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“I’m going to burst your bubble. I know a lot of people really want to see an ETF happen because “to the moon and lambos!” But I think it is a terrible idea. I still think it is going to happen, I just think it is a terrible idea.”

This quote comes from Andreas Antonopoulos, author of the highly cited book Mastering Bitcoin, and one of the first public advocates of blockchain technology. Antonopoulos made his comments after the formation of the new start-up Bakkt, a firm founded by an eclectic group of corporate giants such as Starbucks and the New York Stock Exchange, that promises to make it easy for Wall Street to invest in cryptocurrencies.

Specifically, Andreas is addressing the claim that Wall Street’s acceptance is good for Bitcoin. He is skeptical that Wall Street will be a boon for this nascent industry.

“The idea here is to take a reserve of bitcoins and then make them tradeable instruments that can be traded on traditional markets like stocks. This is a custodial reserve system, where the custodian holds the actual bitcoin and what you’re getting is a share in their fund — not bitcoin.”

Are Antonopoulos’s claims valid? Let’s take a step back and assess both the pros and cons of cryptos coming financialization.

The Good Side of Financialization

Obviously, there is a lot of excitement about Wall Street’s entry into the crypto markets because they bring with them A LOT of money. The total amount of assets held by institutional investors was last reported to be over $131 trillion. For comparison, if the bitcoin market cap were $131 trillion, one bitcoin would be worth over $6.5 million (worldwide wealth is estimated $280 trillion )

Currently, these investors are restricted (see ‘Custody Rule’) from investing in the asset because the industry lacks SEC regulated custodians. Bakkt promises to change that.

These services legitimize crypto-assets as being safe for institutions to invest. In this sense, financialization is a positive development for crypto. Financialization adds liquidity to the market, which strengthens the underlying networks that power this tech. As more capital is invested, more resources are allocated towards securing the network (at least in proof-of-work systems). This process is identified by analyst Trace Mayer’s as Bitcoin’s sixth network effect.

While these are all positive, what has pundits like Andreas Antonopoulos worried is Wall Street’s notorious history of creating so-called “financial weapons of mass destruction.” To understand this, it is essential to have an understanding of the financial processes that underlie our markets.

Equity-based Assets vs. Debt-based Assets

There are two types of financial assets, equity-based assets and debt-based assets. Equity-based assets are ones that have no claims against them – they are not IOUs. Land, physical commodities, and personal property are equity-based assets. Cryptocurrencies would fall under this category as well. The one who controls the private keys controls the crypto. Debt-based assets are the opposite- when you ‘own’ a debt-based asset (a stock, bond, or practically any financialized product), someone owes it to you.

Skeptics like Antonopoulos and others fear that Wall Street’s history of leveraging will create debt-based cryptocurrency products, indeed it seems like that’s what Bakkt is doing. This could, in practice, create ‘artificial coins,’ hampering Bitcoin’s number one value, digital scarcity.

Two Words Wall Street Doesn’t Want You to Hear – Commingling & Rehypothecation

What do these terms mean, and how does it apply to your crypto? By, combining these two methods, Wall Street can transform equity-based assets into a debt-based instrument.

Comingling is the process of combining assets in a custody pool, rather than separating them into each account. In regards to digital assets, these pose two problems. One, combining assets into one pool creates a honeypot for hackers trying to steal coin. Two, once assets are comingled, identifying which crypto belongs to who is complicated. Contrast that with a scenario where an individual knew the public key where their crypto reside. Then, they can keep a watchful eye out for funny business.

Once an individual’s assets are comingled, those firms can rehypothecate the collateral for their own benefit. Rehypothecation refers to the practice of lending out assets under custody to other firms for their own benefit. Surprisingly, this practice is not illegal. A client may allow its fiduciary to rehypothecate the assets they hold safe with them to receive benefits like a cheaper borrowing cost or to receive rebates on fees. In practice, rehypothecation can lead to dangerous outcomes. The process allows IOUs to be turned into more IOUs, which are turned into even more IOUs.  It is the financial equivalent of playing musical chairs. An excellent illustration of rehypothecation is found in the Oscar-winning film The Big Short.

Bitcoin is Different

As much as they wish it weren’t true, Wall Street cannot control bitcoin like they do other markets using these methods. As we have seen in the past, those who wish to impose their will on this technology are at mercy to the users who run full nodes and control their own private keys (A.K.A: 1st class Crypto Citizens).

Custodial services who abuse their power by creating bitcoin IOUs will be accountable to the participants of the network. Forbes journalist Caitlin Long wrote a three-part analysis on the double-edged sword of crypto financialization. The twenty-two-year Wall Street veteran and Bitcoin supporter comes to a somber conclusion for those who want to manipulate this technology.

“As bitcoin’s price is increasingly suppressed by creation of more and more off-chain, fractionally-reserved bitcoins, the network’s full-node participants have a bigger and bigger incentive to fork the chain and force a short squeeze—a permanent one—that could bankrupt exposed institutions.”

Ultimately, bitcoin is always the winner in this game-theoretical scenario. It’ll be up to Wall Street to cater to the tech, not vice versa. That’s because it is not possible to build secure applications on top of an insecure base layer, but it is possible to create secure (or insecure) applications on top of a secure base layer (Listen to Caitlin Long and Trace Mayer Discuss this in Depth on the Bitcoin Knowledge Podcast).

“Cryptocurrencies either will push incumbents to make the traditional financial system fairer and more stable, or will outflank and dominate them.”

We’ll be watching this development closely over the coming years, even though the likely outcome is that Bitcoin wins.

Edit: After this article was submitted, the CEO of Bakkt, Kelly Loeffler, announced that her company’s products “will not be traded on margin, use leverage, or serve to create a paper claim on a real asset.” If her word rings true, this would be seen as a victory for equity-based financial assets.