The finance giant Goldman Sachs has announced that the investment bank will begin using its own funds to trade a variety of derivatives contracts tied to the price of Bitcoin with the bank’s large institutional clients. Goldman Sachs has historically maintained a more open mind to cryptocurrency than most of its competitors. Back in January, the investment bank issued a nine-pagereport to some of its clients entitled “Bitcoin is Money.”
Trading Bitcoin derivatives can be seen as a sort of trial run, a way for Goldman to expose themselves a bit to the extremely volatile market without going all in at once. If the derivatives experiment is successful and well-received, that would likely pave the way for Goldman to begin trading Bitcoin and perhaps other cryptocurrencies directly.
A derivative is a financial instrument that derives its value from an underlying asset (or assets), without requiring direct investment in that asset itself. Futures are a common example of a derivative contract.
Futures contracts allow buyers and sellers to enter into obligations to transact at a set time for a set price. Say I’m a wheat farmer, and I need to secure a price for my harvest. I can enter into a futures contract with a buyer that will obligate that buyer to purchase my wheat at a predetermined price on a predetermined date. This benefits me, as I now have guaranteed the price of my harvest before bringing it to market. If the price of wheat rises above my contractual price, I miss out on the potential gains, but if the price falls, I’m protected against potential losses. Thus, a futures contract is essentially a transfer of risk between two parties. In the wheat example, the farmer would be offloading risk onto an investor with a higher risk tolerance.
Bitcoin derivatives are not a Goldman Sachs invention. CME Group has been trading Bitcoin futures since December. Bitcoin futures operate on the same principles as any other futures contract—if I’m a Bitcoin miner and I need to guarantee that my operation will be profitable, I can enter into a futures contract to sell my BTC at the price necessary to be profitable. If Bitcoin’s price collapses, I’m not exposed to the risk. Conversely, if the price increases, I’m not exposed to the gain either—my bets are hedged.
Goldman Sachs has already been operated behind the scenes in the Bitcoin futures market, clearing trades for CME Group. The decision to begin offering Bitcoin derivatives comes after the investment bank concluded that there was sufficient demand on the part of their clients to speculate on the virtual currency as one would on a commodity such as gold.
If the derivatives experiment is a success, the investment bank will likely move towards trading Bitcoin directly, although there are some hurdles to overcome. For Goldman Sachs to begin trading Bitcoin directly, they would need approval from the Federal Reserve and the State of New York. Also, the bank would have to find an industry-standard means of maintaining custody of the Bitcoin it held, as currently custody solutions are not up to Wall Street standards.
The notion that Goldman Sachs will be offering derivatives based on Bitcoin is somewhat ironic, given the original anti-bank ethos of cryptocurrency. Bitcoin was intended to subvert traditional financial institutions by eliminating the need for a trusted third party in the transfer and storage of value. The whole point of cryptocurrency was to enable individuals to, as the slogan goes, be their own banks. While Goldman’s foray into Bitcoin derivatives should undoubtedly boost confidence and interest in the crypto-space, it comes at the cost of sacrificing the initial revolutionary promise of the technology.
One could also argue that investing in Bitcoin derivatives defeats the purpose of investing in cryptocurrency entirely. Bitcoin was built to be an asset that existed beyond the control of any state or financial institution, and to offer security against the collapse of those institutions. Investing in Bitcoin through a complex financial instrument offered by an investment bank seems counterintuitive.
However, one must acknowledge that there are serious hurdles preventing many investors from purchasing cryptocurrency directly, including a lack of trust in exchanges and custody providers, and insufficient technical knowledge to properly safeguard digital assets. After all, digital assets are only as secure as we make them—exchanges can be hacked, private keys can be stolen—some investors might not want to expose themselves to those risks, especially if they are not particularly tech-savvy. Shouldn’t those investors have the opportunity to engage with cryptocurrency, even if it is through a derivative contract offered by a trusted third party?
Perhaps investors in these derivative products see a future where cryptocurrency and the traditional financial system exist side-by-side and work together. That would resolve the apparent conflict between the bank issuing the derivative, and the asset that derivative was based upon.
Or, perhaps these derivatives products will be marketed towards investors who wish to bet against Bitcoin. Bill Gates stated in May that he wouldshort Bitcoin if he could. There are certainly no shortage of Bitcoin bears who might be interested in taking this same position. Bitcoin derivatives offer a simple means of doing so. If I believe that Bitcoin’s price will drop to one thousand dollars in three months, I can enter into a futures contract to sell Bitcoin at its current price in three months. If my prediction is correct, my profit would be the difference between the price at which I sell Bitcoin to the buyer (the current price) and the price at which I obtained that Bitcoin ($1,000).
Regardless of the reasoning behind investing in Bitcoin derivatives, the expansion of this market signifies that cryptocurrencies are continuing to evolve from a niche peer-to-peer payment method into a new mainstream asset class. Lloyd Blankfein, the CEO of Goldman Sachs, recently rebutted the disparaging comments about cryptocurrency made by other financiers such as Warren Buffet and Jamie Dimon. While emphasizing that neither he nor Goldman Sachs owned any actual Bitcoin, Mr. Blankfein stated that dismissing the new asset class simply because one doesn’t understand it is “too arrogant.”
About the author
Cameron Carpenter is a student of economics and computer science at Sarah Lawrence College in Bronxville, New York. He is the President and Portfolio Manager of Gryphon Capital Management, a student-run investment firm. In his spare time, Cameron enjoys reading and playing chess.