Wall Street Can Kill Crypto: Here's How

Cryptocurrency hopefuls have long believed that institutional investors may hold the key to bitcoin's next bull run. They want to believe that Wall Street is just another eager investor, ready to pump money into the young market and enjoy the same returns that retail traders saw in 2017. But that projection misses the mark in two ways: first, Wall Street is already neck deep in the cryptocurrency market; and second, the last thing Wall Street intends to do is “pump” the precarious market with its own capital.

Institutional finance has had many opportunities to make money in the cryptocurrency space —but as its influence spreads, the crypto market is transforming into something new. Whether intentionally or as a byproduct of its own flaws, Wall Street is slowly killing cryptocurrency.

The short answer is hypothecation. We'll save you a trip to our dictionary: hypothecation is when a firm that owns equity shares in a company signs those shares away to a lender as collateral. Let's say Fund A needs $100 million. Broker B agrees to lend them the money in exchange for $100 million worth of the securities owned by Fund A. That's hypothecation. Rehypothecation occurs when Broker B reuses the assets that they got from Fund A as collateral in its own business operations. In the traditional financial world, this is easy to do for a few reasons. 

The first is that shares are not settled physically. Rather, they are written as certificates of ownership, so it’s easy to pass them along as an ‘IOU.' Another reason is that accounting and tax laws allow the same asset to be attributed to different parties as long each party records a different amount of debt on their balance sheets. Though counter-party risk increases significantly with a system like this, it’s necessary to grant increased flexibility to banks and brokers.

Now consider that many major cryptocurrencies, though they claim to rely on a hard-coded Proof of Work or Proof of Stake, are actually traded on centralized exchanges. If a bitcoin were to be rehypothecated six times as brokers and exchanges trade debt and collateral, who gets to claim custodianship in the event that it’s needed? Who actually owns the cryptocurrency at the end of the day if multiple parties know the private key — or if no one does?

If a broker goes bust and someone needs to pay up, or if a hard fork occurs and someone needs to vote with their ‘stake,' it’s unclear who actually owns the bitcoin because the collateral chain is so long. Regardless, this complex model of transient ownership simply doesn’t work when it comes to ledger-based assets and may result in multiple parties expecting remuneration at the same time. The chance of a meltdown in this scenario could be devastating.

Eight years ago, bitcoin was traded exclusively on fiat exchanges, meaning users could only buy or sell. There was no way to short bitcoin and there were no futures or derivatives based on the cryptocurrency. All purchases were settled in bitcoin, meaning those who bought a coin effectively removed it from the market. Bitcoin's limited supply and deflationary nature made it easy for the price to rise exponentially as more people bought and fewer people sold, expecting greater returns the longer they held on to the currency.

This naturally contributed to volatility because the market was directly exposed to the forces of supply and demand. Mass fear of missing out could send bitcoin's price soaring, while the same fear could bring it back down just as quickly. Wall Street’s introduction of bitcoin futures to its own brokers and exchanges reduced volatility significantly, simply because futures allow people to speculate on bitcoin’s downside as well as its upside.

This balances the market and makes it just as profitable to suppress bitcoin as it is to pump it. Additionally, with instruments that merely mimic Bitcoin’s price and aren’t cryptocurrencies themselves, the supply and demand factor is less relevant. Bitcoin’s spikes and swings become much less pronounced. High-frequency trading bots also now populate crypto markets, which further reduces their once impressive instability. Sophisticated bot programs like those employed by Wall Street can still be extremely profitable in low-volatility environments. Volatility is part of the reason that bitcoin is so popular and profitable for the average trader, and without it the asset really has no fundamental or unique value to the masses. 

The Futures Industry Association (FIA) is a powerful financial trade entity with influence in traditional market around the world. Composed of clearinghouses, exchanges, trading firms, and other stakeholders of the global financial industry, the FIA may be behind the consecutive delays and rejections of the many bitcoin exchange-traded funds (ETFs) that have been proposed in recent years. 

A Bitcoin ETF represents the real pipedream for crypto enthusiasts for two major reasons: first, ETFs are settled in an underlying asset; and second, they’re plugged into the traditional financial market via brokers. With an ETF, bitcoin would become more accessible to retail investors who still don’t have the patience or wherewithal to buy bitcoin on cryptocurrency exchanges or operate a blockchain wallet. Simply put, it’s the secret ingredient for mass adoption. 

Bitcoin ETFs from several firms have been flat-out denied — including from the early bitcoin investors Cameron Winklevoss and Tyler Winklevoss, as well as those from GraniteShares, Direxion, ProShares, VanEck, and others. It's hard not to see the past few rejections as a greater indicator that Wall Street may want the cryptocurrency to die before it enters its heyday. Even though there are avenues for profit in crypto, Wall Street cannot ignore the significant threat that the crypto market — and its great ambitions — represent.