Bakkt: Novel Settlement Risks for Institutional Investors (1/2)

On September 23, 2019, online market space Bakkt will commence offering physically settled Bitcoin futures contracts. The first U.S. firm to offer Bitcoin derivatives that are settled in Bitcoin rather than a fiat currency, Bakkt has taken New York-based LedgerX’s position to be approved by the Commodity Futures Trading Commission (CFTC).

This end-to-end regulated derivatives custodian aims to cater to institutional investors by providing the infrastructure necessary for funds and investment banks to operate in the newly emerged crypto-space. Bakkt is, in fact, a subsidiary of the Intercontinental Exchange (ICE) which owns the New York Stock Exchange. Therefore, it will be able to utilise several of the ICE’s institutions. Not only will Bakkt’s bitcoin futures contracts “[…] be exchange-traded on ICE Futures U.S., [but also] cleared on ICE Clear US, which are federally regulated by the CFTC”, as CEO Kelly Loeffler explains.

Futures contracts are legal agreements between two parties to buy or sell the underlying asset of the contract at a predetermined time for a specified price. Such a bitcoin future, or standardised forward contract, could resemble the following example:

The price of one bitcoin is US$10,000 in early September 2019.

Person A believes bitcoins are already very expensive and the price will not increase any further.

Person B assumes one bitcoin will be worth at least US$10,000 by October 2019.

A sees that Bakkt offers daily and monthly futures, meaning that if the price of a bitcoin drops below US$10,000, Person A, who sold the future to B, will have the obligation to buy one Bitcoin a month later for less than A originally paid (A might also be lossmaking in case the price goes up). Why this works, is because Person B betted that the price will increase. B will pay for the difference between the price of the initial contract and what a bitcoin is worth after the month to A. Interestingly, the settlement of this contract will take place in bitcoin, which is the underlying asset of the contract. Thus, the name ‘physical settlement’.

Since it is possible to own a fraction of a cryptocurrency, no issues arise from profits in the interval of two numbers, for instance 9.3 bitcoin.

Bakkt has the potential to play a crucial role in further price developments and mass adoption, especially for the bitcoin cryptocurrency. The first stakeholder to be geared to institutional investors looking to trade physically settled crypto-futures, it will possibly drive up demand for and prices of bitcoins, as well as other cryptocurrencies and tokens. This is ascribable to the high price development correlation of bitcoin, the figurehead of crypto, and the so-called ‘altcoins’, i.e. all other distributed ledger projects which created cryptographically encrypted, decentralised coins.

Bakkt COO Adam White accentuates their commitment to highest industry safety standards by harnessing ICE’s infrastructure. “Bakkt leverages the same institutional-grade hardware, operational controls, and cybersecurity systems that Intercontinental Exchange (ICE) uses to manage all thirteen of its regulated exchanges worldwide, including the New York Stock Exchange”. As the lion’s share of the novel business is facilitated via ICE institutions, Bakkt must embody the role of the compliant, trustworthy custodian for digital assets in order to win globally active financial institutions, major banks and funds.

What exacerbates an appreciation of Bakkt, however, is the settlement risk stemming from combining cryptoassets with legacy assets, as Caitlin Long points out. Long warns that one needs to differentiate between two different “hybrid” products, namely “crypto wrapped around legacy” and “legacy wrapped around crypto” hybrids.

The former category refers to products, such as tokenized gold and stablecoins, that are “issued, traded and settled on a blockchain”, however, the underlying asset exists in the legacy, or conventional, financial ecosystem.

The latter, “legacy wrapped around crypto” hybrids, are the novel products this article is concerned with. These include “bitcoin-settled ETFs, futures, swaps, […] and any other derivative backed by any cryptoasset”. Here, investors acquire a financial instrument that derives its price mainly from the underlying crypto-asset, which is stored in an account to this specific purpose, also called “ring-fenced”. “These hybrids are issued, traded and settled in the legacy system, but the underlying cryptoassets (e.g., bitcoin, ether) that back this category of hybrid are issued, traded and settled on a blockchain”.

While in the legacy system settlements amongst brokers take place usually after the markets close in order to simplify transactions (“net settlement”), the trading of security tokens occurs instantaneously. Long, again, highlights the importance of the difference: “[O]ne system embraces unsettled trades and considers counterparty risk and imprecise ledgers to be normal, while the other does [not]”.

Settlement hybrids bring about complications by crossing the settlement platform, i.e. euros cannot be transferred on a blockchain and neither can blockchain-native tokens leave their ecosystem. This leaves institutional agents with systemic hedging requirements that they themselves will create.

Author: Patrick Lehner