Krypto Connect Issue #3

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Krypto Connect is a fortnightly commentary on the evolving world of Cryptocurrency assets and the world of finance and banking. Our underlying assertion is that we are at the early adoption phase on the blockchain and cryptocurrencies curve, but that the impact on money, assets and financial services is rapidly gaining pace.

Our goal is to:
1. Provide some education that is not 'geek speak'; and 
2. Keep readers abreast of what’s interesting - where the finance and banking industry collides with the cryptocurrency industry.
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Hello <NAME>,

Welcome back to Krypto Connect!  Well, here we are at issue #3. We have shifted the publish date to Mondays - we hope that works for everyone.

Ok, let's crack right on with this issue.  

In this issue we seek to answer the question; how safe is bitcoin?  It's a prudent question if you think about the risks associated with gold in terms of having it stolen or if you are holding shares in a company that holds gold. How can an investor confirm claimed holdings?  What they are storing? Of course, bitcoin is a digital technology, so part of the challenge is how you hold it, and the other part is the question: can it be hacked like other software?


1. Can Bitcoin be hacked? 

I recently read Ben Mezrich’s book, ‘Bitcoin Billionaires’, which is primarily about the guys who invented Facebook, the Winkelvoss twins, and how they got into bitcoin early (damn them!). It’s a good read, but in the 267 pages, only one page blew my mind: page 187.

It’s mid-2013 and the twins have been invited to a secret gathering in San Francisco of some of the most influential and powerful people in technology. Bitcoin is the only topic of conversation which in of itself is incredible.

Mingling, the twins meet Dan Kaminsky, ‘arguably the greatest security expert in internet history’ who proceeds to tell them the answer to the question, can Bitcoin be hacked?

Famously, Dan spent weeks trying to penetrate the Bitcoin protocol, to no avail. He tells them that at first, he expected to easily find a weakness in such a complex piece of code - the longer and more complex the code, the more weak spots to exploit. But every time he thought he’d found a bug or exploit, he was met with a message in the code proclaiming “Attack removed.”

To Dan, it seemed as if Satoshi Nakamoto, the creator of Bitcoin, had already thought of every attack vector and vulnerability ahead of time. This lead Dan to two possibilities: Satoshi was a team of people or he was a genius operating on a whole different level.

Whoever or whatever Satoshi is, Bitcoin was not hacked by Dan Kaminsky then, and it has not been to this day. That achievement is astounding.

For a deeper dive, read Dan’s 2013 Wired article, ‘Let's Cut Through the Bitcoin Hype: A Hacker-Entrepreneur's Take’.


2. Buying or selling bitcoin over the counter (OTC). 

Inevitably financial services professionals will have to answer the questions from clients, how do I buy bitcoin?  It’s only a matter of when that will occur and how prepared you are for that conversation.  
 
Trading cryptocurrency via OTC is trading that takes place away from digital currency exchanges like acx.io or coinspot.com.au. There are a number of reasons OTC is preferred as a method of purchasing Cryptocurrency, much has to do with risk and depending on how much you are buying, and for whom, the risk.  I’ll talk about that further on.

Types of OTC trades:
 

• Institutional: Via brokers. Brokers who specialise in large transactions handle them via OTC trades done either face to face or remotely. These platforms offer a personalised service to help high-volume traders execute large block trades and avoid problems with slippage by accessing funds through liquidity providers that hold large amounts of cryptocurrency.
• Online Retail: Through various chat rooms or online portals. These are effectively businesses buy from liquidity providers on your behalf or exchanges depending on the amount purchased. They make sure you have parted with your money and complied with KYC and AML rules and report to the Authorities all transactions.
• Face to face retail: Bitcoin ATMs allow customers to convert their fiat currency into digital coins without needing to go through an online exchange.

Leaving retail and face to face aside, I want to focus on institutional OTC and the complexities and realities of buying significant amounts of bitcoin and other cryptocurrencies.

INSTITUTIONAL INVESTORS & OTC

Unlike standard cryptocurrency exchanges, a Bitcoin OTC market executes trades through a private dealer network. Investors looking to purchase or sell Bitcoin, meet up and exchange these assets without the need to inform the market. The Bitcoin OTC market is popular with institutional investors because cryptocurrency exchanges lack the technical infrastructure and liquidity for large orders. In Australia, this is a fledgling industry, and many cryptocurrency exchanges also have a daily cap or trading limit.

Breaking up a large order into small Bitcoin batches could send a negative response to the market and cause slippage. Structurally, for many institutional investors, Bitcoin OTC is the only method they can use to trade the most liquid assets.

While the lack of strong technical infrastructure along with liquidity is a big problem for institutional investors, many startups see this as an excellent opportunity to bring more sophisticated technology and infrastructure to the OTC market.

An example is the USA based Fidelity, a multinational financial services corporation with over $7.2 trillion in client assets. Fidelity launched Fidelity Digital Asset Services, a company that will provide enterprise-quality custody and trade execution for institutional investors. However, it’s not only financial corporations that are keen to offer services to institutional investors. Caspian, a startup which recently raised $20 million - via an initial coin offering - is looking to provide sophisticated traders with better tools. They also partner with others to serve the liquidity requirements and needs for large OTC traders.

Globally, there are many startups and companies offering solutions like new platforms and tools for institutional traders,  however, Australia is not as progressed as quickly as other places in the world. We also believe the market will gravitate to the traditional OTC equity traders who will, in time, extend their operations to cater to this market, or will acquire struggling startup businesses in this space.

OTC MARKET RISK

There is a lack of clarity and sophistication in the bitcoin OTC markets. It’s an approach that many institutional investors will find uncomfortable. Some institutional investors in the cryptocurrency industry are conducting six-figure trades over Skype chat rooms, Telegram, and even connecting on public forums like LinkedIn to find each other and undergo these trades. The counterparty risk here is evident. However, OTC trading currently works for some institutional investors, but the unsafe and murky environment is a significant deterrent for large players who are keen to enter the industry.  

In practice, the larger the trade, the more complex the process becomes. Additional counterparty risk measures become necessary due to the extreme levels of risk. Although the large Bitcoin transaction market is small, the parties involved can be very distrustful.

OTC trades are dependent on many different layers of trust. There is a risk that the other party may default before they deliver the tokens of funds, especially since things don’t always happen in real-time. Even if both parties agree on the trade, there is also no guarantee that the fiat currency transfer will execute since many financial institutions are against the idea of transferring large amounts of money when it is related to cryptocurrency transactions.

While there isn’t a clear solution, many believe that regulations, surveillance tools, and further solutions are required to enter OTC. The industry needs additional tools to enforce these regulations.

That’s it for this issue.  Thank you for reading and please feel free to zap through any feedback, good bad or ugly.  

As usual, if you are new, you can read previous issues here. Also, if you have time, grab a wine and kick back with a few of our favourite videos here <http://christopartners.com/key-topics/>.  

Your friends in all things Cryptocurrency,
Peter Christo & Mark Sefton