Why investment banks and institutional investors are turning to the blockchain

By Linda Wang | 31 January 2018

Fintech firms and blockchain based technology are sometimes cast as the enemies of the traditional financial services industry – but my prediction is that in 2018, that will be proved to be a misconception.

Hedge funds, investment banks, stock traders and fund managers have a long history of viewing the world of crypto assets with suspicion. The likes of Warren Buffet, Ray Dalio (American billionaire investor) and Jamie Dimon (Chairman and CEO of JP Morgan) have all criticised the industry to varying extents. Yet the tide is turning and indeed, Dimon has since expressed his regret at calling bitcoin “a fraud”.

What has changed? Institutional investors tend to be smart people, and most have maintained at least an intellectual curiosity in cryptocurrencies and the blockchain, ever since a mysterious entity, “Satoshi Nakamoto”, first released the bitcoin manifesto back in October 2008.

But getting involved in bitcoin in its early days would have been a big risk, as the digital currency still had many hurdles to overcome; security, stability and sustainability, to name a few, before it could be considered investable.

Doubtless, there are many fund managers and traders kicking themselves for not getting involved in bitcoin or other “alt coins”: Ethereum, Ripple, Litecoin; in the bull run of 2017. Although they may have missed out on some serious profit taking, the reality is that the digital currencies were and are probably not ready for an influx of major financial players. Just a brief look at the transaction speeds across different payment networks including VISA, PayPal against other cryptocurrencies, shows that the new crypto economy still has a long way to catch up to the incumbents.

Financial services that act as enablers for bigger players to access markets have been notable only by their absence at the crypto currency party. Investors have lacked the tools they need to manage positions in a sophisticated manner; the ability to hedge their exposure, for example, cover positions, trade derivative style products, and borrow and lend securities.

How securities lending can change the game for digital asset “Hodlrs”

Securities lending has been common practice in the institutional world for decades. It enables those who wish to hold assets over the longer term (known as “Hodlrs” within the crypto community) to earn interest by “lending” their securities to other parties who wish to “borrow” them.

To make the exchange theoretically riskless, the borrower also pledges collateral of their own (over and above the amount of funds borrowed), which is cryptographically secured until the contract is over and both sides get their original assets back. The borrower makes regular interest payments to the lender in exchange for the right to borrow.

Why borrow cryptocurrencies?

There are many good reasons for borrowing a crypto asset, but the three major areas are to sell a cryptocurrency short, engaging in sophisticated trading, hedging strategies or arbitrage, or to borrow working capital in the case of some utility tokens and managing balance sheets.

For shorting, if you think a coin or token that you do not own is going to fall, you can sell it and hope to buy it back later at a lower price. However, if you sell a coin you do not own, you will need to have something to deliver to your counterparty. Short sellers, therefore, can go to a broker, or a lending platform, and borrow their desired token. The cost can vary depending upon supply and demand.

When might I wish to borrow securities?

Let’s say I was over-exposed in a particular asset class, and wanted to hedge against a fall in price. By borrowing an asset that tends to move in an inverse direction to the asset I am holding, I can realise a gain to cover the loss I will experience should the market turn. If the price movement never comes to pass, I can return the borrowed assets, having lost only a few interest payments, as opposed to having to find a buyer for my unwanted stock.

Are there other reasons why I would borrow securities?

Yes, and they tend to be business critical. Covering failed trades, for example, or ensuring the right fund portfolio split.

Another example? If I wanted to take advantage of an expected fall in the price of a security, I could employ a short selling strategy, but I may have to pledge assets to cover my position at the insistence of whoever sold me the stock I am shorting. In this instance, again, borrowing securities as opposed to buying them outright is the more effective strategy.

When might I want to lend my cryptocurrencies?

If I want to increase the overall performance of my crypto portfolio through interest returns, maximising the opportunity to leverage my portfolio or finance new projects.

In the crypto economy, it is currently not possible to lend out, or borrow, crypto assets on a cross asset and particularly, institutional basis. This must change, and it will, because digital currencies are starting to attract the attention of traditional finance specialists, and they will demand the same, or better services, than they have at their disposal in the institutional world.

The ability to, for example pledge bitcoin in order to borrow Ethereum, or vice versa, provides much needed flexibility and liquidity to the crypto asset marketplace.

The fact that the crypto economy is currently taking a hit in terms of its market cap can be viewed in one of two ways. The wrong way; the bitcoin fad is finally over. Or, the right way; the crypto economy is maturing, and it is currently experiencing growing pains. Soon, it will have the underlying financial services infrastructure it deserves.

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