On September 22, a product designed to remake Bitcoin as a mainstream investment for the world’s investment managers will go live. When ICE Futures U.S., one of the world’s largest commodities markets, opens trading at 8 p.m. ET that day, it will offer Bakkt Daily and Monthly Bitcoin Futures, the first physically delivered crypto-currency futures contracts ever traded on a federally regulated exchange.
If the exchange works as planned, it will give institutional investors a secure, well-monitored place to trade Bitcoin, the world’s most widely used cryptocurrency. That in turn could help alleviate the problems with volatility and trustworthiness that have kept Bitcoin from being more widely adopted—giving the asset a major boost in legitimacy.
With the Bakkt futures, endowment funds or brokerage firms that trade the contracts will be able to channel their payments, and secure a guarantee that their Bitcoin will be delivered, through the same ICE clearinghouse that protects settles contracts traded by global oil giants. Their newly-purchased tokens will be stored in a super-secure warehouse overseen by the same team, deploying the same cyber-security measures, that safeguards their equity trades on the New York Stock Exchange.
The venture behind this effort to wed tradition and disruption, to bring blue-chip asset managers off the sidelines to embrace crypto-currencies, is Bakkt, so-called because it’s “backed” by majority owner Intercontinental Exchange. ICE is the $52 billion-market-cap trading colossus that owns the NYSE; NYSE Arca, the world’s largest platform for ETFs; ICE Futures U.S., one of the world’s dominant players in agricultural commodities; and ICE Futures Europe, home of the Brent crude contract that’s the leading benchmark for world oil prices. Bakkt is the brainchild of ICE’s founder and CEO, Jeff Sprecher, long the leading figure in the transformation of major exchanges from open-outcry venues dominated by rowdy floor brokers to today’s electronic marketplaces.
Bakkt’s CEO is Kelly Loeffler, a top Sprecher lieutenant at ICE over 17 years (as well as Sprecher’s wife). Bakkt debuted with great fanfare in August of 2018, unveiling a group of investors and partners led by ICE that have so far invested $182.5 million. That group included Microsoft’s venture capital arm M12, hedge fund Pantera Capital, billionaire money manager Alan Howard, and Starbucks.
Trading was initially expected to begin last December, but that timetable proved far too optimistic. The federal government shutdown in December and January delayed talks with Bakkt’s main regulator, the Commodity Futures Trading Commission. The CFTC also reportedly took time mulling whether to oversee custody of digital assets, but so far hasn’t committed to taking on that role, further extending the approval process. Meanwhile, the Bakkt buzz receded, and news that a prestigious consortium including Facebook and Visa planned to create a global cryto-currency named Libra stole the headlines.
Now Bakkt is back. Despite the delays, its product will beat Libra to market, and will start trading before competing contracts planned by LedgerX and ErisX. Bakkt secured approval from the CFTC in June, and cleared the final hurdle on Aug. 16 when the New York State Department of Financial Services granted it a charter for creation of a trust company as its vehicle for custody. Over the past few days, Bakkt granted Fortune exclusive interviews with Sprecher, Loeffler, COO Adam White and other executives, including in-person talks at Bakkt’s main office, a glass cube in an office building near ICE’s modest headquarters on the outskirts of Atlanta.
Making Bitcoin more popular
The Bakkt brass stressed that their immediate goal is making Bitcoin a popular alternative investment along with gold and private equity. But an efficient, regulated market in the currency could eventually remake the way we pay for everything from coffee to airline tickets.
“The funds that trade on our exchanges expressed to us that they don’t want to deal in today’s unregulated markets, and want end-to-end federal oversight, on the level of the NYSE, to feel safe trading in Bitcoin,” says Loeffler. Adds White, “Pension funds, for example, are diversifying into alternatives. Regulated Bitcoin futures could be part of their investment mandate, since they have different correlations with both stocks and bonds, and other alternatives such as gold.”
Once hedge funds, family offices, and the Charles Schwabs or TD Ameritrades of this world embrace Bitcoin, the gigantic trading volumes in the Bakkt contracts should smooth the lurching price swings that scare both investors and would-be users, creating a stable, trusted currency. If and when that happens, it’s not hard to imagine that Bakkt will create a Bitcoin app for retail purchases. Bakkt hasn’t shared its plans for retail payments publicly, but acknowledges that its partnership with Starbucks suggests big plans in the future. It’s also in talks with other consumer brands looking to use digital currencies for consumer payments. After all, the big fees that credit card companies and banks extract from merchants are ripe for disruption––and Sprecher’s a past master at making an array of transactions faster and cheaper.
For now, Sprecher tells Fortune, whether asset managers will transform strong interest into action is highly uncertain––creating an aura of suspense around the launch. “It’s not demand yet, it’s intense curiosity,” he says. “It’s the sense that money managers want to be at the front of this train and not left out. The day-to-day news covers Bitcoin when the prices goes way up or way down, but underneath we see sophisticated people investing in infrastructure and compliance that’s unrelated to the price. But they won’t use that infrastructure, there won’t be true global acceptance, until we can build out the rails in a regulated manner.”
It will take weeks or months before Bakkt’s Wall Street audience judges its production a hit or a flop, notes Sprecher. “It’s like opening night,” he says, “Everyone is nervous.”
Making regulation less scary
Whether what Sprecher describes as “something of a moonshot” succeeds depends on Bakkt’s wager that traditional regulation is the bridge that will lead money managers to Bitcoin.
It’s easy to see why endowments and pension funds view the crypto world as dangerous. In short, the industry lacks the uniform, rigorous federal oversight that safeguards America’s securities and commodity futures markets. A recent study by Bitwise, a crypto-asset management firm, found that 95% of the trades on digital currency exchanges were fraudulent, meaning they were designed inflate volumes or prices, not for legitimate transactions between customers who want to buy or sell Bitcoin. Among the fraudulent practices are “spoofing,” where traders have no intention of buying but enter phony orders to manipulate prices. “Theft and loss of digital assets has been rampant in the industry, and responsible fiduciaries are dissuaded from participating as a result,” says Alex Daskalov, CEO of KNØX, a firm that provides custody and insurance for digital assets.
U.S. authorities have deemed Bitcoin a “commodity,” and hence it falls under the jurisdiction of the CFTC (rather than the Securities and Exchange Commission, which regulates securities). But the CFTC does not currently grant a license to operate “spot” commodities markets that trade oil or soybeans or currencies, where the physical commodities are bought and sold instantaneously for cash. As its name suggests, the CFTC’s domain is commodity futures, derivative contracts mandating payment from, say, a refinery to a seller of crude oil for delivery of the fuel at a future date.
(Currently, Bitcoin futures do trade on the Chicago Mercantile Exchange, but unlike the Bakkt Daily and Monthly Future, these futures aren’t used for the purchase and sale of physical Bitcoin. The CME futures settle in cash, not Bitcoin tokens, based on the change on a Bitcoin price index that’s pulled from the spot market.)
Outside of those CME futures, crypto-currencies have been trading on spot markets that aren’t classified under federal rules as “exchanges,” but in most cases hold money-transmitter licenses issued by the states in which they’re domiciled. Investment firms are clearly less comfortable with the fragmented oversight of these multiple trading venues than the rigorous, uniform standards imposed by the CFTC on futures trading. More than 200 crypto platforms dominate trading, each establishing their own prices. As a result, Bitcoin doesn’t have a definitive, centralized price.
It’s just that benchmark that Bakkt aims to provide.
In a CFTC-regulated futures market, such as ICE U.S., only broker-dealers and Futures Commission Merchants that are members of the exchange are permitted to trade. The trading records and capital reserves of those members are carefully vetted by the exchange, and the vetting is overseen by the CFTC. Those firms are also members of clearing organizations––it’s ICE Clear US in the case of ICE Futures U.S.––that route payments between buyers and sellers, and shield participants against losses. For any contract traded on the exchange, if the buyer fails to pay, the clearinghouse imposes protocols designed to make the seller whole. If a producer purchases an oil or soybeans contract, and the seller defaults, the clearinghouse arranges to reimburse the buyer. The clearinghouses for futures are also licensed and supervised by the CFTC.
Bakkt’s coup was creating a futures contract that trades like a spot contract. By purchasing Daily futures, a buyer gets physical Bitcoin delivered to his or her account the same day, just as on a spot exchange. The difference is that the Bakkt product boasts all the advantages of rigorous CFTC regulation of trading, clearing and ability use margin for leverage that money managers prize. The Bakkt Monthly Bitcoin Futures will establish centralized prices extending 12 months into the future.
It’s likely that Bakkt will soon face plenty of competition. LedgerX and TD Ameritrade-backed ErisX, two prominent crypto trading firms, have won recognition as fully regulated “Designated Contract Markets” from the CFTC. They plan to launch contracts that will vie with the the Bakkt’s contracts in trading physically delivered Bitcoin.
Custody is key
So what’s Bakkt’s edge? Bakkt is banking that the trust big customers harbor for ICE will extend to its offspring, and that piggybacking on ICE’s technology will create an ultra-safe vault for storing digital assets.
The safeguarding of stocks, bonds and commodities such as gold from theft is known as “custody.” Ironclad protection is especially essential for crypto-currencies. If Bitcoin is sent from the owner’s wallet to the wrong digital address, and the recipient has a private key, he or she keeps the coins––there’s no way for the owner to get their money back. Likewise, you’ll never get your tokens back from the thief who hacked into your Bitcoin wallet.
It’s important to recognize that the CFTC hasn’t traditionally regulated custody. Contracts such as oil futures are either settled in cash, or the crude or corn is shipped to the buyer’s warehouse; gold silver are held in massive vaults frequently owned by banks or third parties. Many digital trading platforms provide custody, but few operate as “qualified custodians,” a designation often required by asset managers. The exceptions are a few operators that obtain trust bank charters from one of four states, New York, South Dakota, Nevada, and Wyoming. The warehouses operating under those state licenses are required to meet strict capital requirements, as well as anti-money laundering (AML) and know-your-customer (KYC) security protocols. Bakkt operates under the New York charter, and rivals Gemini, run by Tyler and Cameron Winklevoss, and Coinbase also established custody as New York trusts.
ICE does not provide custody, either for securities or commodities. But it commands strong fraud-detecting tools to protect trades on its exchanges and shield payments in and out of its clearinghouses. At the Bakkt clearinghouse, called Bakkt Trust Co., ICE is deploying the same cyber-security systems that buttress the NYSE. Unless a client wants to shift tokens from Bakkt Trust for storage at a rival’s site, the transfer of Bitcoin from one customer to another all happens inside its warehouse. If client A sells 100 tokens to fund B, the transaction happens on ICE Futures U.S. But Bakkt simply credits client B’s account for 100 coins via an entry on the centralized warehouse ledger, debits A’s account, and channels the cash to A through ICE Clear U.S. The Bitcoin moves around like a stack of lumber moving from one part of a Home Depot to another, but never leaves the warehouse. Since all balances are settled on the internal warehouse ledger, the futures transactions avoid running on the blockchain, where Bitcoin could be sent to the wrong address. It’s like transferring cash from your checking to your savings account all at your own bank.
With ICE’s help, Bakkt also has installed fortress-like protection for Bitcoin that leaves the warehouse for, say, the owner’s wallet. The vast majority of Bitcoin in the Bakkt warehouse is stored in what’s known as “cold storage.” To leave the warehouse, the Bitcoin must move from cold to “warm” storage, then exit via electronic transfer over the internet. Warm storage is connected to the internet so that the coins can be sent from Bakkt Trust to another exchange or the wallet. Cold storage parks Bitcoin in the deepest of deep vaults disconnected from the web.
Nothing is approved automatically. For Bitcoin to go from cold to warm, multiple people, in two or more offices at Bakkt or ICE, must sign off after applying cyber-security protocols that protect everything from oil to ETF trading. Then, the move from cold to warm requires approval from several additional members of the security team, along with other proprietary processes for authentication of identity. A combined team from ICE and Bakkt are now in place to handle these sign-offs, and their ranks should grow when trading begins.
Will money managers embrace Bitcoin?
Loeffler says asset managers have told her that Bitcoin could be a boon for balancing their portfolios––if it’s safe enough. “Bitcoin’s volatility is a big negative for retail transactions right now, but not for institutional investors,” says Loeffler. “A lot of commodities that funds use as alternative investments are highly volatile. Oil and coffee prices careen up and down, often wildly.” She notes that Bitcoin is the ultimate maverick; its spikes and valleys are uncorrelated with trends in stocks, bonds, gold and real estate. And despite its volatility, over the past decade Bitcoin outperformed those rivals in total gains. In theory, Bitcoin deserves a place in the baskets of alternative assets that are a staple of large, diversified portfolios.
Who’s mostly likely to bite? Loeffler expects lots of action from retail brokerage firms, in part because millennials and Gen X-ers crave holding Bitcoin as an investment. “The brokers are always looking for an edge to attract new customers, and offering Bitcoin could have lots of appeal,” she says. As for money managers, Loeffler thinks the most likely takers are college endowments and pension funds: “They’re the ones who are usually in the forefront in adopting new investment ideas.”
In the past, adventurous, usually crypto-only hedge funds have been the major institutional investors in digital assets. It’s likely that the rise of Bakkt will attract more hedge fund players. For example, just this week, Elwood Asset Management, the firm that manages the personal crypto portfolio of billionaire fund manager Alan Howard, a Bakkt shareholder, announced that it’s looking to create $1 billion in portfolios for institutional investors by placing money with a variety of digital hedge funds.
What about Bitcoin ETFs or mutual funds from, say, a Vanguard or Merrill Lynch? They’re unlikely to arrive anytime soon. Since funds holding Bitcoin are securities, not commodities, they would be regulated by the SEC. And that agency has repeatedly told applicants that today’s Bitcoin trading is not protected by adequate oversight. In particular, the SEC has noted that Bitcoin has no price established by a central exchange, making it difficult to establish reliable quotes for newly-created securities. On the other hand, if Bakkt acquires gigantic volumes, it could eventually set a global, benchmark price as ICE does now for Brent crude. In that scenario, Bitcoin purchased by asset managers on ICE Futures U.S. might pass the SEC’s test for packaging Bitcoin into ETFs and mutual funds.
Shopping with cryptocurrency
Bakkt’s partnership with Starbucks has led to speculation that its ultimate goal is to bring Bitcoin into the world of retail payments, something Loeffler and Sprecher confirm. The fat fees paid by merchants are just the kind of target they relish attacking. Today, consumers around the globe purchase a staggering $25 trillion a year in goods on their credit cards. The players who process the payments, notably the card providers and bank intermediaries, reportedly charge retailers an average of 2.4% to 2.5% on those purchases. The card companies return part of that “interchange fee” to consumers in cash back, or in airline miles, hotel points, or other rewards designed to build loyalty.
Merchants would love to get control of those dollars to design the rewards programs themselves, instead of loading customers with miles or points that they may never use and may not bind them to the brand. It’s likely that retailers will never accept getting paid in Bitcoin. But millennials and Gen X-ers have shown more enthusiasm for Bitcoin and other crypto-currencies. They’re also digital natives many of whom have never known life without a cell phone in their hands. They’re often a lot more comfortable paying with an app than paying with a card—if they have one at all.
If Bakkt succeeds in unleashing a surge in institutional trading in Bitcoin, the tokens could take on a new role as a highly liquid, alternative currency. Folks with a Bakkt app on their cell phones could readily use Bitcoin for purchases from merchants. Bakkt would manage the conversion from Bitcoin to dollars, so the merchant would never see Bitcoin, only traditional currency. According to experts who’ve compared the transactions costs of paying via Bitcoin versus credit cards, the former would cut the current interchange fee by around 75%. Merchants could use those savings to lower prices or design their own rewards aimed at swelling the ranks of its 20-something fans.
That “moonshot” vision would only work if the current moonshot, ready for launch, takes off. Stand by for countdown.
More must-read stories from Fortune:
—What do bitcoin and Las Vegas have in common? The size of their carbon footprints
—Finance and tech execs opine about how millennials invest
—How the media shapes the crypto industry
—7 CEOs on the future of Bitcoin
—Winklevoss twins launch a crypto storage service
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