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—specifically, those that mix cryptocurrencies with legacy financial products—are the latest trend at the intersection of blockchain and Wall Street. Regulated versions of these hybrid products are quickly coming to market, including stablecoins and bitcoin-backed ETFs, futures, swaps and depositary receipts. There’s much excitement surrounding this trend—with good reason, in one case—but everyone should be warned that there are also unknown and potentially big risks to “crossing the streams” between the settlement systems of legacy and crypto.
Mismatches are inevitable. Accidents will happen. No one should be surprised when they do.
Even so, demand for these hybrids is likely to be significant.
In Part 1 of this two-part series, I’ll lay out the differences between the legacy and crypto settlement systems and explain 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 settlement system differences mean for owners of hybrid products.
“Crypto wrapped around legacy” hybrids include stablecoins and tokenized gold bars. In this category of hybrids, the owner buys a cryptoasset designed to track the legacy asset’s price by holding the actual legacy asset in a ring-fenced account. In other words, legacy assets (such as dollars, securities, commodities or real estate) collateralize the cryptoasset. These hybrids are issued, traded and settled on a blockchain, but the underlying assets (e.g., cash, gold) that back this category of hybrid are issued, traded and settled in the legacy financial system.
“Legacy wrapped around crypto” hybrids include bitcoin-settled ETFs, futures, swaps, depositary receipts and any other derivative backed by any cryptoasset. In this category of hybrids, the owner buys a traditional financial instrument designed to track the cryptoasset’s price by holding the actual cryptoasset in a ring-fenced account. In other words, cryptoassets collateralize the traditional financial instrument. These hybrids are issued, traded and settled in the legacy system, but the underlying cryptoassets (e.g., bitcoin, ether) that back this category of hybrid are issued, traded and settled on a blockchain.
An Important Distinction
Neither security tokens nor cash-settled bitcoin derivatives (e.g., ETFs or futures) are crypto/legacy hybrids as defined here. Why? Because they settle entirely within their own settlement system (crypto and legacy, respectively) and don’t cross streams with the other system.
I draw a critical distinction between security tokens and tokenized securities. A security token is native to a blockchain—it’s issued, traded and settled on a blockchain, and is not a hybrid. A tokenized security is a hybrid that fits into the “crypto wrapped around legacy” category—it’s a cryptoasset backed by a share of Apple stock, for example, for which the cryptoasset settles on a blockchain but the Apple share settles in the legacy settlement system.
Cash-settled crypto derivatives settle entirely in cash within the legacy system, and never touch the underlying cryptoasset. Consequently, they do not introduce the risks of crossing streams between settlement systems. They certainly involve price risk, but they do not entail the exogenous settlement risks that their “physical” settled brethren do.
How the Legacy and Crypto Settlement Systems Differ
Why do these distinctions matter? Because the crypto and legacy settlement systems differ at basic, fundamental levels. In my experience, few Wall Street professionals even understand the spaghetti labyrinth of the legacy settlement system—most finish their long careers without ever needing to interact extensively with it since the culture encourages deep specialization and it’s difficult to move out of narrow swim lanes. When problems arise there’s always someone else in the “back office” who will sort it out. It wasn’t until I was forced to dig deeply into the settlement system, while structuring pension transfers from corporations to insurance companies, that I had to learn it—because every transaction involved significant and unique settlement complexity both for the assets and liabilities. We had to choreograph and practice the procedures down to the minute, literally, because the costs of any little settlement failure would have been major. That experience made me realize that the cryptoasset settlement system (on a blockchain) is far superior to the legacy settlement system. Here’s why.
Cryptoassets are digital bearer instruments that are designed to settle peer-to-peer, on a gross basis, in near-real-time and in “physical” form (i.e., in the actual cryptoasset). When cryptoassets trade, the buyer and seller simultaneously exchange value for value (“gross” settlement).
By contrast, the legacy financial system uses a delayed-net-settlement system involving layers of intermediaries. The key words are delayed, net and intermediaries.
Delays are purposeful in the legacy system—usually measured in days—and they enable financial intermediaries to settle with each other on a net basis. Netting is a practice that favors the intermediaries at the expense of customers, since netting minimizes the liquidity and capital intermediaries need to hold. Netting means buyer and seller do not simultaneously exchange value for value in every trade—rather, their intermediaries don’t settle and simply accumulate unsettled debits and credits for a defined time, and then settle by exchanging only the difference at the appointed time. Netting is why the securities industry commingles “street name” securities in omnibus accounts rather than segregates them for each individual customer. For example, brokers only exchange the net of all their customers’ buy and sell orders for Apple shares each day. They don’t send every Apple share back and forth to each other. Instead they settle up on a net basis—usually once a day after markets close.
The combination of netting, delays and layers of intermediaries—the practice of allowing unsettled trades—mean (1) counterparty risk and (2) inaccurate ownership ledgers are simply facts of life in the legacy financial system. Counterparty risk is the risk your broker will default after taking your money but before delivering you the Apple shares, in the above example. Imprecise ownership records enable situations such as Dole Food to arise (where Wall Street’s accounting systems created 33% more valid claims to Dole Food shares than there were Dole Food shares) and proxy voting inaccuracies are inevitable (a prominent Delaware attorney declared that it’s not possible to verify the true winner of a proxy contest closer than 55-45%). The legacy settlement system, in my experience, is why the financial system is unstable and unfair to regular investors.
In the crypto system, by contrast, counterparty risk doesn’t inherently exist—because it’s a peer-to-peer system that simultaneously delivers the asset and the payment to buyer and seller, respectively. It’s inherently a delivery-versus-payment system. As a settlement system, it’s inherently stable and fair to all users.
There are other major differences too, and they’re summarized here:
I’ll preview Part 2 by sharing the punch line. Here’s how I would generically rank settlement risk by category. Again, this is not investment advice and every instrument will have unique risks! But since crypto systems objectively have lower settlement risk than legacy systems, we can make the following generalization about settlement risk by category:
Lowest to Highest Settlement Risk:
Lowest Settlement Risk: (1) Cryptoassets (assets natively issued, traded & settled on a blockchain)
Next Lowest Risk: (2) Crypto wrapped around legacy hybrids (e.g., stablecoins)
Next Lowest Risk: (3) Legacy assets (e.g., the status quo—assets are issued, traded & settled in legacy systems)
Highest Risk: (4) Legacy wrapped around crypto hybrids—most “accident prone” operationally because they “cross the streams.” Worst of both worlds.
In Part 2 I’ll explore what these major differences in settlement systems mean for buyers of crypto/legacy hybrids.