What problems are institutions currently facing when looking to trade crypto-assets?
Alexis Atkinson: Bitcoin is a bearer asset and therefore requires high standards in terms of custodianship over those digital assets and robust security. If someone externally gets control of your private keys they can transfer the assets and they are gone – with no recourse – so security is paramount.
The structure of the crypto market today is primarily geared towards retail platforms for OTC trading. As such, institutions face a large amount of counterparty risk as current platforms are acting as the custodian of the assets, the matching venue, and in some cases the provider of credit also.
Crypto platforms have a poor record of performing custodial duties and there have been a lot of high-profile hacks, with a high percentage of venues having lost digital assets at some point or another.
This means that customers need to assess and assume in some cases large counterparty risk when deciding which platforms to place their assets on and trade. Clearly the ability to have insured funds is desirable and, whilst offerings are starting to become available in the space, the market for trusted custodial services with insured funds is still underserved.
There are a lot of retail platforms available and a lot of fragmentation, and there can be significant action taking place on multiple venues. If you want to trade efficiently with best execution, which is a difficult thing to define for crypto, institutions need to maintain assets on multiple venues and have the ability to move it around quickly, which is capital intensive and requires non-trivial operational capability and expense. In spot FX markets, the Prime Brokerage structure allows for the separation of the roles of ‘provider of credit and custody’ from ‘execution venue’ and further developments in crypto should enable trading to become more capital efficient and safer as the market structure develops.
Many of the current retail trading platforms are opaque in terms of their ownership structure and terms and conditions. There have been many cases whereby retail platforms act as market makers on their own venue, effectively trading against their own customers to generate liquidity but often without disclosing it.
We should also consider trading costs. For example, in FX people generally think about execution costs in terms of Dollars per million. A lot of the crypto venues have costs starting from 0.3% of the value of the transaction, which equates to $3,000 per million. As a platform operator, you can see the attractiveness of these levels, but for an investor a round trip cost of 0.6%, before considering other execution costs (slippage, market impact etc) begins to look expensive.
What structural changes do you foresee in crypto-asset trading if it is to be successfully adopted by the institutional market?
AA: Some of it will depend on regulation and more clarity would be welcomed here, but also there needs to be some basic infrastructure available. Custody services are obviously important but a separation of execution services from custody and the provision of credit will enable a safer trading environment, but also be more capital efficient as the need to maintain assets at many trading venues would be reduced.
The credit aspect is also important as well considering how people trade OTC today in larger amounts. If two market makers want to try Bitcoin against dollars with each other today, then one side either must take counterparty risk and transfer either the Bitcoin or dollars first, or you have things going on like “I’ll transfer you some of my Dollars, you transfer me some of your Bitcoin, and then we’ll do some more transactions and gradually get to the entire amount.” There is no centralised credit provision.
Now, you can look at it and think about how that will develop. Ultimately if you want to have a measure of someone’s credit, you generally look at the collateral, so increased and ironically more centralised custodian offerings are the precursor for credit models developing later, which will make it more capital efficient for institutions to trade and reduce the counterparty risk.
On the execution side, the retail platforms today don’t satisfy the requirements of institutions and I see a gradual separation of retail trading from institution trading here – as we see in more established markets.
The platforms that satisfy the requirements of institutions and have the trust of existing institutions and regulators have a head start here. There are also cost advantages to platforms that are cross asset, both in terms of the platform operator, but also their customer base.
What can the FX industry learn from crypto and in what areas does crypto lead FX?
AA: There’s a lot to be learned from both sides. Crypto trading is maturing all the time but the current infrastructure it designed, first and foremost, for the Internet, so a lot of the exchange protocols are Internet protocols. The Internet is available 24/7, 365 days a year and so is crypto. There’s no weekend downtime, no value date roll at 5pm New York time like there is in FX.
It’s available all the time and that’s an interesting property that FX can learn from. The world never stops so why should the ability to convert from one currency to another?
Settlement is another area where crypto leads FX. Currently settlement of Bitcoin is built into the protocol, so within an hour you can have six confirmations on the blockchain, and you can be fairly certain that your money is there and that’s 1 hour versus, say, T+2 if you are trading spot FX. Crypto-asset and blockchain related settlement procedures may end up being the catalyst, but also form part of the implementation of a speed up in currency settlement.
There is also the data and volume transparency element with today’s crypto-asset trading venues. Whilst some of the reporting is inconsistent, you are seeing very transparent market data available, with volumes published by all the venues, and that’s something you don’t have today in real-time across all of FX.
There are also lower barriers to entry for new entrants into the market than exists in FX. It’s easy to get started, very cheaply, trading crypto-assets, as you don’t have a requirement for a prime broker as you would in the spot FX market.
However, the primary areas where crypto leads FX is volatility – that I don’t think is in question!
Will FX be the natural home for crypto-asset trading?
AA: Here I think the answer depends on the type of crypto-asset. Regulation will play a leading role and we are likely to see different market structures emerge for different types of crypto-assets to reflect the market structures we see in different assets today. As an example, security based crypto- assets will likely be regulated differently to utility-based crypto-assets and crypto-assets that are attempting to ask as money will likely differ also.
A number of the first movers in this space tend to be those that trade FX, because there are a number of properties that are the same. The market structure is similar in terms of the fragmentation of the OTC markets, the worldwide locations for trading (which allows FX participants to leverage their infrastructure further) and the fact that you’re really trading one asset for another, which very much fits into the realm of FX trading.
Ultimately, as a decentralised currency, a natural home for Bitcoin would be in FX, but this is very much dependent on what the regulatory structure looks like and how that changes going forward.