Several astute readers asked follow-up questions about the risks facing Wall Street amid a Bitcoin chain fork, a topic that I introduced in a recent Forbes.com piece (here). Put simply, chain forks and rehypothecated Bitcoins don’t mix well and could cause the financial system to experience losses if it has any uncovered exposure to Bitcoins amid a hard fork.
The chain-fork issue is confusing. Chain splits, for example, seem so simple—if you own Bitcoin before a hard fork, you own the post-fork coins too, right?! Nope, not when uncovered Bitcoin exposures are involved—these are positions in a Bitcoin-substitute that are not 100% collateralized with real, on-chain Bitcoins. The uncovered amount is the amount not backed by real Bitcoins. For example, if the financial system has promised 5 Bitcoins to customers but has only 3 Bitcoins in its custody, the system’s uncovered exposure is 2 Bitcoins.
Here’s the problem: how does the financial system come up with the 2 new post-fork coins to meet its obligation? It promised 5 Bitcoins to customers but holds only 3 in its custody, so it received only 3 of the post-fork coins. Consequently, its total uncovered exposure after the fork is now the 2 pre-fork coins plus 2 post-fork coins. The system must immediately credit its customers’ accounts with all 5 post-fork coins, but it has only 3.
Can the financial system solve this by conjuring 2 post-fork coins out of thin air? Nope. No one in the financial system has power to create new coins.
Can it just replicate the process by which it originally created the uncovered position in the 2 pre-fork coins? Nope, because it takes time to build uncovered exposure—it builds gradually within the system as institutions lend and re-lend the same Bitcoin to each other.
So, the financial system has no easy out. It must cover the shortfall immediately.
How will it immediately come up with the 2 post-fork coins?
Answer: it would need to purchase them into a what could be a very illiquid secondary market. Why would it be so illiquid? Because forked coins could take several days to start trading in large volume as few holders begin to trade them immediately, and as engineers at crypto exchanges typically take time to determine the feasibility and security implications of adding the new coin. But the financial system owes those post-fork coins to its customers immediately.
Could the financial system delay delivering the 5 post-fork coins to its customers, or never deliver them? This is how many crypto exchanges have handled previous forks. But crypto exchanges serve mostly retail customers, while Wall Street is in a whole different zip code. The fiduciaries for institutional investors will expect all forks to be delivered as soon as they are available, just as they expect all stock dividends and other corporate actions to be credited to customers when paid. Giving full discretion to any custodian or counterparty regarding whether to deliver a fork might fly for retail crypto investors, but the fiduciaries of institutional investors are unlikely to agree. More on the fiduciary issues below.
Net-net, the financial system would need to source those post-fork coins somewhere. Fast. And at any cost.
Many folks are surprised to learn that uncovered exposures would ever be allowed to develop, such as the 2 pre-fork Bitcoins in the example. Actually, it’s standard operating procedure on Wall Street.
Uncovered exposures build gradually within the traditional financial system, mostly owing to commingling and rehypothecation of securities. This can take many forms, including securities lending, repurchase agreements, derivatives and prime brokerage. But the end effect is the same—uncovered, fractionally-reserved exposures build within the system slowly and mostly undetectably.
Rehypothecation is nearly impossible to measure at a systemic level, which is why I’ve referred to the practice as insidious and subtle. Why? Because US GAAP accounting enables multiple parties to report on their financial statements that they own the very same asset. No one really knows how many times that same asset has been double/triple/quadruple/quintuple counted, which means that no one really knows how solvent the financial system is if all such double-counting were backed out.
Returning to the Bitcoin hypothetical example, it’s very possible that the Bitcoin fork itself causes the system’s uncovered exposure to become measurable for the first time. It’s likely no one (including regulators) knew how big the uncovered position was before the fork. The magnitude of uncovered exposure usually isn’t discoverable until a triggering event requires an accurate accounting, which is when the game of musical chairs stops. Such “reckoning” events could be a merger (such as the
example, where brokerage…