoin since shortly after its inception, and has become a leading expert on the digital currency ecosystem.