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Software & Systems

Paving the Way for Digital Currency Use

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September 25, 2017

LedgeX approvals facilitate corporates’ use of digital currencies.

Distributed ledgerAdopting new payment methods such as PayPal and Apple Pay typically involves complications. But solutions are emerging to facilitate their use. Companies that have agreed to accept digital currencies like bitcoin and ethereum have faced similar hurdles, and a recently approved derivative exchange and clearinghouse may prove to be just such a facilitator.

Today, a wide range of companies accept bitcoin as a source of payment, ranging from Microsoft to Virgin Galactic to numerous online travel agencies and gaming companies. Unsurprisingly, many of their businesses are technology-powered, but non-tech firms have also jumped onboard—Helen’s Pizza in Jersey City, NJ, has sold slices for the $2.50 equivalent in bitcoin since 2014, and it gives customers a 10% discount for using the digital currency.

From a corporate treasury perspective, however, digital currencies are highly volatile—a bitcoin nearly reached $5,000 on September 1, dropped to close to $3,200 on September 14, and rising above $4,000 on September 18. For that reason, they’ve tended to use services provided by firms such as Coinbase and BitPay to convert bitcoins immediately into fiat currencies of their choice.

Soon, financial derivatives allowing companies to mitigate that volatility risk will be available. In July, the Commodity Futures Trading Commission (CFTC) granted approval to LedgerX, first as a swap execution facility and later that month as a clearer for those trades. The trading platform plans to offer bitcoin-based put and call options contracts as well as “day-ahead swaps” by the end of September, with derivatives for other digital currencies such as ethereum to follow.

LedgerX is not the first trading platform to offer digital currency-based derivatives. Derivabit was a short-lived trading platform for bitcoin options that regulators shut down for failing to follow regulatory procedures, and the Bitcoin Mercantile Exchange and Deribit offer offshore alternatives for trading digital currency-based derivatives. LedgerX’s distinguishing features, however, are that it has been approved by a US regulator not only to trade but also to clear transactions, much like major derivative exchanges such as the CME Group and the Intercontinental Exchange.

That should provide a green light for many accredited institutional investors. “These licenses offer a degree of comfort so far unseen in the digital currency space,” notes Paul Chou, CEO and cofounder of LedgerX, in a recent blog. “If you are a hedge fund, commodity trading advisor, or any large asset manager that trades currency options, gold futures, or oil swaps, then LedgerX will look no different from the platforms you already use.”

Aaron Brown, who analyzed digital currencies as the head of financial markets research at AQR Capital Management, said that LedgerX is essentially making digital currencies resemble more traditional financial products in the eyes of institutional risk and operations managers. And much as companies hedge interest-rate or current volatility, they’ll be able to project revenues in bitcoin or another digital currency and then use derivatives to hedge swings in the currency’s value.

“A company that projects one bitcoin per day in revenue could send all those bitcoin to LedgerX, and use them to collateralize the selling of options to smooth the dollar cash flows,” Mr. Brown said. “For example, [it] could sell call options and buy puts. If bitcoin soars, the calls get exercised, and the company sells the bitcoin for the call exercise price. If [the price of] bitcoin falls, the company exercises the put, and sells the bitcoin for the put exercise price.”

Another significant distinction of LedgerX, noted Richard Johnson, vice president, market structure and technology, at Greenwhich Associates, is that trades are physically settled, whereas derivative trades on other digital currency-based trading platforms have been cash settled.

“That’s a benefit because if an institution executes a forward or options contract on LedgerX, it will have the option of taking delivery of the bitcoin, whereas other trading platforms do not allow that,” Mr. Johnson said.

In the case of corporates, however, they may not want to hold the digital currency, perhaps because it would require significant systems changes, or their auditors might decline to accept price validations due to accounting complications. Instead, Mr. Brown said, institutions may choose to roll day-ahead swaps. They allow for participants to reach an agreement on a price for bitcoin a day ahead of the transaction, a critical risk mitigation tool because bitcoin can’t be purchased in advance, and so its price may change between when the transaction is agreed upon and when it is settled. By perpetually rolling those swaps the end user will never have to take delivery of digital currency.

“It would be similar to rolling an oil futures contract. Instead of owning oil and having to worry about storing it, environmental problems, and so forth, an end-user can roll the futures contracts when they come due and retain all the economic exposure to the commodity without actually owning the messy, smelly stuff,” Mr. Brown said.

Likewise for the digital currencies. Or a corporate could simply deposit its bitcoin in LedgerX, which isn’t a bank but accepts digital-currency deposits as potential collateral for future derivative transactions. The corporate would no longer hold the digital currency and instead LedgerX would allocate to it an ownership share of the trading platform’s blockchain-recorded digital-currency holdings, much as brokerages allocate shares of the stock certificates they hold.

“That’s going to be much more satisfying to institutions, because it takes them out of the bitcoin process,” Brown said. “They’ll face the risk of the clearinghouse collapsing, but that shouldn’t happen because the clearinghouse is supposed to take no risk.”

Roger Park, innovation and strategy lead for financial services at EY, said that because LedgerX’s clearing function requires participants to deposit bitcoin as collateral, it may reduce the amount of bitcoin or other digital currencies available for transactions and potentially bring more stability to the currencies. And, he said, bringing into the digital-currency market more institutional investors, who presumably will view the currencies as a more viable asset class, should also service to reduce volatility.

The notion of investing in digital currencies may be premature for most corporates. However, a few large technology and pharmaceutical companies with sophisticated trading desks may view them favorably because they’re uncorrelated with the financial markets, and hence a hedge against a 2008-type market collapse. And with digital currency-based derivatives soon to be available, they would be able to hedge those investments.

“If they’re making an investment in bitcoin, for example, they could hedge that with some puts, putting a floor on the downside risk,” Mr. Park said.

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