Let’s face it, many aspects of FinTech innovation are not innovations as such but more so a modification of existing models thanks to the use of new technologies. If for example you look at cryptocurrencies and some of the related services and activities, the underlying concepts can be found elsewhere in more traditional areas of financial services. Take the recent news about the planned launch of future contracts by the Chicago Board Options Exchange (CBOE) and the CME Group, which is the company that operates exchanges like the Chicago Mercantile Exchange (CME). Rather than approved by a regulator, these new contracts for Bitcoin futures products are self-certified by the two companies, but the Commodities Futures Trading Commission (CFTC) had a say in certain aspects of the design and settlement of these contacts. Once the contracts are launched over the next ten days, the CFTC will engage in risk-monitoring activities as well as keeping an eye as to whether any further changes are required to the contracts’ model, as the regulator highlighted in a statement last week.
Wall Street upset
While the move has been criticised heavily by some of the world’s largest banks, the crypto community has been lamenting the limited options to hedge exposure in cryptocurrencies (see for instance this excellent article by Jonny Fry on the subject). Initiatives such as the introduction of future contracts like Bitcoin and potentially others in the not to far future are also a sign that the market for cryptocurrencies is maturing and moves them further towards mainstream investing.
The entrance of Crypto Hedge Funds into the Bitcoin arena means that these kind of investors will use similar tools and strategies as regular hedge funds do, i.e. long and short strategies for vanilla products such as equities and debt instruments but derivatives and structured products as well.
The basics of Crypto Lending
An activity that shares similarities with the use of derivative contracts mentioned above, which has been gaining track of recent is the lending of cryptocurrencies for investment purposes. This can be in the form of margin trading as a collateral or for the purposes of supporting a shorting strategy, whereas the borrower sells the cryptocurrency to buy it back when is due to be returned to the lender; obviously this is based on betting on the assumption that the price will drop from its current value and allow the borrower to buy it back cheaper in order to make a profit. Even in the world of traditional financial instruments such as shares this is risky business as you may have imagined. Margin trading basically generates leverage that can multiply gains, it can also result in heavy losses and is in the world of traditional finance subject to a number of rules and controls. Short selling has been under fire especially in light of the financial crisis of 2007/2008, when it was argued that short selling in companies such as Lehman Brothers that were already struggling created further market pressure and drove down share prices further. Not for nothing did regulators introduce new rules to monitor and, if and where necessary, forbid short selling as a result of these events.
Examining the parallels with other financial instruments, potential issues as well as solutions for the use of, for example, short selling and margin trading in cryptocurrencies become apparent but also shows how to best address the use of these activities. Let’s have a quick look at how this work in practical terms for margin trading for cryptocurrencies. The idea is similar and fairly simple as the lender makes the cryptocurrency he or she owns available to loan for margin trading at a specific rate on an exchange. The rate is the fee in form of interest the lender seeks to receive from the borrower for the period of the lending. The borrower, for instance believes that the price is edging higher, i.e. he or she goes long on, say, Bitcoin, and uses the borrowed funds to create leverage. Bitfinex, one of the exchanges offering margin trading, allows for up to 3.3x leverage by receiving funding from the peer-to-peer margin funding platform. Other cryptoexchanges that offer these or similar services are Poloniex or Liqui but there are more and the available cryptocurrencies differ from exchange to exchange as well as the way it is done. What all have or at least should have in common is that they should have safeguards in place to limit the risk for lenders, but again the specifics vary and it should be remembered that the overall risk is even higher in an already volatile business.
The Real Wild West
You should also bear in mind that there is literally no regulation in place to govern and protect the involved parties. A heavy market downturn, the bursting of the proclaimed bubble, would thus potentially leave many market participants in difficult positions. Considering the difficulties authorities around the globe seem to have in making up their minds how to treat cryptocurrencies in general, it is doubtful that such activities are to be addressed soon, so for once the Wild West analogy might still be true.