The CFTC approved a Bitcoin Derivatives exchange “LegderX” several weeks back. Because Van Ecks ETF will rely on that rather than Bitcoin it means that clearing and moving funds will arguably be more transparent and secure because the derivatives settle in cash. The SEC and CFTC understand cash better than they do Bitcoin.
I personally thing the challenge the SEC has with the Winklevoss ETF is that they cannot wrap their heads around how the storage of Bitcoin will take place and where the funds will held. There are lots of security issues here which needs to be addressed and that makes for a lot of challenges.
There is “GBTC” which is not actively managed and usually trades at a very high premium to Bitcoin – see here.
The CBOE is now launching Bitcoin Futures in a plan with the Gemini exchange. I am not certain what the implications are of this for the Bitcoin ETF that the Winkelvoss were working on. Launching Futures is a much easier task for the CFTC and/or SEC to wrap their heads around as the Future just has to track the Bitcoin price. Whereas with ETF the SEC has to figure out how actual trading and settlement of the Bitcoins underlying the ETF would work.
One could argue that the Bitcoin ETF would have had a much bigger impact on price that the Future. But inevitably there will be players in the market which are arbitraging Futures versus the underlying. This means more capital flowing into the cryptocurrency space. It also means more legitimacy for Bitcoin wherein regulators and stock exchanges are grasping and embracing the products.
The chart below shows a good move up in the S&P500 (an Index of the US stock market) and Ethereum. Both moves occured right in the 10:11-10:12AM EST time frame. The top chart is Ethereum from GDAX and the bottom is the S&P500 (SPX).
Clearly there are good sized traders out treating Ethereum and Bitcoin as an asset class like equities…
Its more than apparent that hedge funds and banks are pushing into the Bitcoin and crypto markets. Today I noticed that both Bitcoin and Ethereum prices gapped up at 9:30AM EST. Coincidentally thats when the US stock markets open for trading. Forgive the terrible notation in the GDAX charts below, I was in a rush.
There is no obvious reason why the two would be linked, I suspect it has something more to do with some traders who have algorithms for the US stock markets. When their machines flip on they also have Bitcoin and Ethereum in their portfolios, so they begin trading them, too.
I don’t currently have the time to backtest this, but I wanted to post something as a reminder.
There is a lot of action in Bitcoin and Ethereum trading – intra-day volatility can be huge. One thing that is frequent in crytpo trading is buy or sell “walls”. I great example happened today on the GDAX exchange.
You can see at the bottom section of the chart below you have an aggregate of buy and sell volume at various prices. On the left in green is the amount in total that people are willing to buy at various prices. On the right in red is the amount sellers are wishing to unload. As you can see there is a massive amount of Ethereum for sale around $230 ETHUSD. This is almost 8,000 ETH units for sale at $230/ETH which is roughly $1.8 million USD.
For the price of Ethereum to move over $230 there needs to either be very strong buying demand to “tear down that wall”, or the large seller(s) need to pull back.
Buy and sell “walls” is something you will see frequently in crypto trading.
In addition to the continuous trading order book, each of the order matching engines conducts two Auctions (or “crosses”) every day, one at 4:00 p.m. Eastern Time (20:00 UTC during EDT and 21:00 UTC during EST) and one at 7:00 p.m. Singapore Time and Hong Kong Time (20:00 JST, 11:00 UTC). This provides an opportunity for both buyers and sellers to trade in an instant of elevated liquidity and price discovery. All active orders (including resting limit and MOC orders) may interact with the Auction and influence the final auction price, which is determined by finding the price at which the greatest aggregate buy demand and sell demand are fulfilled. All participating, eligible orders are fulfilled at the final auction price. (We use a mechanism similar to the New York Stock Exchange’s Arca marketplace, Nasdaq, Bats, and other large stock exchanges throughout Europe and Asia, which is sometimes called Walrasian equilibrium.)
In the stock trading world Auctions are useful because it allows you to trade “size” (aka large orders) without (hopefully) having much impact on the stock price. If you are a large hedge fund and need to offload 5 million shares you can really push the price of a stock down, especially if you are a large part of the volume. Theoretically the auction might allow you to cross (aka match in the auction) with a large buyer without having a major impact on the price of the stock.
There are a bunch of stats on the Gemini Auction here.
On the stats page, there are a few interesting things. There are about 340 data points and the average “Absolute Difference” between the midpoint on the “continuous market” (aka normal price) vs where the Auction Matched price is 0.27%. With Bitcoin at ~$2,500 thats about $7. The highest spread though was 3.83%, with a standard deviation of 0.41%. Remember, these are ABSOLUTE numbers, so you don’t know if the auction price is higher or lower.
A real statistician would rip my math apart here, but basically this says that you have a 66% chance of achieving a price thats almost 1/2 a percent from where the continuous market is trading.
For the average joe, this isn’t worth much. The price of Bitcoin or Ethereum can move 1/2% in a few seconds so you’re opportunity to lock in an arbitrage seems a random. But, if you are a market maker or an arbitrager using an API to trade instantly its pretty interesting. Not only could I use the difference in price between the “continuous” exchange on Gemini and the Auction mechanism, but I could also arbitrage between any one of the other exchanges like GDAX, kraken, OKCoin, etc.
First, some caveats. I spot checked exchange websites to verify these prices. It appeared like I could trade the Bitcoin/USD pair on each of these exchanges. How the exchanges adjust their local currency into USD could cause the price differences. For example, the Chinese exchange might use a delayed quote to adjust their price from Yuan to USD for advertising purposes. Then, when you try to trade you’ll see a different quote. What follows below is just a thought exercise – do not take it as anything more.
Want to make ~10% of your money instantly?
Buy bitcoin on Poloniex and sell on LakeBTC. Poloniex lists themselves as a Wilmington, DE company whereas LakeBTC is Chinese. So if that geographical difference bothers you, then flip to GDAX or Gemini vs Poloniex where the arbitrage is closer to 5%.
Why is the Price Difference Between Bitcoin Exchanges so Big?
There is no real linkage between various Bitcoin Exchanges. Historically stock exchanges didn’t have linkages either and it was market participants who made their living arbitraging between exchanges. As more arbitrage players step in the price spread between exchanges shrinks. More players, more competition, smaller (aka “tighter”) spreads.
Why haven’t arbitrage players/market makers jumped into Bitcoin?
Well, many have. There are players in the arb game already but there are some challenging barriers to entry.
Exchanges often have API’s which allow you to connect and with a bit of code you could be on your way. Now the fun part.
Bitcoin wallets are local to the exchange.
There is no “central” wallet (that I’m currently aware of) which all the exchanges connect to. If you are trading on OKCoin you have to have a bunch of funds on that exchange. If you want to arbitrage against Gemini you need funds there, too. What happens if you buy a bunch Bitcoin on OKC and then need to sell a bunch on Gemini? Suddenly you’d be out of cash on OKC and flush with cash on Gemini. You then need to either transfer cash or Bitcoin to OKC so you can buy more on that exchange.
Great, lets transfer more cash to OKC:
This can be time consuming – will the exchange take in the funds instantly? When arb’ing time is of the essence. Additionally, many exchanges won’t take US customers. Some find ways around this of opening local companies and local bank accounts. Enter in the issue of currency.
If you’re primarily in USD’s you might have to account for the currency conversion to the local exchnages currency. OKC is in China, so you have to get USD into Yuan and factor that into your arbitrage. When the price spread is $200 between exchanges this might not matter much – but when that spread gets tighter it may become a problem.
Option two: send Bitcoins from Gemini to OKC: Generally this is cheap and efficient. BUT, Bitcoin has been known to have some network issues that slow down the transfer of Bitcoin from one wallet to another. Particularly when the prices are really moving fast. As an arbitrager its when markets are moving fast that you’re most likely to have to move Bitcoin between wallets. Lets say you need funds at OKC immediately because you sold some at Gemini – a 5 minute delay in sending coins could wipe out your arbitrage.
Keep in mind – most arbitrage players want to trade on many exchanges simultaneously not just two. You can see how this could get confusing quite quickly.
These problems are solvable, but far from trivial.
Enter Bitcoin Exchange “counterparty” risk.
Alright, you need to keep a bunch of funds distributed to all the various exchanges on which you trade. As any long time Bitcoiner will tell you, keeping funds on an exchange brings a lot of risk. You’re exposed to everything from hackers hitting the exchange (see Poloniex) to the people that own the exchange just deciding your funds are theirs (see Mt. Gox). Certainly exchanges are getting better and more secure as they evolve. Buy lets say the Konim exchange messed up your wire transfer. They’re Turkish – do you speak Turkish? There are also plenty of stories involving US Banks which aren’t wild about your evil cryptocurrency related money transfers. So they hold up your funds.
These and others are all risk that you have to consider.
All that aside, it appears there is money to be made. Its also a safe bet that more players are going to pile in, technology will improve and the price difference between exchanges will close up. For most of us normal “buy and hodlrs” that means more efficient markets.
Hedge funds and Wall Street firms have been slow moving into trading and investing in cryptocurrencies such as Ethereum and Bitcoin. There are some
indicators that sentiment is shifting such as JP Morgan (and others) joining the Enterprise Ethereum Alliance and Goldman Sachs initiating research coverage of Bitcoin.
Assume for a second that sentiment is suddenly 100% positive and that all the “scam” and “crime” stigma has left the building. So, whats the problem?
Regulation of Bitcoin, Ethereum
Party of the beauty and attraction of crypto is the decentralization and lack of regulation. There are many reasons why this is beneficial. But if you’re a big bank or managing billions of dollars, regulation matters. First, Bitcoin is not “legal” in all countries. Just look at what China did a few months ago when they started “regulating” Bitcoin. As per wikipedia: “While private parties can hold and trade bitcoins in China, regulation prohibits financial firms like banks from doing the same.” Not only is there (outside) risk of the US doing this, but if you’re a fund thats has Chinese investors or does business with China this clouds the water.
Most assets are also considered collateral. If I have $10 million in gold I can bet that the bank I deal with would consider that an asset against which I can borrow. Does every bank see Bitcoin in that same light?
A lower risk, but still foreseeable is the risks of regulators such as the SEC or FINRA coming after you for engaging in (for example) an investment used to launder money. Maybe you buy Monero and build up a large position and
those assets are seized because the FBI thinks they were used in some hacking blackmail scheme. Probable? Probably not. Possible? Sure.
The facts are that until a regulator “green lights” Bitcoin and/or Ethereum its going to be tough for large institutions to trade or invest.
When Might Regulators Weigh In?
I’ve been watching the SEC’s ruling on the Winklevoss Bitcoin ETF launch. Its taken years for a ruling, and earlier this year it was initially rejected. However in April the SEC decided to take another look. I think its a bit underestimated the impact that approval would have to the price of Bitcoin. This would give not only a regulatory stamp of approval, but paves the way towards clearing and settlement of Bitcoin at an institutional level.
Clearing and Settlement is a Major Problem
Take stock or ETF trading as an example. When funds (or anyone as a generalization) trade publicly listed stock that stock clears through a central clearing house called the DTC. If I am a hedge fund and have my assets at say, Goldman Sachs (your “prime broker”), I can trade stock with JP Morgan. JPM sends the stock to my account at Goldman through the DTC. Its a pretty seamless process and universal to US stock trading.
Now, lets say I’m a hedge fund and I want to buy $1 million Bitcoin. Buying is easy enough – you go to one of the exchanges, wire money and buy your Bitcoin. The problem is there is no way to get your Bitcoin back to your prime broker. No, a wallet even with vaulted cold storage wouldn’t work. The risks associated with that are high, but the mechanics of trading in and out are a huge hindrance. If the fund needs to immediately raise assets by selling Bitcoin they need to have immediate access to those coins. While yes, you can work out the mechanics if you are a small fund or “crypto” is your dedicated business. But for large institutions who want to simply invest in crypto this is a major hindrance.
How Could Clearing Change?
One possible way is for clearing houses/prime brokers like Goldman or Morgan Stanley to have some type of central clearing wallet. Linked to that wallet would be “sub-wallets” for each fund that owns Bitcoin. Therefore if I go to Gemini Exchange and buy 1000 Bitcoin, I tell Gemini to send that Bitcoin to Morgan Stanley on my behalf. Morgan Stanley then has custody and can allocate the Bitcoin to my funds sub-wallet. This “sub-wallet” concept seems to peripherally exist and I’d imagine banks could pay someone to hash it out rather quickly.
If the Bitcoin ETF launched this would circumvent all of this, because you could just buy the ETF and it would clear via the DTC like all other stocks and ETFs. (Yes, I am aware the GBTC exists, but the premium on that product is absurd). To this point I think this clearing/custodial aspect is probably one of the problems the SEC is having with the product.
In the End
I’m confident these issues will be worked out. The fact that they haven’t yet makes (in my opinion) Bitcoin and Ethereum such an interesting investment at the moment. The door is currently cracked open to big investors, but eventually we could see a real flood of assets.
The alternative title for this post was set to be “Coinbase: Spread ’em!”, but its probably best to tone it down.
For those in the US, Coinbase is arguably the most convenient and mainstream way to purchase Bitcoin, Ethereum and Litecoin. They link to your bank account and will allow you to buy and sell crypto with the click of a button. They offer relative security in that they have “grade A” investors like the New York Stock Exchange. (This would be in comparison to some non US exchanges owned by…???) I personally use Coinbase and have recommended them to friends.
Coinbase is superficially a retail application that routes orders to their exchange, GDAX which offers more advanced functionality.
According to CoinMarketCap, GDAX is the 7th largest crypto exchange by volume.
With the recent price explosion in crypto, CoinBase has had many issues with downtime. Often when markets were at the jumpiest users would see the following screen:
Uptime aside, I think its important for users to really understand the price they are paying for this convenience and security.
How [I Speculate] Coinbase Works
Coinbase does not give users the ability to place limit orders – for that you have to use GDAX. Coinbase gives you a live price at which you can buy or sell the crypto of your choice. That price comes from GDAX, and that is where they “source liquidity” (i.e. actually buy or sell). When you buy they then pull money from your bank account or credit card. This opens Coinbase up to two principal points of risk
Price Risk – Coinbase guarantees you a price for a few seconds, during which the actual price could move. Coinbase still has to grant you the quoted price, even though the price may have changed between when they quote you and when you click “Buy”.
“Funding” Risk – Your crypto is not available under Coinbase has received the funds from your bank. However you could probably find ways to cancel the funds transfer and stick Coinbase with the crypto you bought. This leaves them with unwanted inventory and the associated risk. Coinbase caps how much you can buy or sell, and you need special permission for higher levels to greatly mitigate this risk.
This risk is baked into the price when you receive a quote and pay their fee. It appears in two places:
Crypto Pricing (Not Very Transparent): They “spread” you, meaning they increase the price over (buying) or under (if selling) where the actual market is trading. For example, the actual mid point price for Bitcoin might be $2,000, but Coinbase will sell you Bitcoin for $2,010. Note that if you use GDAX you can place limit orders and have better control of your price.
I surmise that when markets get really crazy, spreads widen out. Meaning the price Coinbase is quoting you will be father away from where actual market is trading. This is what happens in stock and options trading: market makers widen their bid/ask quotes to reduce their risk.
Here is a real time example using Coinbase on iOS:
Buy 1 Bitcoin:
Coinbase Offer Price: 2284.65
Coinbase Fees: $34.04
Simultaneous market on GDAX:
GDAX: Bid $2,268 x Ask $2,273
Therefore Coinbase is going to sell me 1 Bitcoin at $2,318.91, then simultaneously buy on GDAX for a worst case $2,273. They clear $45 from the trade or about 2%. For the security and convenience of using Coinbase, I’d argue thats not a terrible price.
Its possible that they also have a matching engine which would pair or match my buy order off against another Coinbase user that is selling. This means that they could fill both of our orders “mid market” (halfway between the GDAX bid/ask) which would be a price of $2,270. That adds a few more dollars of profit for them.
Not a bad business.
The Flash Crash
Last week Ethereum [ETH] prices “Flash Crashed” on the GDAX/Coinbase exchange. Price went from ~$320 to $0.10 and then back to the $300’s in seconds. Heaps of money were made and lost, and Coinbase is sorting it out trying to make it right. Clearly, this was not a good thing. Yet, even “mature” exchange (like the NYSE) can flash crash and have outages. The important thing is that Coinbase is trying to make it right and that in the end will build trust. How did it happen? From Coinbase:
On 21 June 2017 at 12:30pm PT, a multimillion dollar market sell was placed on the GDAX ETH-USD order book. This resulted in orders being filled from $317.81 to $224.48, translating into a book slippage of 29.4%. This slippage started a cascade of approximately 800 stop loss orders and margin funding liquidations, causing ETH to temporarily trade as low as $0.10.
Our initial investigations show no indication of wrongdoing or account takeovers. We understand this event can be frustrating for our customers. Our matching engine operated as intended throughout this event and trading with advanced features like margin always carries inherent risk.
We are continuing to conduct a thorough investigation and will keep customers updated with any resulting actions. With that in mind, it is important to note that these trades are final in accordance with our GDAX Trading Rules (Section 3.1). Honoring properly executed orders is critical to maintaining the integrity of an exchange.
In response to the large price movement we decided to temporarily halt trading of ETH-USD. Once we confirmed all systems were operating correctly, we restored trading in accordance with our Downtime Process(Section 5).
Because there really isn’t a linkage between global crypto exchanges I think the fallout was pretty minimal. Had other exchanges traded more in lockstep with GDAX we may have seen sustained issues from this event.
For US investors and those abroad with access to Coinbase I think they are best of pure from a purely “retail” or buy and hold (HODL) perspective. For active traders or those a bit more technologically inclined GDAX is a better alternative. Gemini is another US exchange which merits mentioning here as a US based competitor to GDAX. These platforms offer better security and a more regulated environment than not US competitors and while that may come at a slight cost, its valuable insurance.