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ICOs and the money markets

It’s worth putting the recent fad for initial coin offerings (ICOs) — the funny money ICOmedy — in the context wider monetary and funding phenomena.

In the ICO market every man and his dog is currently capable of raising millions of cryptocurrency for nothing more than the promise of some hypothetical future code. If that.

In reality, however, these venture-less (and often profit-less) business models are replicating the ancient art of taking other people’s money on the promise of returning it at a higher relative value in the future. The difference is they’re not even pretending there’s a need to invest that capital in productive cash-flow lucrative businesses in the interim. (There is, to put it mildly, an alarming disregard for positive cash-flows in most of these models).

It’s unclear as a consequence where the future value underpinning these valuations is supposed to come from.

In the conventional money markets, the average interest rate returned on a unit of national currency over time is supposed to match the rate charged on an equivalent FX swap deal for the same duration. This ‘no arbitrage’ condition is called covered interest parity (CIP).

Simply put, if holding US currency generates a 1.25 per cent return but holding UK currency generates a 0.25 per cent return, the price of the UK currency in the forward swap market should be priced at a premium to the US currency to prohibit investors from borrowing UK currency and swapping it into US currency with the option of swapping it back into the UK currency on an entirely risk-free basis.

But, as widely reported, this relationship may have broken down in recent years because of a lack of institutions that can fund at the 1.25 and 0.25 per cent respective rates due to unforeseen costs, discriminations and limitations at an institution level. Consequently, nobody is executing the available arbitrages to their full potential.

Since the majority of financial institutions can’t fund at those rates — and those that can are limited by other factors — the differential clearing price over or below CIP reflects the breadth and scope of heterogeneous ambiguity in the money market.

Which brings us to the ICO factor…

For ICOs, a similar situation holds true. Except… the scale and scope of the ambiguity and heterogeneity is even more substantial due to the lack of clarity on associated cashflows.

Those who invest in ICOs tend to do so for the purpose of parking easily obtained bitcoin profits (whether from speculation, theft or illicit activity — all bearing effectively different funding rates) in other coins for further appreciative exposure. They do not, consequently, want to hedge their FX exposures in the swap market: the whole point is exposure to further capital appreciation (at huge risk) as opposed to steady income (at little to no risk). What’s more, even if they wanted to, no such swap market exists in any depth.

From a CIP point of view, however, how can you determine fair relative value or what the no-arbitrage condition for a multitude of crypto currencies should be if they bear no income potential whatsoever? They have no time value of money in the ordinary sense.

If and when they do bear interest it is derived not from lending to a productive industry but to short sellers — and this is done at heterogeneous rates across varying exchanges and at varying risk. There is no uniform base lending rate. Everything is arbitrary. Worse than that, the lack of income equates the whole thing to a casino-style game of chance, with ongoing profits entirely dependent on ongoing capital inflows from external sources.

Nevertheless, while ICOs do not (yet) deliver income they certainly do burn cash. Perhaps, then, there’s logic in using an implicit negative interest rate or negative time value of money to gauge what the relative value of all these currencies should be?

Theoretically, the forward swap rate for a “cash-burning” currency should be as prohibitively expensive to ensure it is not possible to raise crypto at a negative rate, swap it into positive yielding currency, and then be able to swap the proceeds back into crypto profitably and at zero risk.

And indeed, if you look at the fledgling cryptocurrency derivative market forward premiums tend to be ridiculously expensive.

Take as an example the September bitcoin future on the BitMex exchange. This was trading at $2321 at pixel time, compared to a spot price of $2270. BitMex’s “perpetual swap“, meanwhile, currently sees longs (those “borrowing” BTC) receiving 0.027 per cent and shorts (those “lending” BTC) paying 0.027 per cent. (Though it must be noted, these swaps do not operate in the classical manner, not least because of a lack of benchmark interest rates to price differentials against).

Crypto enthusiasts, however, don’t look at these rate curves and think “cripes, bitcoin has a negative time value of money, is hugely volatile and is impossible to protect long term value in without being abandoned” or “cripes, the only way I can generate income is by lending to short-sellers who are likely to destroy the market value of my currency”. They think: “wow, the market is predicting major appreciation! I’ll hold! To hell with the risk!” (That’s if they look at them at all.)

Meanwhile, if we presume the crypto market is even more segmented than the conventional market (because you know, everyone is their own bank and there’s no such thing as a benchmark funding rate because funding is either free, cheap or equivalent to the standard fiat depending on who you are and what you’re prepared to do to get your bitcoin), there’s no guarantee any forthcoming discount in forward rates implies an actual carry trade opportunity.

To the contrary, it probably implies there is so little enthusiasm for your coin or such an inability to trade out of it without crashing it, that the rates are entirely unrealisable or realisable only for a handful of early, early adopters who benefited at the cost of everyone else.

As ever, there is no free lunch. Don’t let the ICO madness get you.

Related links:
Wither the law of one price? – FT Alphaville
In the crypto world, you can get something for nothing – FT Alphaville

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