Trading in cryptocurrencies has mainly been driven by retail investors, particularly on the hunt for profits from short-term, speculative transactions. Meanwhile larger institutional participation in cryptocurrency trading has been mainly kept on the sidelines due to several missing, but extremely important, features.
In order for crypto to become a true asset class, it is “absolutely required” for larger regulated institutions to be involved, says Hu Liang, co-founder and CEO at crypto-trading platform Omniex.
“This means from a system and infrastructure perspective, scale and regulatory compliance are both necessary. A single point of access to multiple venues, best-execution algo capabilities, complete audit records, and detailed recording are just a few areas where retail needs are different from institutional requirements,” he says.
Apart from the elephant in the room—regulation, or rather, the lack thereof—key custodianship is a term that has been creeping up more often. But putting effective custody solutions in place may not be as simple as it is in other asset classes.
Craig Borysowich, a digital platform strategist at consultancy firm Capco, says one of the unique features lacking in crypto trading at present is key custodianship capabilities that help manage and secure public and private key pairs, as well as assist with cold storage of crypto assets that are stored for longer periods of time.
“More professional trading floors that are looking to dabble in crypto asset trading also need a more advanced key custodian that will keep key pairs from being revealed directly to traders and can also enforce trading volume limits on a trader by trader basis,” he says.
If you’re a trader, you need the access to be there. Sebastian Higgs, Lendingblock. Having key custodianship would insulate the traders from being able to access specific keys, he adds. This could be important to institutions keen on crypto assets, particularly if a disgruntled trader makes off with those keys. “A key custodian platform could protect these keys. And through that custodian, they [traders] only will get exposed on the trading side,” Borysowich says.
According to Sebastian Higgs, business development manager at Lendingblock, a firm providing securities lending for cryptocurrencies and digital assets, the technologies that crypto traders look for fall within two main categories—technology that meets trading desks’ execution needs, and technology that meet trading desks’ administrative needs.
Of the two, Higgs says the latter is a highly underserved market. A lot of the focus has been put on access to liquidity. “The problem is, if you want to move a large position on an exchange, it will cost you a lot of money. At the moment, this is pertinent to institutional traders; the ability to chip away at their position, rather than in a block,” he says.
In his opinion, fragmentation and liquidity are dispersed everywhere. “If you want institutions trading in this space, they can’t be exposed for hours and days. In the traditional market, this is something you can leave in a certain way. There are specialists in the traditional market to ensure there is minimal impact to the price,” Higgs says.
Key custodianship is a topic that is getting hotter in this space, he says. Keeping “things” at hot storage and moving assets around is fairly easy to do. But, exchanges are getting hacked.
This is an ongoing development. Specialists are still trying to find the balance between having the keys kept at cold storage but also, having it capable of responding to market needs within a certain time. “If you’re a trader, you need the access to be there,” he says.
Lendingblock acts as a security trustee, which Higgs says is a concept that exists in the traditional market. “We are a third-party agent and we manage the trade as well. It is enforceable under English law and the trades are completely segregated from our own assets. It’s fully safe and segregated. From an operational and legal point of view, even if either party becomes insolvent, there won’t be a loss for the other party,” he says.
But Tim Enneking, managing director at San Diego fund manager Digital Capital Management, says the key custodianship topic is going into the mechanics of custody. Large institutions are used to trading in a world where the “Holy Trinity,” or, the brokers, exchanges, and custodians exist in an established ecosystem. Currently, the roles are often blended—predominantly at the exchange level.
“Key custodianship is just an implementation of custodianship. That’s a mechanic. It’s not something conceptual. That’s like looking at the grass when you and I are looking at the trees… until you have the broad outlines of how the business should be done, you can’t implement the mechanics,” he says.
Custody Is the Key
Having effective custody solutions in place is critical for institutions to enter the market. But, it is important to understand how custody works in the fiat space first, Enneking says. “When you trade with any broker, the custody is built into the exchange and the brokers. It could be with Merrill Lynch or Goldman Sachs, they will use a custody solution and it’s totally transparent to the user.
“There’s a custodian that works in the triangle of broker, exchange, and custodian. So there are no concerns because there is a custodian involved. None of that exists in the crypto space,” he says.
Until recently there were no licensed brokers or licensed exchanges, and there are no custodians whatsoever, he adds. Now, that is slowly starting to change. But a problem still exists in that the custodians are static, Enneking says.
“What that means is you can get a custodian if you want some bitcoin, you can park it someplace and it doesn’t move. But if you want to trade it you have to move it to one of these platforms out of the custodian and yourself. So that Holy Trinity of exchange, broker and custodian doesn’t exist at all,” he explains.
Archax, a relatively new crypto exchange, is trying to tap into the custody area but says it is not a small challenge.
The lack of a comprehensive, secure and trusted custodial solution for digital assets… needs to be addressed. And it is being addressed Prash Puspanathan, Caleb & Brown. “How do you generate profit and loss, transaction costs, anything that has any part of the puzzle to deal with? And what about the ISO standards and all those regulatory issues? There is lots of work involved to get them,” says Andrew Flatt, the firm’s CTO.
Although far from a “dynamic” custody solution, there are efforts underway to get there.
Earlier in October, Goldman Sachs added to its stake in digital asset custodian BitGo. BitGo now holds about $2 billion in customer assets, across 95 different cryptocurrencies. So far, it is the only regulated custodian for crypto assets, after receiving approval from the South Dakota Division of Banking.
Asset manager Fidelity has also made headlines in this, with its announcement that it will launch Fidelity Digital Asset Services, a company providing crypto custody and trade execution services for institutional investors. Existing digital currency exchanges, such as Coinbase, are also pushing hard into the institutional space with the launch of custody and prime services.
Even with these new services coming to market, Flatt says traditional institutional players would want to adopt it within their existing systems. “They’ve got a traditional EMS [execution management system] that they already transact in, and now they want to add crypto assets to the traditional front end so they can see everything in one system. This will support the trader’s workflow, he says.
Archax is building its systems up for that, to support infrastructure such as private connectivity networks, he adds. “I don’t think institutions care what my trading front end looks like, but they care about the back end and what runs under it,” Flatt says.
It has partnered with Aquis Technologies to provide it with a suite of exchange operations services and tools. This includes matching engine and market surveillance technology, which will be aimed at high-frequency traders, he says. “We have seed funding now and realistically, we will start building six months down the line and go live in the third quarter of next year. The first initial test cases are there” he says.
To Prash Puspanathan, founder and CEO at Caleb & Brown, an Australian-based boutique consultancy firm providing cryptocurrency services, the two primary barriers that impede greater institutional investment are a lack of regulatory oversight and trust.
“It is the latter of these factors, trust, where technology can play a huge part in cementing. The lack of a comprehensive, secure and trusted custodial solution for digital assets which allows institutional investors who need to be considerably more risk-averse to be assured that their assets will not disappear off the balance sheet due to security factors out of their control needs to be addressed. And it is being addressed,” he says.
This is through the development of innovative solutions for secure custody from multi-signature wallets, to sharded private keys, to analog thumb-printing of hardware wallets, combined with secure vault storage.
“However, it is only when we achieve dependable underwriting of these assets that we will be able to justifiably state that a custodial solution worthy of institutional reputational risk exists,” Prash says.
Ciáran Hynes, managing partner at Cosimo Ventures says even though many features are necessary for institutional crypto trading, there is an order in which each feature can and must materialize.
“The first is crypto custody solutions. Without the ability to securely store digital assets on an institutional scale, the space will be restricted to retail speculators—the result of which will limit liquidity, make credit too expensive, and dry up demand for specialist brokerage services,” he says.
It’s much easier to build something the second time around. It’s crypto imitating fiat. It’ll happen much faster than how it happened in the fiat space because there is already a model for crypto to refer to. Tim Enneking, Digital Capital Management. Once that has been solved, liquidity will improve, and access to credit will improve it further. “Finally, specialist brokerage services—outside of market/limit orders—will take the form of structured products and crypto-based derivatives. This is the natural evolution we envision, and I don’t believe we are far away from it barring any drastic regulatory decisions, which are always a wild card,” he adds.
Omniex’s Liang says it is difficult, if not impossible, to pinpoint just a single area that can solve the problem of wider adoption among institutional traders. For cryptocurrencies to be truly recognized as a new asset class, custody, platform access, brokerage services, as well as back-office settlement, will all be needed.
“At Omniex, we’ve taken the approach to create the infrastructure that can connect all these needed areas to create a single, unified crypto ecosystem,” he says.
Another important point that is needed is to have technology that can integrate the exchanges, wallets, and custodians to allow for full reconciliation and audit trails, explains Chris Jenkins, managing director at Caspian, a joint venture between Kenetic Capital and trading technology vendor Tora.
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