(Bloomberg View) -- The Commodity Futures Trading Commission granted LedgerX -- a cryptocurrency trading platform -- registration as a clearing house for derivatives contracts settling in digital currencies. This indicates increasing official acceptance of cryptocurrencies. More important, the move could redefine them.
Derivatives clearing houses catalyze enormous economic change. The creation of agricultural futures clearing houses in the mid-19th century American West transformed a sparsely populated backwater into ground zero for the second Industrial Revolution. In the same place exactly 125 years later, on April 26, 1973, financial options clearing houses gave birth to the modern global derivatives economy.
The key features of derivatives clearing houses are centrally cleared, collateralized, asset-settled contracts with mark-to-market margin. Existing cryptocurrency futures and options have none of those characteristics, they are merely side bets. LedgerX has the first three, which may be enough to transmute cryptocurrencies.
Consider cryptocurrency renters, users and investors. Renters buy cryptocurrency for a transaction, say an international payment to someone in a financially repressed country. In effect, they pay transaction fees for payment processing services. Users both pay and receive in cryptocurrencies, and maintain balances for transactional purposes. Investors buy cryptocurrencies but don't use them.
If LedgerX succeeds in creating a high-volume, liquid exchange, investors are likely to be the first adopters. Today there is no convenient way to short cryptocurrencies or to take levered positions in them. Buying call or put options meets these needs.
Investors are also natural option sellers. Instead of buying one bitcoin, for example, an investor can get similar exposure by writing two at-the-money put options, or buying two bitcoins and writing at-the-money calls on them. This is more complicated than just buying one bitcoin and the positions need to be rebalanced, but the demand for options should make the expected return higher for taking the same economic exposure. Moreover, LedgerX offers a facility for intermediaries to offer cryptocurrency-exposed accounts with the same advantages for less sophisticated investors.
The natural trade of cryptocurrency users is to write at-the-money call options and buy at-the-money puts on their holdings. But this would require them to post their cryptocurrency as collateral, so they could not use it. A reasonable alternative is to write at-the-money (say $2,800 for bitcoin) call options on half their holdings, and use the premium to buy puts on their entire holdings at a strike of perhaps $2,000 for bitcoin. They give up half the appreciation on their holdings plus tie up half of it in collateral, in exchange for a floor price to protect them against a crash.
This could touch off a virtuous cycle. More investors are attracted to cryptocurrencies due to availability of leverage and shorting, plus enhanced returns for passive unlevered investors. Holders hold larger balances because it's safer, and because they use some of their balances for collateral. Large amounts of cryptocurrencies are taken out of circulation to use as collateral, pushing up prices and dampening volatility. Renters are encouraged to avoid the transaction fees of constant buying and selling by the increased attractiveness of holding balances. People who never used cryptocurrencies are pulled in by the reduced volatility, attractive returns and a better suite of retail products. More use means more legal and regulatory clarity. All of this means more liquidity, higher prices and lower volatility, feeding the cycle.
Of course, it's a classic chicken-and-egg. If LedgerX and future cryptocurrency derivatives clearing houses succeed, cryptocurrencies become more successful, which helps the clearing houses succeed. But if LedgerX never attracts the volume and liquidity to make the above strategies practical, then cryptocurrencies are less likely to thrive, making the clearing houses less useful. I have no strong opinion about which way this will go, but it's possible that LedgerX will be the push that rationalizes and stabilizes cryptocurrencies.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Aaron Brown is a former Managing Director and Head of Financial Market Research at AQR Capital Management. He is the author of "The Poker Face of Wall Street."
As a result, volumes are negligible and bid/ask spreads too wide for serious trading.
Side bets can no more affect the economy than bets about whether it will rain tomorrow can affect the weather.
Consider an investor who wants exposure to cryptocurrencies as part of a diversified portfolio. She could buy one bitcoin for, say, But she could get very similar exposure by selling two at-the-money three-month bitcoin put options, for which she might be paid at current volatilities percent annualized volatility, roughly in line with recent history and ask prices at existing option platforms). This means she must put up in net collateral, but since this is part of a diversified portfolio, she just takes the extra from cash. In return for providing leverage to other investors and taking a more complex position that must be rebalanced as prices change, she would expect to earn a considerably higher return with the same risk versus holding one bitcoin, due to demand for options pushing prices well beyond expected value.
Or our investor could buy two bitcoins and sell at-the-money call options on them for She has to come up with the same net, and deposit her two bitcoins as collateral at the exchange. Again, she expects to earn a considerably higher return for the same economic exposure as owning one bitcoin. If she combines the two strategies she reduces her need for rebalancing.
This is why the fourth feature of a true derivatives clearinghouse, mark-to-market collateral, would make LedgerX even more attractive to investors and users.
To some cryptocurrency true believers, pulling cryptocurrencies into the mainstream financial system is a betrayal of their original purpose. Cryptocurrencies used as collateral in regulated clearinghouses, or spent or obtained via regulated financial contracts, lack anonymity and can be taxed or seized by authorities. They could even be inflated by reduction in margin requirements. But since cryptocurrencies are cheap to create, nothing stops the true believers from using their own unclearable currencies.
To contact the editor responsible for this story: Max Berley at mberley@bloomberg.net.
For more columns from Bloomberg View, visit http://www.bloomberg.com/view.
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