Settlement Risks In Crypto/Legacy Hybrid Instruments

Note: this post is not investment advice and is for educational purposes only. Caveat emptor!

“Don’t cross the streams. It would be bad.” –Dr. Egon Spengler, Ghostbusters

Crypto/legacy hybrid financial instruments are all the rage. Major financial market players are joining the trend by introducing new products—such as regulated stablecoins and bitcoin-backed ETFs, futures, swaps and depositary receipts, for example.

This is Part 2 of a two-part series. In Part 1, I defined major differences between the legacy and crypto settlement systems—one system embraces unsettled trades and imprecise ledgers while the other doesn’t—and explained why the category of “crypto wrapped around legacy” hybrids involves fewer operational risks than the category of “legacy wrapped around crypto” hybrids. In Part 2, I’ll explain what these differences mean for owners of hybrid products.

More Background, Which Leads to a Key Question

“Crossing streams” is risky business. Continuing with the war story introduced in Part 1, I’ve experienced how hard it is to “cross streams” in many situations that were entirely confined within the legacy settlement system—which itself is messy. But by piling on the added complexity of crossing over between crypto and legacy, the settlement for crypto/legacy hybrids will be even trickier—and much riskier for crypto-backed ETFs, futures and other “legacy wrapped around crypto” hybrids.

My experiences came from deep and broad interactions with the legacy settlement system from 2010-2016. And while I was buried in the weeds of settlement details for the first multi-billion-dollar pension transfer transactions in 2012, I came across bitcoin. Seeing the simplicity of its settlement system while mired in the morass of the legacy settlement system, it became obvious that yes, there is a better way to settle financial transactions!

Pension transfers are a form of “stream-crossing”—they cross streams between pension plans and insurance companies in order to settle pension obligations with regulated, fully-funded and irrevocable annuities. They require threading a needle to settle the same-day transfer of assets and liabilities worth billions of dollars each, while also threading a needle between very different ERISA and insurance regulations governing each. No one had done this before 2012—all prior transactions were very small and all-cash, but for many reasons the large transactions are paid for mostly by in-kind asset transfers using very specific assets—hence the settlement risk. Different types of assets settle on different time schedules, as you already know—publicly-traded securities settle T+2 days (T+3 days back then) and private securities and partnership interests can take days or even weeks to settle. Cash is the only asset that’s designed to settle same-day (on Fedwire)—and even then, it’s not as easy as you’d think because multi-billion-dollar wire transfers between non-bank counterparties are fairly rare (which is why their banks usually directly involve the Fed itself). And ever-present is the risk of intra-day default by a financial intermediary after the assets have been sent but before they are received.

Here’s the constraint—in pension transfers, everything must settle same-day. It’s illegal for an insurance company to settle an annuity contract unless it’s 100% paid for, and it’s also illegal for the pension plan to transfer assets without receiving value in return. So, everything absolutely must settle same-day—there’s zero fault tolerance. Consequently, settling pension transfers same-day requires intricate orchestration and practice in advance. The detailed planning involved—especially in those first transactions—was staggering (a sense of which you could glean from redacted SEC filings or this Harvard Business School case study). Large teams of many talented people have pulled off these huge pension transfers successfully, again and again, since the first one was completed in 2012.

I share this context to help you understand the complexity of settlement processes in the legacy financial system—which is a mess, quite frankly. Judge Travis Laster of the Delaware Chancery Court says it perfectly: “The current system works poorly and harms stockholders.”

The crypto settlement system is much simpler and fairer.

But the two systems are very different, and therefore so are the skill sets required to master them.

So, here’s the question everyone should ask when analyzing a crypto/legacy hybrid: what are the skill sets of the people involved, both regarding technology and operations—does anyone involved have deep experience in both the legacy and crypto systems? This is material information that every issuer of a crypto/legacy hybrid product should publicly disclose, in my opinion.

Aside from that basic question, here are generic thoughts about crypto/legacy hybrids. Again, these are high-level generalizations and every hybrid instrument will be different. I make no recommendations, other than this:  do your own homework, and read the fine print!

What Do Differences in Settlement Systems Mean for Crypto/Legacy Hybrids? 

1. Expect Issues.

When the hybrid instrument and the underlying asset backing it are settling in different settlement systems, problems will inevitably arise—because they “cross the streams” between settlement systems that, from my experience in both, cannot be melded together without problems. Timing mismatches and settlement failures are bound to happen. The impact will most likely appear as a price divergence between the price of the hybrid and its underlying asset, and periodically those price differences are likely to be big.

2. Don’t Expect a 1:1 Relationship Between the Hybrid and the Underlying Asset.

Currency pegs eventually fail, and for technical reasons the price of ETFs and depositary receipts can massively diverge from the price of the assets backing them—these things already happen in traditional financial markets periodically. The same will be true for all crypto/legacy hybrids—but additionally they face the risks introduced by crossing over the two settlement systems. A good example of an issue that may arise is the loss of a 1:1 peg by Tether, the first stablecoin.

But for “legacy wrapped around crypto” hybrids—bitcoin-backed ETFs, futures, swaps and depositary receipts—the risk is even bigger because the legacy system inherently loses track of 1:1 backing due to unsettled trades and rehypothecation (the latter of which causes a systemic short that grows insidiously over time). Audits can’t catch the amount of divergence caused by rehypothecation, since US GAAP requires both parties to record that they own the same rehypothecated asset as long as the borrower records a new dollar of debt against it—that’s why I refer to rehypothecation as an insidious, hidden form of leverage. Multiple parties report that they own the very same asset—!! Audits are therefore useless protections against uncovered exposures that grow undetected at a systemic level (i.e., less than 1:1 collateralization)—because while your intermediary may achieve a clean audit (showing 1:1 backing), no one knows if the system as a whole has 1:1 backing. Systemic 1:1 backing is what really matters, not whether your intermediary has 1:1 backing, and in the legacy settlement system systemic 1:1 backing simply cannot be confirmed. So, don’t be surprised to see big price gaps emerge for these “legacy wrapped around crypto” hybrids when a reckoning event someday tests the degree of their collateralization. A reckoning event could be a hard fork, a “run-on-the-bank” confidence scare or a “honeypot” hack attack of the custodian/warehouse that holds the private keys (whether real or merely rumored). Remember, there’s no fault tolerance in the crypto settlement system.

3. Don’t Expect Transparency for “Crypto Wrapped Around Legacy” Hybrids.

Dollars can’t be tracked on a blockchain because dollars aren’t issued, traded and settled on a blockchain, and neither is any fiat currency. Consequently, no stablecoin can possibly offer perfect transparency. It doesn’t matter whether the stablecoin is regulated or unregulated—neither can be fully transparent. The same is true for tokenized gold, diamonds or any other asset that isn’t natively-blockchain. Unless the underlying asset is itself natively issued, traded and settled on a blockchain, there will always be a break in the digital chain of information and 100% transparency will be impossible.

4. Expect “Operational Shorting” By the Issuer of a “Legacy Wrapped Around Crypto” Hybrid

The legacy settlement system is so complex that regulators allow fault tolerance to keep it functioning as well as it does. The main form of fault tolerance is “operational shorting,” another name for fault tolerance coined by authors of a recent academic paper. In simple terms, operational shorting happens when a broker/dealer sells non-existent securities that it will later seek to obtain (or, in the case of an ETF, that it can create later). If it can’t obtain the securities, it will “fail to deliver.” This practice of selling something you don’t own would be fraud if you or I did it—but it’s allowed to occur daily in financial markets! Broker/dealers can simply compare the cost of delivering versus the penalties for failing to deliver, if any, and choose the cheapest option. Failures-to-deliver sometimes incur no penalty for the broker/dealer. Operational shorting is similar to fractional-reserve banking—the process creates an uncovered short position at a systemic level. (Many will defend operational shorting as a normal part of market-making. I criticize it vehemently. It violates basic property rights. It allows today’s trades to be settled with tomorrow’s trades (or later). It favors liquidity at the expense of solvency. It means regulators can’t keep track of how leveraged the system is—even audits can’t catch this, as discussed earlier. It’s one of the ways the legacy financial system is unfair to Mom & Pop investors—inherently, but not always nefariously—because it suppresses the price of the asset and permits intermediaries to profit from bid-offer spreads on non-existent assets. It’s permissible theft by another name…but I digress…)

The academic paper about operational shorting contains a treasure trove of data about failures-to-deliver, which is a daily occurrence in legacy financial markets and is on the rise in ETF markets specifically.

I found the following figure from the paper helpful because it shows how failures-to-deliver work and displays four different options available to a broker/dealer before the appointed settlement time (in this example, the broker/dealer is an “authorized participant” acting as an ETF market-maker). If it elects Option 4 and fails to deliver on schedule, it gains another three trading days to settle the trade. (Important caveat—the figure shows T+3 settlement but markets have moved to T+2 since this figure was published.)

Regardless, the key takeaway for you is that the legacy financial system permits unsettled trades, which creates the possibility of operational shorting and failures-to-deliver. This creates more claims to the asset than there are assets. Remember, in a crypto settlement system, such operational shorting and failures-to-deliver simply cannot occur because buyer and seller exchange value simultaneously.

5. Some Hybrid Issuers Will Be Riskier Than Others. Details Will Matter!

I don’t provide investment advice but strongly encourage everyone to do your homework and read the fine print, because small differences in settlement procedures can someday cause big price divergences in hybrids relative to underlying assets—and this is especially true of “legacy wrapped around crypto” hybrids, such as bitcoin-backed ETFs, futures, swaps and depositary receipts.

If every issuer of a “legacy wrapped around crypto” instrument followed these rules, the issuer would go a long way to minimizing the risks both to buyers and to themselves:

• Never commingle bitcoin in an omnibus account.
• Never rehypothecate bitcoin, anywhere within the multiple layers of intermediaries.
• Always require 100% collateralization with on-chain bitcoin, even intra-day.

Again, though, this is not how the legacy settlement system works. Rehypothecation is as integral to Wall Street as it is antithetical to bitcoin, and the reality of unsettled trades, delays in margin calls, collateral substitution and other differences means no issuer will ever be 100% collateralized all the time—even intra-day.

Still, issuers of “legacy wrapped around crypto” hybrids could significantly improve transparency by publishing verifiable NAVs (by disclosing public keys). Crypto exchanges that take custody of customers’ crypto have for many years grappled with this same issue. Kraken, for example, offers a type of “proof of reserves” audit, and a group of researchers proposed a privacy-preserving method for crypto exchanges to prove solvency called “Provisions.” (Disclosure: I’m an investor in Kraken.)

Of course, though, it’s simply not possible for any issuer of a “legacy wrapped around crypto” hybrid to provide 100% transparency because settlement “crosses the streams” of two different systems. This applies to custodial crypto exchanges too. Caveat emptor!

6. Don’t Be Fooled by Misleading Marketing.

“Bitcoin in your 401(k)” is very misleading marketing. Almost certainly you won’t ever own real bitcoin in your 401(k), simply because most 401(k)s only invest in funds and bitcoin is not a fund. “Buy bitcoin through your stock broker”—don’t be fooled if you see this either. Unless you hold the private keys, your stock broker isn’t selling you real bitcoin. If anyone else holds the private keys, what you own is a substitute—an IOU from your intermediary—rather than the real thing. Yes, a bitcoin ETF or a bitcoin mutual fund could someday be in your 401(k). But not real bitcoin—not real, base-layer bitcoin. Again, “not your keys, not your bitcoin.”

Yes, bitcoin really is different than traditional assets—it has no lender of last resort, its settlement system has no fault tolerance, there is no clearinghouse to facilitate failures-to-deliver it. By design, Bitcoin has zero flexibility in its settlement system and that critical distinction relative to legacy financial instruments means it will be harder for Wall Street to get away with misleading marketing. Any intermediary that markets a bitcoin hybrid as if it were the real thing faces lawsuit risk—plaintiffs’ attorneys are likely to have a field day.

Be careful, everyone involved—on all sides! Do your homework and read the fine print!

Stablecoins…Oh, the Irony!

Necessity, as they say, is the mother of invention, and stablecoins were born out of necessity. The banking sector has largely shunned the cryptoasset sector and made it difficult (and expensive) for customers to convert crypto to fiat. The crypto sector responded by creating stablecoins, a dollar proxy meant to obviate the need for frequent crypto traders to convert to actual fiat when they want to reduce price risk in their portfolios. Here’s the irony:  stablecoins have the potential to become a powerful disruptive force in traditional payments, doing an end run around the very banking system that largely shunned crypto in the first place!

Some very astute financial minds—including legendary investor Stanley Druckenmiller, former Fed governor Kevin Warsh and executives at many companies rushing to issue stablecoins—rightly saw much broader applications for them:  in institutional payments.

For institutions, stablecoins solve a real problem that the legacy financial system doesn’t solve—settling dollar payments with simultaneous delivery-versus-payment (DVP) and on a real-time gross settlement (RTGS) basis. Regulated stablecoins have the potential to become useful much faster than “utility settlement coin” (which began in 2015) and similar efforts of the incumbent banking industry to speed up payment settlement—because stablecoins are freed from the cruft that weighs down incumbent payment systems. To achieve this, though, they need to jump through critical hoops—they need to avoid classification as a security, and accountants need to classify them as “cash-equivalents” so owners can value them at par.

Here’s potential I see for stablecoins that meet these criteria and gain liquidity:

• Solving the “comfort deposit” problem that many multi-national companies face. Corporate treasurers are constantly looking for the cheapest way to move cash around the world, and many companies are trapped by their banks into holding significant “comfort deposits” in their bank accounts to fund their own unsettled payments. The ability to settle cash payments in real-time would free up enormous amounts of dormant “comfort deposits.”
• Replacing correspondent banking services. Correspondent banks are netting intermediaries that today provide an expensive, slow and cumbersome way to clear payments.
• Supplanting escrow agents with a cheaper, faster, less error-prone and immediately auditable digital alternative.
• Solving the “de-risking” problem where entire countries and industries are losing access to traditional banking services (as the high cost of complying with KYC/AML rules is causing banks and correspondent banks to exit).

If you’re interested in learning more about the “comfort deposits” issue and the opportunity to release huge amounts of trapped capital, here’s my interview on the topic with Dave Morton, then-CFO of Seagate Technology.

Here are some open questions regarding stablecoins:

• Which ones are securities?
• If not a security, will any of them qualify as cash-equivalents (allowing owners to report them at par under accounting rules)?
• If privately-issued stablecoins gain traction, what’s to stop central banks from crowding them out by issuing their own versions? There are three “superregional” central banks whose currencies are most frequently used as intermediary currencies in their regions (the Fed, Bank of England and Bank of Japan in the Americas, Europe and Asia, respectively), and if one of them were to issue a central bank digital currency—a.k.a. a central bank stablecoin—much of cross-currency foreign exchange would likely migrate to that as an intermediary currency globally due to its superior settlement system.
• Can any stablecoin out-compete Bitcoin as a high-value payment system? Corporate treasurers (who control most volume in payment systems) will route payments through the cheapest intermediary currency, and it’s important to remember that intermediary currencies never touch the company’s balance sheet—so the price volatility of bitcoin won’t matter much if it’s used as an intermediary currency in company-to-company foreign exchange.

Conclusion

Settlement is a complicated subject, but when it comes to preserving your wealth it’s a critical topic—what do you own, really? Are most of your financial assets actually IOUs? This whole discussion boils down to one simple fact: the legacy settlement system embraces unsettled trades and imprecise ledgers, while the crypto settlement system does not. “Crossing the streams” between legacy and crypto will pose some of the biggest operational challenges that have ever existed in financial services. No one should be under any illusion that the two systems can be seamlessly melded together. Caveat emptor for all crypto/legacy hybrids. Do your homework. Read the fine print!

The legacy system’s embrace of fault tolerance to band-aid its myriad problems may sound good at first blush, but that’s exactly what makes the financial system unstable and unfair. If we could start over from scratch, I believe we’d adopt a purely crypto-based financial system—because as a settlement system, it is far superior. It’s an honest ledger. As more folks learn about this, as more institutional investors invest in this, and as more issuers issue security tokens and other natively-blockchain assets, the end-run around the legacy settlement system will accelerate.

All this innovation is worth celebrating!