08.29.2017

OPINION: Are Digital Currencies Worth the Risk?

08.29.2017

Digital currencies are the new bright shiny assets that are captivating hedge funds for the past few years, but are they the appropriate investment for more conservative institutional investors?

Their volatility and explosive growth in value have made them far more attractive to investors living in today’s world of low volatility and tight spreads of regular equities, derivatives, and credit markets.

Except for those hedge funds dedicated to investments in digital currencies investments, it is hard to believe institutional investors plan to hold digital currency directly when they have problems their asset managers investing in other bearer instruments or even simply making prices in well-regulated markets like corporate bonds.

The risk profile for digital currencies is just too high. Their high trading volatility is just a symptom of the weak design of their market structures.

There are no regulators to ensure fair and orderly markets. The individual exchanges have their terms of service for clients, but those will not do much to prevent actors from manipulating the market across multiple trading venues.

Just imagine what damage a modern day Jim Fisk and Jay Gould could do to a market if they had access to trading algorithms, FPGAs, and no regulatory oversight whatsoever.

If market manipulation can happen, it will happen, and, according to reports, is happening. The world of digital currencies is the equities world before the passage of the Securities and Exchange Act of 1934.

Some regulators have stepped up and approved trading of derivative instruments based on digital currencies like the US Commodity Futures Trading Commission did in July when it approved LedgerX’s status as a swaps execution facility, and, more importantly, as a clearinghouse for bitcoin options contracts. LedgerX expects to be trading the new contracts sometime in September.

The Securities and Exchange Commission has taken the bold wait-and-see approach to making sure that the bitcoin options market functions as expected before the SEC approves the listing of any digital currency ETF.

It will be interesting to see how the bitcoin options market matures when tied to such an untamed underlying asset.

Some market participants like retailers who accept payment in digital currencies will have little choice whether to participate in the new market since they need to hedge their digital currency holdings like it was any other currency holdings.

Institutional investors may do better if they adopt the SEC’s patient approach before jumping into the market.

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