2018 November 19 - Volume.2 Issue.45

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2018 November 19 - Volume.2 Issue.45

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IMF Explores Evolving Forms of Money, Prospects of CBDC

The International Monetary Fund released their latest perspective on the development prospects of Central Bank Digital Currencies. Exploring the benefits of various forms of money, the IMF seems to be of the mindset that while cryptocurrencies have gained traction, it is in fact private eMoney solutions that provide stored value facilities and an easy user experience that are best ranked. While citing Bitcoin, Ether and Ripple, the report seems to be remiss of the larger and intertwined developments occurring in the space as of late. One cryptocurrency firm is, at the very least, attempting to address issues and concerns the report highlighted having secured the necessary licenses, in the US and the UK, provide on-chain stable stored value facilities, in line with KYC and AML compliance requirements, as well as an easy customer facing interface – Coinbase.


Last week at the Singapore Fintech Festival, International Monetary Fund (IMF) Managing Director Christine Lagarde took to the stage addressing the case for new digital currency. Ms Lagarde remains unconvinced that cryptocurrencies could potentially fill a void left by a cashless society. And so, a complicated question has come and gone and not yet answered entirely – should Central Banks issue a digital currency?

While the IMF report finds that currently and into the foreseeable future, a Central Bank Digital Currency (CBDC) would unlikely displace cash “for political reasons,” such a new form of digital money would be a direct liability against the central bank, rather than today where deposits sit on the ledger of a commercial bank. Still, the report does hold the prospect viable as a “CBDC seems to be a natural next step in the evolution of official coinage.”

|| CBDC, NOT BLOCKCHAIN?

On the prospect of the use of Distributed Ledger Technology (DLT), the IMF holds a fairly neutral stance. “Although the technology [DLT] is evolving, it currently falls short in scalability, energy efficiency, and payment finality. DLT could be used over a closed (“permissioned”) network managed by the central bank. But there are other types of centralized settlement technology that may prove more efficient.”

There are other more important pressing issues that however arise with a CBDC, mainly, the risks that commercial banks would face as customers opt to hold their monies directly on the central bank ledger minimizing their risk exposure to the potential of a failing bank.

Commercial banks would begin to feel a profit squeeze as they would have to increase interest on savings to keep depositors at bay, and attempt to recoup lost revenues through a hike on loans. But that too could result in a loss of business, further marginalizing their profitability ratios should the bank not have a large enough market share (Diar, 19 March). “When banks have more market power in lending, they can better insulate their profits by passing the deposit rate hike on to loan.”

|| FUTURE CHUMS

 “Private e-money provided by stored value facilities scores high on several fronts. It offers widespread acceptance, low transaction costs via user-friendly interfaces designed by customer- centric firms, and full-service bundling with other financial as well as social services” the report stated.

But it was in Ms Lagarde’s speech which this was emphasized further.

Highlighting the risks to innovation that a Central Bank would pose having full reign over the development of a CBDC, Ms Lagarde took to the middle ground. “What if, instead, central banks entered a partnership with the private sector—banks and other financial institutions—and said: you interface with the customer, you store their wealth, you offer interest, advice, loans. But when it comes time to transact, we take over…. your bank, or fellow entrepreneurs, would have ensured a friendly user experience based on the latest technologies.”

|| AND WHAT OF CRYPTOCURRENCIES?

In an extremely rare occurrence for such financial organization reports, illicit activities were not the condemnation of cryptocurrencies. Volatility, now, is the key issue. Cryptocurrencies “struggle to fully satisfy the functions of money, in part because of erratic valuations.” In a footnote, the report said that as for stablecoins, there are “doubts about the ability to maintain a peg, short of full backing by fiat currency.”

And while Bitcoin, Ether and Ripple would have unlikely been part of such a discussion at the start of last year, the cryptocurrency space has developed further at rapid pace with multiple on chain financial products looking to fill future market demand in 2018. Of course, as it stands, little if any of it can work on any grand scale without regulator support, especially in the case of lending, as bad debtors would face no repercussions with current on-chain infrastructure (Diar, 16 July).

But Coinbase has been the one cryptocurrency company that’s been addressing many of the concerns, issues and prospects laid out in the IMF report, from a fully collateralized stablecoin addressing volatility, which would also adhere to anti-money laundry compliance requirements, to the financial support given to multiple on-chain protocols from the company’s alumni that promise traditional financial services (Diar, 29 October).

It’s not all roses, however. Coinbase must address multiple problematic areas in tandem – network scalability and the onboarding of consumers and merchants – both, currently, very tall orders.

Attractiveness to Users of Different Forms of Money


Source: IMF


Can Coinbase's 'Open Financial System' Plans Make The Difference?


Should cryptocurrencies be able to compete in view of the merits of the various forms of money, multiple areas are needed to be addressed. Scalability, transaction costs, the retention of anonymity while complying with KYC/AML requirements, extended services, loans (see Dharma), returns (see Compound), and most importantly, acceptance - as of today - little to none. 

Rationales for Exploring CBDCs

wdt_ID Country Monopoly Distortions Operational Risks Cost Efficiency Financial Inclusion Other
1 Bahamas X Countering derisking
2 Canada X
3 China X X X X
4 CBCS X X X
5 ECCB X X X
6 Ecuador X
7 Norway X
8 Senegal X
9 Sweden X X
10 Tunisia X


Notes: Monetary policy was not cited as a rationale by any of the central banks surveyed. It was not possible to ascertain the rationales, based on publicly available information, for Australia, Bahrain, Denmark, the European Union, Hong Kong SAR, India, Indonesia, Jamaica, South Korea, and Switzerland.CBCS = Central Bank of Curaçao and Sint Maarten; ECCB = Eastern Caribbean Central Bank

Source: IMF


BIS Central Bank Survey: Likelihood of Issuing a CBDC


Very Likely   Somewhat Likely  Possible  Somewhat Unlikely

Short-Term General Purpose CBDC:

Medium-Term General Purpose CBDC:

Short-Term Wholesale CBDC:

Medium Wholesale CBDC:


ICO Issuers, Class Action Lawsuits Find Succor from US Regulator

Following action against Decentralized Exchange EtherDelta, last week also saw the US Securities and Exchange Commission issuing settled orders against two companies, Airfox and Paragon, for the sale of unregistered securities after raising capital through an Initial Coin Offering. The regulator may have given class action lawsuits against token issuers much needed guidance, one of which was filed against Paragon earlier this year. On the flip side, Washington has also given those who raised capital through the contentious vehicle an opportunity to make good allowing for the retroactive filing of their token as a security.


This year has seen the US Securities and Exchange Commission (SEC) amp up its pace and rhetoric against breaches of securities laws by cryptocurrency operations in quick succession.

In almost identical fashion, and wording, the SEC has now charged and settled against Airfox and Paragon for raising $15Mn and $12Mn respectively through Initial Coin Offerings (ICO) after failing to register with the regulator which has deemed their tokens issuing as the sale of securities.

Investors now have a window of opportunity to reclaim their initial outlay. The companies are also required to file regular disclosures and meet with compliance. And a $250,000 penalty was imposed. But in comparison to Merril Lynch who paid out a whopping $1.25Mn for the sale of unregistered securities earlier this year, the penance paid by the token issuers seems almost merciful.

While lenient, the SEC’s moves now indicate the beginning of the end of unregistered ICOs lest issuers wish to face much harsher punishment having now set precedence.

And while the two companies charged where in fact US domiciled, given the global nature of cryptocurrency trading, the SEC, as it does today, would not shy away from going after non-US entities who may have sold their tokens to US persons. This is unlikely however to be their priority target.

|| REGULATORS DON’T COMPETE

Much like the SEC’s Swiss counterpart, FINMA, one of the first regulators to publish ICO guidelines, the US regulator cited lack of functionality at the time the companies conducted their fund-raising activities – earmarks of financial instruments (see table below).

This latest development reveals a synergy of thought processes conducted by other securities regulators worldwide that, intentionally or not, are concerting themselves in harmony.

|| WHAT HAPPENED TO “WE ONLY SELL, DON’T USE”?

It’s clear that the SEC has been doing their homework as the 13-page cease-and-desist orders looked at the promotion and listing activities pursued by the token issuers from the very beginning.

Paragon, which said it would address the marijuana ecosystem, with blockchain, of course, may have dipped into its own honey pot while writing up their Whitepaper as it was peppered with return promises on secondary markets making for a fairly straight-forward target for the SEC to bring charges.

Anyone taking notes is hardly surprised. Jay Clayton, Chairman of the SEC, stated earlier this year that any token that was used in a fundraising process and can give investors a return, or investors can get a return on the secondary market by selling the token to someone else, qualifies as a security.

|| CUE CLASS ACTION LAWSUITS

Legal analytics firm Lex Machina places 45 lawsuits in the first half of 2018 related to cryptocurrencies, Bitcoin and Blockchain – triple the amount than all of the previous year (see chart). And the SEC is said to be responsible for 30% of the cases filed indicating a dozen ICOs that will also likely follow suit in registering with the regulator as a security.

Cryptocurrency, Bitcoin & Blockchain Related Lawsuits Moon


Source: Lex Machina


SEC Division of Digital Assets Industry

Offers and Sales of Digital Asset Securities
To comply with the requirements set by the Securities Exchange Act of 1934 ("Exchange Act") and the  Securities Act of 1933 ("Securities Act")

Investment Vehicles Investing in Digital Asset Securities
Investment vehicles that hold digital asset securities and those who advise others about investing in digital asset securities, including managers of investment vehicles, must be mindful of registration, regulatory and fiduciary obligations under the Investment Company Act and the Advisers Act.

Trading of Digital Asset Securities

Exchange Registration - Exchange Act Rule 3b-16 provides a functional test to assess whether an entity meets the definition of an exchange under Section 3(a)(1) of the Exchange Act. An entity that meets the definition of an exchange must register with the Commission as a national securities exchange or be exempt from registration, such as by operating as an alternative trading system ("ATS") in compliance with Regulation ATS.

Broker-Dealer Registration - An entity that facilitates the issuance of digital asset securities in ICOs and secondary trading in digital asset securities may also be acting as a "broker" or "dealer" that is required to register with the Commission and become a member of a self-regulatory organization, typically FINRA.


With the latest charges, class action lawsuits have been given a boon with maybe enough ammo to win against token issuers. And with the bear market taking its toll across the board, its likely many more early investors that have seen their portfolio value dwindle take action. Number crunching showed that 70% of tokens are now valued at less than their initial price during their ICO (Diar, 24 September).

|| WASHINGTON WEAVES WAY FORWARD WITH SLAP ON THE WRIST

The SEC didn’t stop at that last week. The regulator also published a statement on digital asset securities issuance and trading, clearly classifying how they’ve divided up the cryptocurrency industry (see table).

On the offer of and sale of tokens, the SEC has given issuers an out – “…there is a path to compliance with the federal securities laws going forward, even where issuers have conducted an illegal unregistered offering of digital asset securities.”

Token issuers may then now find a warmer embrace from the very regulator they wished to circumvent than in the hands of a federal judge where restitutions as well as claims to punitive damages may very well put them under lock and key.

Swiss FINMA ICO Guidlines: SEC's Nod to "Crypto Valley"?

wdt_ID Type Description ICO Guidelines
1 Payment Payment tokens are synonymous with cryptocurrencies and have no further functions or links to other development projects. Tokens may in some cases only develop the necessary functionality and become accepted as a means of payment over a period of time. For ICOs where the token is intended to function as a means of payment and can already be transferred, FINMA will require compliance with anti-money laundering regulations. FINMA will not, however, treat such tokens as securities.
2 Utility Utility tokens are tokens which are intended to provide digital access to an application or service. Tokens do not qualify as securities if their sole purpose is to confer digital access rights to an application & can be used in this way at the point of issue. If a token functions solely/partially as an investment it will treat such tokens as securities
3 Asset Asset tokens represent assets such as participations in real physical underlyings, companies, earnings streams, or an entitlement to dividends/interest payments. In terms of economic function, the tokens are analogous to equities, bonds & derivatives. FINMA regards asset tokens as securities, which means that there are securities law requirements for trading in such tokens, as well as civil law requirements under the Swiss Code of Obligations (e.g. prospectus requirements).


Bankrolling Bitcoin Forks in Hash Power Face-off

A minimum of 38 Bitcoin forks have taken place since the Bitcoin community saw Bitcoin Cash come to life last year. All but Bitcoin Cash who have forked have failed by almost every sense of the word. And last week saw Bitcoin Cash also split following two competing proposals led effectively by companies rather than community, resulting in an all out hash power war to avoid a permanent split into two coins. But will that be the inevitable outcome?


Bitcoin.com who has taken the helm of promoting the use of Bitcoin Cash has found itself fighting with mining power in order to keep the pecking order of the current protocol against a competing proposal called Satoshi's Vision tabled by nChain's Craig Wright.

Last week, a scheduled network upgrade saw Bitcoin Cash split into two with both sides amping up hash power to retain control of the longer chain. This has resulted in an average hourly combined loss of $30,000, with only wholesale electricity costs taken into consideration with optimal equipment. As a total, an astounding $3.3Mn has been spent on maintaining power alone.

|| "I'VE GOT YOUR BACK"

Powerful players who have curled up on either side are now losing money by the fist load in order to back their aligned favorite. In the corner of Bitcoin Cash (ABC), Bitmain has come to Bitcoin.com's aid. And in the other corner, Coingeek.com has unleashed over half of Satoshi's Vision hashrate - Such efforts outside of support with deep pockets, and a great deal of faith in the price recovery of the coin would be impossible.

And should miners not be selling their coins and holding off till the end, their cost price to cover electricity at press time stands at $1613 for Bitcoin Cash (ABC) and $1149 for Bitcoin Cash (SV). Bitcoin Cash was at $450 average before the fork initiated.

Ultimately, however, the overall cryptocurrency industry is the loser as fears from the same complications puppeteered by powerful actors could arise again, marking the asset class beyond dangerous.

Cumulative Losses of Mining Nears $3Mn In Best-Case Scenario


Notes: The calculation only take into account electricity costs running S9 Antminers at $0.04KW/h and the average price at the time of reward on Poloniex.


Bitcoin Cash (SV) Hash Power Distribution


Bitcoin Cash (ABC) Hash Power Distribution


Source: Coin.dance, Diar Calc.


Op-Ed: Do We Need Stablecoins After all? An Options Market Perspective

Emmanuel Goh and Tim NoatSkew

Stable coins are in focus this year in response to last year’s frenzy in crypto markets where daily swings versus the US Dollar of 10%+ were fairly common. The fate of bitcoin as a global currency was then quickly decided: it is too volatile to meet the three requirements that define a currency - store of value, medium of payment & unit of account. In a short period of time, $300m of funding went into over 50 stable coin projects globally to solve the problem.

|| BITCOIN & GOLD VOLATILITY

When discussing stability, it is important to first agree on what it means to be stable. If bitcoin is the reference currency - many of its supporters already see it that way - then it is stable by construction. People in general imply stability versus the US Dollar which we will discuss here.

Despite record calm experienced recently - with bitcoin moving on average less than S&P500 in October - it is likely the cryptocurrency will remain reasonably volatile over the short term as this nascent asset hasn’t reached its critical mass yet. Over the long run, some structural forces could however modify the picture and allow bitcoin to “self-stabilize”.

If one asset can give us a flavor of what bitcoin could look like in ten years, it’s probably gold. Bitcoin is often described as the “digital” version of the shiny metal: the two assets in particular share similarities in the way they are being issued with inelastic and exogeneous supply functions. The yearly inflation rate of bitcoin, irrespective of what its price does, is at 4% currently compared to gold at 2%. This is one of the technical reason why stable coins got traction in the first place: if the supply function is determined in advance then it cannot adjust to demand shocks which force adjustments to be made only through price and hence it can’t be stable.


Statistics on gold volatility since 1991

wdt_ID Years Average absolute daily price change No of > 2.5% days (%) Average absolute monthly price change
1 1991 - 1995 0.42% 0.56% 2.10%
2 1996 - 2000 0.52% 1.11% 2.66%
3 2001 - 2005 0.70% 1.83% 3.32%
4 2006 - 2010 1.00% 7.38% 4.68%
5 2011 - 2015 0.76% 3.33% 4.24%
6 2016 - 2017 0.60% 0.99% 3.30%

Gold should logically also experience the same problem. With a daily average volatility of 0.67% since 1991, it is however one of the most stable asset globally and is widely perceived as the ultimate store of value. One of bitcoin’s value proposition is to compete in this particular use case and our best guess is that it will - should it succeed - be ultimately highly stable. Part of this evolution will come as a consequence of a shift in the public’s perception as people understand better what bitcoin has to offer and gradually start seeing the asset as a safe haven. However, the process could potentially take decades and bitcoin should probably show some stability first as a prerequisite. Derivatives products might contribute speeding up the journey.

|| THE RISE OF BITCOIN FUTURES IS CONTRIBUTING TO ITS STABILITY QUEST

If 2017 was the year of ICOs & altcoins - personified by the rise of Binance -  2018 is most likely going to be remembered as the year in which futures took over. Bitmex and Bitflyer’s bitcoin perpetual swaps are trading over $1bn on most days when physical exchanges have had a much harder time maintaining volumes. Is it purely a coincidence if volatility has structurally decreased over the year while this trend gathered pace?

Bitcoin futures markets have experienced rapid growth this year and are at this stage fairly well developed relative to the underlying market. The four main bitcoin perpetual swaps combined - Bitflyer, Bitmex, Deribit and Crypto Facilities - traded on average $2.2bn a day over the last month which represents a volume similar to physical fiat to bitcoin transactions. CME bitcoin futures also exhibited gradual growth in volumes this year.

Bitcoin options on the opposite trade on average $5m notional a day. In comparison, options on S&P500 trade on average $390bn notional a day. Amazon - one of the most popular stock globally - trades on most days a similar volume of options and stocks - around $10bn each.

Traditional derivatives markets rose in Chicago in the 19th century to answer the hedging needs of American grain farmers. Successful derivatives products - futures, options or more sophisticated ones - share in common that they answer a demand for hedging and risk management (see The Futures by Emily Lambert).

This is partly the reason why futures grew so popular this year - after such a great crypto run, demand for hedging liquidity and neutralizing exposure grew increasingly strong.

|| NOW, DO WE REALLY NEED OPTIONS FOR BITCOIN? 

Futures remain fairly generic instruments with linear exposure to the underlying asset - what is commonly called a “delta one” derivative. For example, if a company produces oil or mine bitcoins, it is not possible to specifically hedge its breakeven cost by simply selling a future contract: it would also force it to renounce to the financial upside. In that case, the relevant instrument would be a put option. The next natural step for crypto markets would be to embrace options so that much better tailor-made hedging solutions can be delivered to industry stakeholders. This would in return allow them to scale their businesses in a meaningful way and benefit the crypto economy overall.

If everyone is properly hedged, then there is less chance of a panic firesale such as the one we had on ether during the ICO complex capitulation in August and September. When looking at the cryptocurrency economy, there is a need for hedging in a number of areas:

• Cryptocurrency “producers” - miners, exchanges, ICO projects - are behind $25bn of natural selling flows this year which could be much better handled;

• Cryptocurrency “consumers” - merchants & customers - are struggling to embrace the product because prices and fees are too unpredictable. If Amazon or another global merchant is to one day accept bitcoin as a payment currency on its platform - an idea which has great merits! - it will need a panel of hedging solutions at its disposal;

• Cryptocurrency exchanges are long volatility and could benefit from a vol selling program. This is quite striking when comparing daily volatility and volumes. In traditional markets, it is quite common to see an asset not moving and large trades being crossed. This is not a behaviour we have seen so far in cryptos as execution methodologies are primarily coming from the FX world and are mostly done “at market” which has the consequence of moving the price in the absence of enough market depth. Another reason is that the market is primarily traded by retail customers which use less sophisticated trading execution methods than institutions.

On the investor side, the natural flows will most likely come from long term holders -  in a similar fashion to what we see in gold markets. A meaningful part of bitcoin investors - the “hodlers” - believe in the store of value narrative and are holding bitcoins for the very long term. Those investors don’t have access to “saving” or “yield enhancement” products to optimize their holdings. Using options is one possibility that could make the “1 BTC today = 1 BTC in one year” mantra potentially evolve to “1 BTC today = 1.1 BTC in one year”.

|| NATURAL OPTIONS FLOWS WILL LIKELY TAME BITCOIN'S VOLATILITY

A common attribute of those options flows is that they would materialize by large amounts of call selling - providing large quantities of volatility to the market as option market makers start “delta hedging” their positions. This would likely tame the volatility of bitcoin over time - at least on the upside. This phenomenon called “pinning” is relatively well known in traditional markets. It is not uncommon to see historically very volatile stocks experience a structural drop in realized volatility as a set of structured derivatives products are being released.

The options market experienced rapid growth in traditional markets after 1973 when Black and Scholes found a straightforward formula to price them - a discovery which earned them the Nobel prize in economics in 1997. Also, commodity futures have happened to soar since 1973 as the oil crisis introduced instability in a previously quiet market. As a result, extensive academic literature studying the impact of derivatives on the price of their underlying’s was published in the 80s and 90s. Figure 2 quite convincingly points in the direction of lower volatility post options listing.

To conclude, it has to be noted that overly complex credit derivatives played an important role during the financial crisis of 2008. To learn from the mistakes of the past, it will be key for market participants to work with regulators towards finding the right level of financial innovation so that the crypto economy can benefit without introducing systemic risks.


Skew, founded by former JPMorgan flow equity derivatives trader Emmanuel Goh and former Citi/UBS flow and exotic equity derivatives trader Tim Noat have setup shop in London to trade Bitcoin and Ether options. Visit their website or twitter.

Effect of stock options listing on volatility and beta
Literature Review – The impact of Derivatives on Cash Markets: What have we learned? - Mayhew, 2000)

wdt_ID Author Sample Period Market Volatility Beta
1 Nathan Associates (1974) 16 1973 USA
2 CBOE (1975) 40 1974-75 USA
3 Trennepohl and Dukes (1979) 32 1973 USA
4 Klemkosky and Maness (1980) 103 1973-75 USA ? ?
5 Whiteside, Dukes and Dunne (1981) 35 1973-75 USA ?
6 Whiteside, Dukes and Dunne (1983) 71 1973-81 USA ?
7 Nabar and Park (1988) 390 1973-86 USA


Binance Complies with Iran Sanctions
Binance has requested that all traders who have stored assets on the crypto exchange to withdraw them immediately as it seeks to comply with US sanctions that have gone back into full effect. This has become a recurring theme for Persians who have seen Bitmex and Bittrex also previously cut them off. Mining crypto seems to be the only profitable route for people given then heavily subsidized power industry as the country faces an economic crisis.
OKEx Settles Bitcoin Cash Futures Ahead of Schedule
In an unprecedented move highlighting the apparent risks of cryptocurrency operations, Hong Kong-based OKEx changed the terms of $135Mn Bitcoin Cash derivatives terminating the contracts early as markets took a down turn. Due to the volatility experienced following the split (see story above) the exchange opted to notify clients only after the fact, in what they deemed as sound judgement in order to avoid potential market manipulation.
BitGo Ups Custodial Solutions Adding Stablecoins
Speaking to CoinDesk, BitGo has revealed that it now offers custodial solutions for over 100 different cryptocurrencies. The companies latest venture has been to accommodate for stablecoins including USDC and Gemini's Dollar. “When investors are looking for a place to custody their funds, they are looking for a one-stop-shop, a place to store all their crypto assets” Isaac Eleftheriadis said, BitGo’s senior technical product manager.
Swiss's SIX Exchange Slated to Launch Crypto ETP
Following the footsteps of the Stockhold Nasdaq exchange, another Exchange Traded Product is set to hit Zurich on the SIX Exchange. The Amun Crypto Basket ETP is set to be an index of major cryptocurrencies and will begin trading as early as next week. But traders within the space will be quick to remember the short-comings of Coinbase's similar index, and the lack of demand seen for Grayscale's Digital Large Cap Fund.

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