Bakkt: What Should We Expect From an Exchange Tailor-Made for Wall Street Investors?

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A deeper look into ICE’s digital assets platform backed by Microsoft and Starbucks.

Last week, the CEO of the Intercontinental Exchange (ICE) said that the firm’s digital asset platform, Bakkt, is expected to launch later in 2019. It is time to look deeper into the project, and see what it can bring to the crypto industry.

What is Bakkt exactly?

Bakkt (pronounced “backed,” referring to “asset-backed securities”) is a digital assets platform created by ICE, the Atlanta-based operator of 23 major international exchanges, including the New York Stock Exchange (NYSE), which is by far the world’s largest exchange, trading nearly 1.5 billion shares a day.

It was first announced on Aug. 3, 2018, when ICE revealed its plans to create a platform “that enables consumers and institutions to buy, sell, store and spend digital assets on a seamless global network” via a press release. Essentially, the company intends to form a federally regulated market for Bitcoin (BTC) with a focus on institutional investment, as Kelly Loeffler, ICE’s head of digital assets, who is also CEO of Bakkt, explained:

“Bakkt is designed to serve as a scalable on-ramp for institutional, merchant, and consumer participation in digital assets by promoting greater efficiency, security, and utility. […] We are collaborating to build an open platform that helps unlock the transformative potential of digital assets across global markets and commerce.”

The list of Bakkt’s investment partners famously includes Microsoft, Boston Consulting Group (BCG), and Starbucks, along with an array of Wall Street players such as Fortress Investment Group (FIG), Eagle Seven, Susquehanna International Group (SIG), Galaxy Digital, Horizons Ventures and Pantera Capital.

The concept of Bakkt was being developed for five years, as its both co-founders, Loeffler and her husband Jeff Sprecher, who is also the founder, chairman and CEO of ICE, told Fortune magazine. “The factory” that powers the platform was being prepared “in the strictest secrecy” for 14 months prior to the August announcement, they added.

It should not be surprising that Bakkt is entering the market during the bear’s reign, given that Loeffler believes that BTC’s price should not be its only metric:

“Notably, 2018 was the most active year for crypto in its brief ten-year history. This was evidenced by rising investment in distributed ledger technology and digital assets, as well as by blockchain network metrics such as daily bitcoin transaction value and active addresses. Yet, these milestones tend to be overshadowed by the more narrow focus on bitcoin’s price, which has been seen by some, as a proxy for the potential of the technology.”

Eyal Shani, who is a blockchain researcher at a consulting group Aykesubir, agrees with that statement:

“The value of Bitcoin or any other currency is far from being the most important measure to the health of the ecosystem.”

According to Shani, the arrival of a fully centralized marketplace would barely make any contribution to the long-term health of the market, although the project should indeed be appealing to Wall Street investors, especially the ones who are already familiar with cryptocurrencies:

“Institutional investors who are strongly considering crypto would probably feel more comfortable with investing via Bakkt or other major banks. However, the entrance of ICE to this market will not change the volatility of the coin markets. At the end of the day, investing in digital currencies is investing in the likelihood the nodes and use will still be there in the long term, and no one knows how to answer that nowadays.”

Prashanth Swaminathan, founder and CEO of XDAT, a recently launched Malta-based crypto exchange, believes that Bakkt’s arrival will bring more confidence into the crypto space due to its mainstream appeal. However, he also doubts that it will turn out to be a game changer in the long run:

“Institutional investors will still be wary of the space until they see regulations coming in. Therefore, I don’t expect a massive influx of institutional investment just yet. Institutional investors also need to see returns, and the best metric to gauge such returns is mass adoption (or demand-supply), as wider adoption implies less concentration of Bitcoin in fewer wallets hence lower volatility, and more likelihood of tangible utility for crypto with users using them for transactions.”

“The real game changer in the industry will be mass retail adoption rather than institutional investors’ adoption.”

Here are the main features that Bakkt has announced:

Physical Bitcoin futures

Bakkt plans to debut physical BTC futures contracts on its platform. In short, futures represent an agreement to buy or sell an asset on a specific future date at a specific price — and hence represent a risk management tool that might be particularly important in volatile markets such as crypto. It is not an entirely new concept for virtual currencies, however — BTC futures have been traded on two major United States regulated exchanges, the Chicago Mercantile Exchange (CME) and the Chicago Board Options Exchange (CBOE), since December 2017.

However, both CME and CBOE’s offers are settled in cash, while the new ICE-backed platform aims to launch physical one-day BTC futures contracts. Essentially, that means that when the contracts expire on Bakkt, customers will receive BTC tokens as opposed to cash. As Loeffler told the Wall Street Journal:

“It’s great to have cash-settled, but there’s a need for physical delivery.”

Swaminathan argues that such offering would be “ideal” for dealing with BTC’s infamous volatility:

“This is ideal for price stability in a nascent asset class such as Bitcoin. Both physical and cash delivery can co-exist as we have in other commodities such as oil and it shows improving maturity in the market.”

Nevertheless, Swaminathan told Cointelegraph it is important to note that, technically, Bakkt’s clients will not own their BTC and that the platform gets the ability to withhold a significant proportion of the circulating supply in its custody:

“The short term impact of this could be a price surge due to lower supply in wider market, but in the long term it could be a negative as you will want bitcoin to be more widely adopted and show its utility in payments and transactions.”

Shani finds the physical delivery of the futures to be particularly useful for the development of BTC-based economies:

“In that case businesses and individuals living both in the Bitcoin and non-Bitcoin economies could actually hedge their risk and get actual Bitcoin they need for their daily expenses. Without this ability, the futures would most likely be another tools in speculators financial games. At the same time, while I’m not aware of the exact numbers, it seems that even with traditional financial instruments, we usually see very little use of the right to exercise it.”

One-day futures contracts imply that trades are performed in a single day. Thus, according to Bakkt’s plan, BTC futures would be sold throughout the trading day. Once the market closes, the ICE clearing house — which is an intermediary between the buyer and the seller — arranges to transfer the cash from the buyer’s to the seller’s bank account, while the BTC tokens are moved to the Bakkt digital warehouse, where they can be picked up by the buyer. If the assets or money are not delivered, the clearing house covers the costs.

The whole process of the futures trading is overseen by the U.S. Commodities and Futures Trading Commission (CFTC). More specifically, the agency controls trading, clearing and safe storage of assets. The CFTC also approves and monitors the exchange’s rules in regard to those areas.

Safe storage

On top of strict Anti-Money Laundering (AML) and Know Your Customer (KYC) policies that are essential for the CFTC’s approval, Bakkt allegedly bolsters a robust storage system. As Loeffler told Fortune, it is one of the main criteria to attract large financial institutions:

“A qualified warehouse is the difference between institutional investors’ getting in or staying out.”

To prevent security breaches — which remain one of the most feared problems for cryptocurrency exchanges — Bakkt plans to store the private keys offline in its reportedly heavily guarded “warehouse,” which essentially resembles cold wallets. According to Fortune, the platform will utilize double-key security, where the clients access their funds using the private key while the warehouse releases them using a public key — just like with safety deposit boxes at brick-and-mortar banks, which require both keys to be unlocked.

Microsoft’s Azure and off-blockchain transactions

As for the technical part of the operation, Bakkt is reportedly based on Microsoft’s Azure cloud computing service, which works through Microsoft-controlled data centers — and is hence centralized.

To deal with BTC’s notorious scalability issue, Bakkt will reportedly use a technology akin to the Lightning Network and build a system that largely operates outside of blockchain.

“Our system would operate on a layer above the blockchain, and we’d keep our own omnibus ledger apart from the blockchain,” Loeffler explained to Fortune.

In other words, transactions would be send within one ecosystem and won’t heavily rely on blockchain, which can normally perform only seven transactions per second.

Retail payments (potential plan for the future)

Besides establishing a platform for institutional investors who are still hesitant to enter the crypto market, Bakkt’s founders — Loeffler and Sprecher — also hope to make BTC payments more common, as they told Fortune. That could push BTC adoption within the retail payments industry as well, where banks and credit card issuers take their cut for each transaction.

That idea could be picked by both Microsoft and Starbucks, two major backers of Bakkt. While the IT giant represents a large base of retailers, handling their operations through the aforementioned Azure technology, Starbucks seems to have plans to accept BTC for its lattes in the future, as Maria Smith, vice president of partnerships and payments for Starbucks, stated in the original press release:

“As the flagship retailer, Starbucks will play a pivotal role in developing practical, trusted, and regulated applications for consumers to convert their digital assets into U.S. dollars for use at Starbucks.”

The project has been delayed several times, as regulators are taking their time

Bakkt’s launch has been postponed several times now, which can hardly surprise the crypto community, who are used to various differals regularly announced by major industry participants, such as the U.S. Securities and Exchange Commission (SEC) and Ethereum (ETH) developers.

First, the digital assets platform was expected to open as early as November 2018. Then, the project’s launch was rescheduled to Jan. 24, 2019. Currently, Bakkt is estimated to go live in “early 2019.” The main reason for the delay is the CFTC’s approval, which is still pending.

According to a Wall Street Journal article published on Dec. 20, the CFTC “is currently reviewing ICE’s business plan.” After that, the watchdog’s commissioners are expected to vote on whether to approve the project “early in 2019.” Then, the public will reportedly be asked to weigh in with comments during the next 30 days.

As per Bakkt’s Medium entry published on Dec. 31, their team has made “great progress” in terms of negotiations with the agency, and currently awaits the regulatory green light. More specifically, Loeffler wrote:

“To that end, our team has been working closely with the Commodity Futures Trading Commission [CFTC] for the better part of 2018. At an industry level, regulatory approval for physically delivered and warehoused bitcoin will establish and amplify the voice of U.S. authorities as the digital asset market evolves globally. We have filed our applications and the timing for approval is now based on the regulatory review process.”

Swaminathan is not surprised with the slow progress. He told Cointegraph:

“It was always going to take a while to launch a new and nascent product which splits opinion. The most recent stumbling block has been Bakkt’s request for exemption from CFTC to custody bitcoin on behalf of its clients, as typically CFTC requires custody through trusted third-party intermediaries such as banks. The recent US Government shutdown has not helped either.”

However, Bakkt continues to attract more investment and to expand, as to not waste time. Most recently, the ICE’s platform announced that it was going to acquire “certain assets” of Rosenthal Collins Group (RCG), a Chicago-based independent futures brokerage. The transactions are expected to be closed this month and will allow Bakkt to contribute to its regulatory operations by “bringing more choice and control to buyers and sellers.”

Prior to that, Bakkt had reported on the results of its first round of funding. According to the company, it raised $182.5 million from 12 partners and investors, including BCG, CMT Digital, Eagle Seven, Galaxy Digital, Goldfinch Partners, Alan Howard, Horizons Ventures, ICE, Microsoft’s venture capital arm, M12, Pantera Capital, PayU, the fintech arm of Naspers and Protocol Ventures.

Further, during an earnings call on Feb. 7, Scott Hill, ICE’s chief financial officer, declared that they were going to spend $20 million to $25 million for Bakkt’s estimated expenses for the 2019 fiscal year:

“And finally, our investment in Bakkt will generate $20 million to $25 million of expense based upon the run rate in the first quarter. We will update you on progress at Bakkt and the level of investment as we move through the year.”

When asked about the expected returns or revenue growth from the investments, Sprecher, who was also present during the call, labelled the crypto platform as a “moonshot bet” for ICE:

“So it’s a bit of a moonshot bet and it’s been organized in a manner that is very different than the way ICE typically does businesses. […] They’re well along in building out an infrastructure that I think you’ll see launch later this year.”

Sprecher added that Bakkt exists independently from ICE, as it has its own offices, management team and infrastructure. He also noted that the platform will be launched later in 2019.

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