Institutionally Bearish on Bitcoins

Bitcon LogoThe more research that I dig up for an upcoming feature on institutional investors and bitcoins, the more I believe that it will be a few more years before asset managers are able to profit from digital-currency investments.

This has nothing to do with the maturity of the bitcoin infrastructure, which is fine and only needs more users to exploit the network effect.

It is that Satoshi Nakamoto was thinking about the individual, and not of banks or institutional investors, when he proposed the digital currency.

If he had, he would not have designed an anonymous currency that traded over-the-counter (OTC) in a peer-to-peer fashion.

These basic characteristics are the root of the professional money manager’s digital-currency headache.

The last thing asset managers want is to run afoul of the Office of Foreign Asset Control (OFAC) or other regulators’ “know your client” requirements.

The buy side also fears peer-to-peer trading. Asset managers do not want to set the price for their holdings for fear of getting it wrong. This is why they rely on their sell-side dealers to price and trade OTC instruments on their behalf. If they didn’t have this fear, the bond market would not be in the mess that it is today.

Even if an asset managers or hedge funds manage to address these market-structure and regulatory issues, the dearth of institutional-sized liquidity surely will disappoint them.

Speaking to one bitcoin-exchange operator, whose platform uses a displayed central limit order book, he said that most fills consist between one and three bitcoins at most.

It’s not better on the listed derivatives side. BitMEX, the only future exchange of which I’m aware that trades US dollar/bitcoin futures contracts, bases its contracts on how many bitcoins $100 could buy.

Even those firms that would like to make money of the spread using their high-frequency trading expertise are in for a rude awakening.

Unlike decimal-priced cash equities, bitcoins take sub-penny pricing to a totally new level. The smallest division of a bitcoin is the microbitcoin, or one millionth of a bitcoin. Talk about tight spreads.

Also, since the bitcoin blockchain, the distributed and unalterable database that records all bitcoin transactions, only updates six times an hour, traders will not be able to enter and exit positions as quickly as in other electronically traded markets

The market and its regulators eventually will figure a way to address these issues.

However, I expect bitcoin-based derivatives and exchange-traded funds will soak up the buy side’s demand for the digital currency for at least a few more years.