Even the primary objective of cryptocurrencies was the creation of a decentralized peer-to-peer authentication system, these currencies today have become some of the most important asset classes of the 21st century. A key factor in that transition has been the financialization of the crypto-economy by allowing conventional investors to be a part of the market through established exchanges and format platforms.

This financialization has been accompanied by enhanced regulatory review on the context of the industry. Given the consensus-driven nature of the crypto-industry, the impacts of financialization have been multidimensional. The nature of blockchain creates exponential impacts on the network because of the price being pushed up with the entry of newer participants into the networks. Users provide increased processing power to the network, and subsequently, these users get to have a higher degree of control over the networks. 

Financialization in the Industry 

In the landscape of the crypto industry, financialization offers multidimensional prospects. The phenomenon represented the opening of the industry to conventional investing tools and resources to provide broader options to members of the crypto network. The opening of the industry to external capital and participant subsequently is linked with an increase in the processing resources and liquidity of crypto assets. However, major risks are also posed by leverage-based investing instruments that have previously negatively impacted other asset classes. 

Benefits of Cryptocurrency Finalization 

Even though cryptocurrencies were primarily designed to be tokens that powered the blockchain, the financialization of the currencies has led to a number of benefits for involved stakeholders. 

Here are some of the biggest benefits of the financialization of cryptocurrencies. 

Increased Computing Resources – Considering the fact that most leading cryptocurrencies, including Bitcoin, Litecoin, and others, rely on a proof-of-work mechanism, there is a strong need to have computing resources to sustain the working of the consensus algorithm. The increase in the number of actors enhances the network resources and creates a much more secure blockchain that is resistant to attack attempts from external parties. This is a direct result of the purchase of crypto-assets on the blockchain. 

Fundamental Prices – The financialization of markets allows the markets to move closer to true fundamental values. This is through the price discovery mechanism that allows external stakeholders to evaluate the value of the crypto-assets. Before 2017, it was not possible for crypto-investors to short-sell or bet on the decline of the prices. This led to a purely positive approach towards bitcoin prices in the markets. Limiting the price structure of the currencies to a purely optimistic approach induces the risks of creating bubbles in the market. The financialization of the assets provides a hedging method for the price structure to correct itself over time. 

Accelerated Adoption – Financialization has resulted in a massive increase in the adoption and acceptance of cryptocurrencies by conventional financial institutions. This is a key positive for the currencies as it enhances the stakeholders in the decentralized process and allows practical applications to be facilitated. Financialization has also led to increased media coverage for the currencies and thus resulted in a larger number of people investing in crypto-related assets. 

Current Steps in Cryptocurrency Financialization – Some Key Steps 

Based on the trends observed so far, the observed financialization in the industry has resulted in positive impacts on the market. Examples of these steps include the following steps.

  • Bitcoin Future contracts have been listed on the CME and CBOE to provide expansive options to potential traders. These contracts have currently been delivered through cash-settled trades, which does not result in the creation of more claims than existing assets. 
  • Margin lending has also been expanded in the industry on the basis of margin loans that have been completely collateralized based on the coins kept in escrow. This protective mechanism prevents the creation of unbacked claims on the coins. 
  • Bitcoin Holders (HODLers) have emerged as key stakeholders, with a key element of the supply being out of reach of financialization efforts. This storage approach has assisted the balance of the financialization and prevented excessive claims. 
Potential Influence of Corporate Entities 

The financial crisis of 2008 was a learning lesson for financial regulators in understanding the potential risks of the credit derivatives industry. The potential of bubbles being created in the market is a subsequent risk that exists in the crypto-industry as well. Theoretical possibilities exist for incumbents to seize control of the market in similar ways to the 2008 crisis, where there are more claims to assets than the existing assets. 

DIF research suggests a strong requirement of having a direct 1-1 connectivity between assets and the derivatives market. In the context of multiple coins existing, it would be possible for potential underlying financial institutions to capture the majority of the market. 

Potentially mitigating steps to the practice exist in the form of capital requirements and regulatory influences to prevent similar steps from being repeated in the market. With further development of the industry, financialization is also offered an expansive range of options to consumers as well. The ability to short sell crypto-assets allows users to anticipate their trust in projects and showcase their interest in the form of financial investments. 

Potential Risk Factors in the Financialization of Cryptocurrencies 

As identified previously, the primary challenge in the cryptocurrency landscape is linked to the introduction of financial tools that allow the generation of more claims than the existing quantity in the market. 

Examples of these tools include:

  • Marginal Loans
  • Coin Rehypothecation
  • Future Contracts 
  • ETFs Without Marketing Tracking

However, regulators have currently managed the risk factors of the industry by limiting the derivatives in cash-settled forms. This mitigates the acting risk in the market by limiting the impact in contrast to highly leveraged markets. The existing difficulty in borrowing Bitcoins and other currencies is a key factor impacting regulatory decisions as well. 

In the future, DIF projects the possibility of regulatory approving enhanced cryptocurrency-based derivates. This would then require a review of the custodial arrangements made by institutional investors to prevent the creation of bubbles and maintain balance in the borrowing arrangements. However, due to the number of long-term investors in the currency, the role of custodians is anticipated to be limited in the long run. 

DIF Insights – Role of Financialization 

Based on our research, financialization has led to a significant increase in cryptocurrency liquidity. This is a major positive step because it allows new investors to enter the market and have protection under lending arrangements supported by established entities. The increase in new investors in cryptocurrencies is also an inherent positive for the currencies because they become more immune to external attacks with the increase in participants across the blockchain. 

However, it is important for regulators and financial institutions to be cautious of the liquidity emerging from leverage-based financial tools that create currencies without existing supply in the market. The behavioral dynamic exhibited by long-term crypto-investors has sustained the integrity of the market, but they need for regulation exists to prevent the creation of bubbles. 

Given the nature of the observed financialization in the cryptocurrency space, DIF experts predict that the positive aspects of liquidity will continue to improve as retail investors become part of the crypto markets.