Bakkt: Novel Settlement Risks for Institutional Investors (2/2)
In part one of this two-part series, the attempt was made to illuminate Intercontinental Exchange’s (ICE’s) new business endeavour ‘Bakkt’ and the unprecedented risks associated with it. Today, on September 23, 2019, online market space Bakkt commences 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).
As pointed out in the first part, there are risks stemming from the creation of so-called “settlement hybrids”, which bring about complications by crossing the platform of settlement. Blockchain-native tokens, such as bitcoin, cannot leave their native database on which they are transferred, just as dollars cannot enter such a blockchain by digitising them.
Caitlin Long delineates how this risk develops by highlighting the implications of the differences in settlement-system hybrids. Long argues that due to complexities emerging from melding legacy and crypto settlement together, issues are to be expected. Where time did not play a vital role for a unidimensional system, timing mismatches and subsequent settlement failures now may certainly induce operational and price risks.
Operational risk on the part of issuers of aforementioned financial hybrid products – e.g. stablecoins or physically-settled bitcoin futures – as well as price risk for both issuers and investors. Time and settlement inefficiencies will have an impact, so Long, that “[…] will most likely appear as a price divergence between the price of the hybrid and its underlying asset, and periodically those price differences are likely to be big”.
The inherent risk to hybrid settlement of the ‘legacy wrapped around crypto’ variant origins in the problematic aspect of ‘collateralisation’ in the case of a chain fork. A ‘chain fork’ is an event during which the validation process of transactions conducted on a blockchain several blocks have simultaneously been verified and the community of miners has the responsibility to decide which of the two validated blocks will be the continuation of the chain of blocks, the blockchain. Following the decision, the blockchain readmits validations. This does not appear to interfere with the collateralisation of bitcoin-backed products that financial institutions offer.
However, the settlement system’s 1:1 – i.e. full – backing will suffer from a priori unsatisfiability, meaning that by default, rather than by operation influence, full backing cannot be guaranteed. This is due to the fact that conventional – legacy – audits may not detect that the intermediary structuring the settlement and being responsible for the pay-out of e.g. 50 bitcoins, in fact only has 40 bitcoins in its custody. While such an institution might have more bitcoins in form of IOUs, as it is common practice with banks’ level of collateralisation regarding fiat currency, this poses a real threat utilising crypto settlement systems.
Unfortunately, uncovered exposures due to more sophisticated methods of financing operations – as it is the case with rehypothecation of securities – create price gaps stemming from a financial institution’s violation of an outstanding payment. “[T]here’s no fault tolerance in the crypto settlement system”. Net-settlement of trades, as explained in the first part of this series, implies that trades are not settled immediately but rather after market close, which opens the door for unsettled trades due to the possibility of a lack of required securities, hence creating more claims to the asset than are in possession.
While this operational deficiency may be deemed more impactful, ‘crypto wrapped around legacy’ hybrids, nevertheless, have demonstrated another weakness. The most known stablecoin in circulation, Tether, offers a good case study for such an entity. The cryptocurrency with the 6th highest market capitalisation, Tether struggled various times to keep its peg to the US dollar, which, being a stablecoin, it aims to do. As no fiat currency is traded or settled on a blockchain, no stablecoin can possibly offer perfect transparency; no tokenised security, such as gold, silver or other assets, in that regard. This means that there is a lack of transparency around the precise and accurate collateralisation of stablecoins and of all assets not natively “[…] issued, traded and settled on a blockchain, there will always be a break in the digital chain of information and 100% transparency will be impossible”, as Long concludes.
Blockchain’s zero-fault tolerance policy is challenging the legacy system by showcasing instantaneous, honest gross-settlements. With Bakkt – and Intercontinental Exchange – allowing institutional investors to invest in hybrid products such as physically-settled bitcoin futures, developments in the bitcoin’s price and adoption are imminent.