Happy Genesis Block Day to all of our readers. Today marks the five-year anniversary of the first bitcoin block ever mined, ushering in not only a new digital currency, but also the functional implementation of a potentially revolutionary value transfer technology. Over the past year, market participants have witnessed tremendous growth cycles driven by regional catalysts around the globe – from the Cypriot financial crisis in March to the Chinese exuberance over the last quarter. With increasing interest coming from institutional finance of late, it appears the most significant wave in bitcoin’s sixth year may be oriented not geographically, but demographically.
Visible, Growing Interest
At a combined USD-equivalent value of approximately $10B, the total value of bitcoin outstanding is now the size of a large-cap company and traditional financial firms are showing signs of increasing focus on the budding market. In the last few months, major sell-side banks like Citi, NAB, and BAML have published formal research on the industry. While most of it has been relatively rudimentary for those already knowledgeable in the space, they were undoubtedly addressing an initial but growing interest from their client base. Meanwhile, Wedbush has published a number of sophisticated reports applicable even to readers with a solid understanding of digital currency fundamentals.
This institutional interest has also been reflected in media coverage of late. CNBC now has a dedicated section for bitcoin that contains their near-daily coverage over the last quarter, with even the Wall Street Journal publishing on the topic at a similar pace. Much of the major news coverage has been about data points that lend to the same hypothesis of institutional interest, including Fortune recently covering speculation that Fortress Investment Group may be involved in the space, or CNN Money noting that a Goldman Sachs board member recently joined the board of bitcoin company Circle as well.
Implications of Institutional Demand
Growing interest from traditional financial firms will likely have a profoundly different impact than the technology enthusiast or day-trading speculators who have been largely responsible for bitcoin’s growth to this point.
Exposure, Not Assets
While they may be interested in the revolutionary benefits of the technology, the likelihood of a professional trader committing the necessary time to navigate the intricacies of safe bitcoin storage is low compared with the likelihood of a general enthusiast managing the same. Most of our readers would consider bitcoin easier than a few tons of oil or corn to hold, but the infrastructure to manage the technical and legal liabilities of the asset to meet institutional standards is something that will take time for most firms to get in place.
Unlike the personal financial management of bitcoin traders, trade settlement at financial firms is generally handled by back office staff executing decades-old procedures, and bitcoin storage would require not only the directive of the trading desk, but also the coordination of new procedures for the back office and IT staff. That many moving parts can dramatically increase risk of mismanagement and extend the time required to build the proper infrastructure.
What this means is that in the near- and intermediate-term, institutional participation will likely be bolstered (and potentially driven) by assets that offer financial exposure while minimizing tech risk. Instruments like the Bitcoin Investment Trust (BIT) offer exactly that, enabling accredited investors to hold BIT shares with weekly liquidity, while SecondMarket manages the underlying asset. Not surprisingly, the NAV of the BIT has climbed to $55M+ from $2M since the inception of the fund in late September – a result of both bitcoin’s price climb and the unique opportunity offered by a firm globally respected for facilitating liquidity in otherwise illiquid markets.
The next step in the evolution of this market would be a vehicle that offers immediate liquidity in a standard exchange environment. An ETF, like the one filed for by Winklevoss-owned Math-Based Asset Services, would be an important step towards that goal. Such a product faces significant regulatory hurdles, including review by the SEC and CFTC, which explains why little definitive progress has been made towards the bitcoin ETF’s launch since the initial filing more than six months ago. That may turn out to be a good thing for such an instrument though, as undependable volume in the volatile bitcoin markets would make management of the underlying asset at appropriate prices difficult during times of high activity in either direction.
No Holding Means No Spending
The enthusiasts who have largely driven the market to this point are generally traders by interest and to an extent, incident. Exchanges were the primary way to obtain bitcoin for many years, so interest in holding and learning about bitcoin largely drove trading volume. If the interest from the next wave of participants starts and ends at trading, their impact will be much different than that of historic holders.
Personal traders will inherently blend their exchange activity with their personal wallets. At a firm level, if traders are even touching the actual asset and not a related vehicle, the bitcoin will likely remain on the firm’s books until it’s traded off. The probability of a fund going out of their way to support the bitcoin economy through spending or to manage the accounting of employee compensation in bitcoin seems unlikely.
The result will be a broad group of interest exploring the space, but not utilization of the technology for its dramatic benefits as a payment technology (at least at the outset, longer-term view explained below), meaning trading volume relative to economic activity may not immediately match the high correlations seen historically. For context, many analysts over the past years have been enthusiastic about AAPL and have gained deep knowledge of the firm, but that doesn’t mean they’re waiting on line for the new iPhone release.
This also means that gaining a view into what exactly is driving the market will be far less transparent than we’ve seen previously. Unlike massive volume increases in XBT / CNY, institutional participation will roll in firm-by-firm across one of the world’s largest and oldest industries. Even sensing the demand and having anecdotal evidence won’t quite lend itself the the traceability we’ve seen to date.
Asset Acceptance Lends Itself to Technology Acceptance
While the impact of institutions between this Genesis Block Day and the next lends itself primarily to trading, there’s reason to believe the longer-term implications may be far more profound. As firms become increasingly familiar and comfortable with the notion of digital currencies in general, they may realize that they’re among those with the most to gain from its existence.
Any institutional trader will likely offer a similar lament to the processes underlying the markets they operate in, with a particular confusion around why trade settlement takes as long as it does. The notion of a purchased asset or incoming cash not hitting a firm’s books until T+3 makes little sense to people used to the functionality of a globally-connected world. Yet, upon realizing that the DTC was established nearly 40 years ago to solve the problem of transferring physical notes representing securities, it’s not surprising that navigating the infrastructure required to settle a trade often takes longer than circumnavigating the globe.
In a world where financial firms are comfortable with the notion of bitcoin, both sides of a trade could eventually be settled with block chain technologies. The securities themselves could be transferred in minutes through a distributed Color Coin-type protocol, or through a centralized cryptographic ledger – perhaps even built and managed by the DTC. The other side of the trade could also be settled in a digital currency. Bitcoin could be in the hands of the seller in minutes and immediately swapped on the open market for their desired holding currency. Alternatively, with a relatively small group of trusted counterparties, Ripple could also work to well to expedite fiat settlement.
Both prospects face significant hurdles that would make them near-impossible to use on a broad scale in the near-term. Notably, the required technical infrastructure to guarantee the secure transfer of financial assets would have to be far greater than even bitcoin’s current 10 PH/s for banks to become comfortable with the idea. Current bitcoin markets also lack the necessary liquidity to facilitate institutional-sized cash swaps and are still too volatile even for short-duration exposure.
While huge firms tend to take many years to make even small infrastructure adjustments, it’s not unreasonable to think these concerns could be addressed by the firms themselves to take advantage of the efficiencies of such a protocol. Mining farms owned by banks to support network security or a block swap curve used to hedge risk until ample confirmations are made to facilitate cash settlement on a trade could well be on the (very distant) horizon. At that point it’s equally as reasonable to assume that these firms, many of whom are issuing banks for credit cards, may want to employ the same technology in the massively complicated and expensive consumer payments network.
Tangential Near-Term Implications
For those still reading, let’s climb out of the rabbit hole and back to the tangible, if tangential, effects that institutional adoption could have on the broader industry.
Institutional presence means greater resources applied to the industry. In addition to increased discussion among financial thought leaders, it also means tangible benefits like the expedited establishment of standard accounting practices and perhaps increased lobbying efforts on behalf of digital currencies.
It also lends credibility to the space in general, as people who see bitcoin in their professionally-managed IRA may be more likely to accept it at their businesses – or at least less likely to dismiss it outright. The current difficulties of bitcoin companies to obtain bank accounts may also be alleviated once the firms holding those accounts gain comfort with it elsewhere on their balance sheets.
While much of the above are years or decades away from becoming reality, they’re catalyzed by the initial acceptance by institutional firms that has already begun. The road ahead is long, but 2014 is already indicating significant industry advancements are well on their way.
Happy Genesis Block Day.