The technology underpinning the Bitcoin blockchain has led to the emergence of an entirely new asset class native to the internet. Diversification and exposure to this new asset class has largely been driven by the retail market thus far, but as technology in the space matures and more people become aware of the asset class itself, institutional interest steadily grows. We believe that a lack of financial product infrastructure and risk management options have been the critical barriers to entry. Investment managers need the ability to hedge risk and until now, the available derivative products are limited in their scope and are not properly regulated.
Emerging asset classes and their early marketplace offerings are attractive investment opportunities when risk is properly managed. As revolutionary as blockchain technology and the new products and processes that it enables is, financial and operational risk arises with significant exposure to these new assets. Two of the largest operational risks, custodial and facilitation risk, both lack immediate off-the-shelf solutions allowing potential investors to easily implement infrastructure, purchase insurance and demonstrate compliance to enable institutional flow. These solutions are being built by companies, regulators and investors working side by side to safely and securely facilitate operations in this space.
Operational risk is easily identified and with best-in-class procedures and operational standards, can be mitigated. In traditional markets, financial risk is hedged by implementing a variety of strategies and using a wide array of derivative instruments. Traditional derivative markets are well established with deep liquidity and highly regulated players and processes. The digital asset derivative market is still in its infancy and to drive innovation and adoption, new and improved derivative products must become the standard.
Digital asset derivatives are currently offered in two ways. Cash settled futures, traded on exchanges such as CME and CBOE, and digital asset settled futures, most notably traded on digital asset only exchanges. Cash settled futures are fiat only and therefore rely on an underlying index to determine pay-outs. CBOE relies on auction data from NYDFS regulated digital asset exchanges, which are prone to price manipulation upon settlement, given the low immediate liquidity available. The CME future product settles based on the “Bitcoin Reference Rate,” an aggregate price across major spot exchanges from 3pm to 4pm GMT. This structure makes the product hard to replicate. An index can change over time and without the ability to replicate the offering at scale, potential market makers will steer clear citing low liquidity. Digital asset settled derivatives, native to digital asset only platforms, such as BitMEX and Deribit, suffer the same problem of their fiat counterparts: they settle contracts based on an underlying index. To make matters more complicated, these products do not serve as perfect hedges to digital asset price movement. Margin calls and settlement is conducted in digital assets themselves, exactly what these products are meant to hedge against. Until digital asset derivative products and market specifications are optimised to allow for more lucrative market making and increased liquidity, institutions will largely stick to the side lines, waiting for better machinery to appear.
New platforms such as Bakkt, and its parent organisation ICE, are creating widespread excitement across the industry with their dedication towards high quality product offerings. However, the launch of the Bakkt platform has been delayed from its original planned launch, crediting the extreme demand for their offerings and desire to have all of the right pieces in place before release. With the launch of Bakkt and other similar institutionally focused exchange platforms, we predict a steady flow of capital into the asset class as investors take advantage of the new tools available.
About the Author(s): Jean El-khoury is Head of Derivatives at Diginex. Mustafa Jang is Head of Research in the Financial Services team. Zach Applegate is an Associate in the Strategy team.