Elation spread through the crypto community in early August with declarations that bitcoin’s going Bakkt to the Moon. That’s because financial powerhouse Intercontinental Exchange (ICE) announced the formation of a new company called Bakkt to “create an open and regulated, global ecosystem for digital assets.” The press release was laden with buzzwords and vague references to the new firm’s actual purpose:
“… will be for trading and conversion of Bitcoin versus fiat currencies.”
“… with institutional and consumer applications for digital assets.”
“… to launch a 1-day physically delivered Bitcoin contract along with physical warehousing.”
“… a scalable on-ramp for institutional, merchant and consumer participation in digital assets.”
References to Microsoft and Starbucks, combined with disconnects between Wall Street-speak and crypto-speak, led to confusing headlines and forum discussions. Will Bakkt be yet another crypto exchange like Binance and Kraken? How will FedEx deliver my physical bitcoins? Will the floodgates open and send bitcoin prices back into the stratosphere?
This article dives into the details of the Bakkt announcement, clears up some of the confusion it generated, and looks at what Bakkt really means for cryptocurrency.
The Tip of the ICE-berg
Most people have no idea what role Atlanta-based ICE plays in the American financial system. The quick answer: ICE owns the world’s largest stock market, the New York Stock Exchange. The longer answer is that ICE brought 21st Century innovation to an industry still transitioning into the digital age.
Besides the NYSE, ICE owns another 11 equities and futures exchanges around the world, ranking ICE among the world’s dominant financial companies. ICE’s derivatives exchanges host almost half of the world’s traded crude and refined oil futures contracts. On the equity side, IPOs on ICE exchanges raise more corporate capital than any other exchange.
ICE also operates six clearinghouses, important parts of the financial infrastructure that few outside the industry know about. To help understand the role of a clearinghouse, imagine you’re organizing a large group dinner. Rather than asking the server for separate checks, you collect the money from the group up front and then pay the bill after the dinner’s over. Of course, you risk having to pay extra if someone doesn’t pay their fair share.
A clearinghouse works in a similar way by handling the payment, called the settlement, of a futures contract or stock sale. In that process, the clearinghouse takes on what’s called the counter-party risk. This is the risk that one of the parties to a deal won’t deliver on their end — like the deadbeat friend who left you paying for his surf and turf at dinner.
The Excitement is Real
It’s easy to dismiss the glowing headlines and exclamation point-filled Reddit comments about Bakkt as froth from hopium-addicted Bitcoin optimists. After all, ICE’s announcement came at about the same time that the SEC rejected Bitcoin ETF proposals for the same reason it rejected earlier Bitcoin ETF proposals.
However, ICE’s move into bitcoin could truly shift the dynamics of the world crypto economy.
“With our solution, the buying and selling of Bitcoin is fully collateralized or pre-funded,” Bakkt CEO Kelly Loeffler explained. “This supports market integrity and differentiates our effort from existing futures and crypto exchanges which allow for margin, leverage and cash settlement.”
Integrity and security are two of the reasons financial leaders in New York, Singapore, London and elsewhere have stayed away from crypto. The anti-establishment, disrupt-everything startup culture so prevalent in crypto circles doesn’t really fit with the compliance-oriented culture of highly-regulated global financial institutions. Now throw in highly-publicized hacks and a (sometimes deserved) reputation for enabling money laundering.
Crypto alternatives slow to start
Some in the crypto community have tried to make bitcoin-trading more credible by developing the kinds of systems financial institutions expect. Gemini Exchange went through New York’s BitLicense process to show, among other things, that it met the high compliance standards for know-your-customer (KYC) and anti-money-laundering (AML). Earlier this year, Coinbase introduced a suite of services designed to serve institutional investors.
The crypto companies’ attempts to develop new products to serve more demanding institutional customers while was always going to be an uphill slog — especially with skeptical regulators looking on.
ICE, on the other hand, is basing Bakkt on its existing systems, to serve its existing customers and meet the demands of its existing regulators. That justifies some of the optimism swirling around crypto circles. ICE has the resources and regulatory credibility to meet the expectations of institutional investors.
“Consumer” doesn’t mean you
Unfortunately, a lot of the crypto optimism is also based on a misunderstanding of what Bakkt is all about. ICE’s press release and the Bakkt website repeatedly use the word “consumer”, prompting more than one article and Reddit comment speculating about opening accounts on a Bakkt exchange or getting a Bakkt credit card.
Bakkt is financial infrastructure, not a consumer financial product. The new company’s customers will be the same multi-billion-dollar companies ICE deals with today.
“As a first step,” Loeffler wrote, “Bakkt is working to address the unique requirements of regulated institutions.” Those requirements may be based on those institutions’ retail customers, but Bakkt won’t be dealing with Joe Crypto directly. Instead, Bakkt will provide the infrastructure, integrity and connectivity that integrate with financial institutions’ existing systems and business practices.
Using trusted infrastructure
The trading platforms used by the first crypto exchanges were hand-crafted by enthusiasts who may or may not have had experience in the fiat financial system. Bitstamp’s founders were coders who figured things out as they went along. Bittrex’s founders cut their teeth developing enterprise-scale apps at Microsoft and Amazon. Al Hayes and his partners at BitMex brought deep experience in high-speed trading. Poloniex’s founder composed instrumental music.
Bakkt, on the other hand, will leverage the systems and relationships that make ICE such a power in the global financial system.
“We believe it’s time to close the gap between the frameworks for mainstream asset classes and digital assets,” Loeffler explained. Bakkt will use “the existing, time-tested, regulated futures market infrastructure” to develop its products.
That includes the same level of regulatory compliance, know-your-customer procedures and anti-money-laundering precautions that ICE’s exchanges and clearinghouses use.
Integrity and security
As a custodian for institutional bitcoin holdings, Bakkt can’t afford the kind of sloppy security that’s plagued crypto exchanges. Pension plans, sovereign wealth funds and other financial firms will expect Bakkt to hold the same “institutional standards for market integrity and asset security” as any other Wall Street firm.
Loeffler’s brief description of Bakkt’s security systems sounds a lot like things crypto exchanges would say on their websites. Traditional financial institutions do get hacked, but these tend to be small companies that don’t operate on the scale of ICE.
Bakkt will also have several layers of financial security. All of the futures contracts will be backed one-to-one with bitcoin rather than leveraged. This discipline “virtually eliminates” the chances of defaults. Bakkt will also fund a separate guarantee fund to protect any bitcoin assets kept in dedicated accounts.
Connecting to Bakkt as a platform
Loeffler’s vision for Bakkt positions the company as an interface that will let the established futures industry “serve as a second layer on the blockchain to facilitate more seamless access for institutions.” Even the references to Starbucks in Bakkt’s announcement is more about Bakkt as an enabler of corporations than a direct developer of consumer applications.
The announcement quoted Starbucks executive Maria Smith’s who described the coffee chain ”developing practical, trusted and regulated applications for consumers to convert their digital assets into US dollars for use at Starbucks.” In other words, letting you use bitcoin within the Starbucks app.
Bakkt would be part of that system, but behind the scenes. The daily bitcoin futures contracts will give Starbucks and other bitcoin-accepting merchants ways to hedge against the risks of bitcoin price volatility.
How Do You Physically Deliver Bitcoin?
Another source of confusion came from the announcement’s description of a “plan to launch a 1-day physically delivered Bitcoin contract along with physical warehousing.” It certainly generated plenty of snark-filled comments in crypto forums.
“I get physical bitcoins? All this time I’ve bought electronic bitcoin like a shmuck!” /Bombuss
“Physical delivery? No, I don’t think so. What would that even mean?” /doctor-yes
“physical delivery? sounds so crazy. back to old time if this happened” /Efficient_Specialist
“’Physical delivery’? I hate to break this to you but…” /Bitbaby11111
“Physical delivery of bitcoin? What is this 1658?” /FlySeal
That’s what happens when a 10-year-old crypto community runs into an economic system with a 6,000-year history. Many of the words the fiat system uses were adopted long before money became digital.
Closing futures contracts
When a physically-delivered futures contract closes, the seller has to deliver the underlying assets to the buyer at a specific time. The asset could be barrels of oil, Treasury bonds or stock certificates.
In the same way, a physically-delivered bitcoin futures contract requires the seller at close to deliver that quantity of bitcoin to the buyer. In the case of ICE’s Bakkt Bitcoin USD Daily Future offering, each contract closes at the end of the trading day.
As Loeffler explained on the Bakkt blog, “buying one USD/BTC futures contract will result in daily delivery of one Bitcoin into the customer’s account.”
Bakkt’s approach stands in contrast to CBOE’s bitcoin futures contracts, which are cash-settled. The Gemini Exchange’s daily auction price determines the contracts’ settlement price. Essentially, trading cash-settled bitcoin futures is like placing a bet on the cryptocurrency’s movement.
Will Big Finance Kill Crypto?
The Bakkt announcement prompted some to take a look at what regulated financial institutions’ entrance into the crypto markets. One of the more balanced takes came from blockchain advocate and former Wall Street analyst Caitlin Long in a series for Forbes. Over the course of three articles, and a couple of follow-up pieces, Long described how financial institutions and crypto could change each other.
Her second piece, “Is Financialization A Double-Edged Sword For Bitcoin And Cryptocurrencies?” described how the debt-based nature of the financial system could undermine the principles on which Satoshi Nakamoto designed his blockchain.
The 2007 financial collapse and Great Recession happened, in part, because of the way financial companies packaged and sold debt as securities. Mortgage companies bundled their loans together and sold shares to investors. Other companies bought shares from many of these mortgage-backed securities on margin to create new financial instruments. And then shares of those bought on margin went to create more instruments and on and on.
Phrase for the day: bitcoin rehypothecation
This “rehypothecation” of the original loans creates a problem, Long writes, when “someone doesn’t own the asset and still lends it anyway, so now more people believe they own the asset than there are actual assets.” With so much leverage built into these layers, there weren’t enough actual assets to keep the system going and the house of cards collapsed.
Bitcoin and many other cryptocurrencies depend on a scarcity deliberately programmed into the blockchain’s system. The ever-increasing complexity of Bitcoin’s mining algorithm and the 21 million bitcoin cap on coin production limits the bitcoin supply.
That won’t be true anymore if the financial system fully integrates bitcoin into its way of doing business. Using people’s bitcoins as collateral for debt-based securities would then let Wall Street create bitcoin “out of thin air” by rehypothecating the supply. Long calls this “fractionally-reserved bitcoin” and warns of the risks it poses to financial institutions who create it.
After the 2007 collapse of mortgage-backed securities, central banks like the US Federal Reserve bailed out banks and other financial companies by injecting new money into the system. If markets for leverage-based crypto securities collapse, there’s no lender of last resort. Miners are the only people who can create more bitcoin and the algorithm limits how many they create. Financial institutions, Long warns, would be left without a safety net and would pay the price.
Or Will We Go Bakkt to the Moon?
Dan Morehead, the CEO of crypto investment fund Pantera Capital, talked about the Bakkt announcement during a CNBC interview. While everybody in the crypto community was stressing about the SEC’s predictable rejection of Bitcoin ETFs, Morehead they should be paying more attention to Bakkt.
“That’s huge news,” Morehead declared. “That is going to be a very profound impact over the next five or 10 years for the markets.”
Morehead’s comments are similar to crypto seed investor Boris Wertz’s observations from a few months earlier. “For mass adoption, the tools aren’t there, the users aren’t there,” Wertz said. “The next two to five years will see what we call layer 1 and layer 2 solutions, where building out the infrastructure will be the very big focus. So it started with wallets and exchanges, and now it’s moving to rebuilding financial infrastructure.”
Bakkt is one example of that financial infrastructure. It will make crypto investing easier for the regulated financial industry, but it won’t send fiat investors into crypto overnight. Infrastructure takes time. We may be going back to the Moon, but it won’t be giant leaps that get us there.