Are We Ready for Institutional Crypto Trading?
Crypto trading boomed alongside the ICO craze, but as that ICO bubble burst and the price of bitcoin and other major cryptocurrencies came back to earth, trading volumes have still grown year- on-year. According to research firm Diar, their data suggests, the combined volume on major United States crypto exchange Coinbase rose 21% in 2018 compared with 2017. Last year, crypto exchange operators Kraken and Bitfinex saw trading volumes rise 192% and 50% respectively. In addition to growing trade volumes, Coinbase had a 14.1% increase in the number of trades, with 94.4 million in 2018 up from 82.7 million the year before.
As volumes rise, and the incentive to create a smoother path for institutional money to enter crypto markets is also rising, however, key challenges to adoption remain.
REGULATION, STABILITY, CUSTODY
There are several main types of businesses trading cryptocurrencies currently: alternative or hedge funds, proprietary trading desks (which are a combination of funds) and large individual investors, and OTC brokers. Crypto hedge funds accounted for around 20% of all hedge fund launches in 2018.
Lack of regulation is definitely one area that is holding back institutional investors in getting involved. They are relatively conservative by nature, so they cannot easily invest in an unregulated market. Crypto trading is a relatively unregulated industry in some countries, and entirely unregulated in others. There is a clear need for some sort of regulation across the market, in order to encourage the larger institutions. It will be a challenge to persuade traditional long-only investors, such as pension funds, to invest and then trade in cryptocurrencies until they have a more developed regulatory structure in place.
What those regulations look like may drive how fast and how much money goes into cryptocurrencies. These regulations might not resemble those of equity and fixed income markets, but perhaps the model regime looks more like FX trading. It could potentially be the right approach to look at cryptocurrencies as a currency-type instrument. Different regulators will suggest different approaches. Even now, the SEC has a different view from ESMA, Switzerland’s FINMA, UK’s FCA, JFSA, SFC or China’s PBOC and CSRC.
There is a thought process that regulation will help bring stability, and, until there is price stability, a pension fund will not be able to rationally argue that cryptocurrencies are a place where they want to put long-term investments. While some regulation is not a ‘silver bullet’ to get traditional managers involved, it may certainly help. Currently, cryptocurrencies appeal to the hedge fund market, as they tend to run strategies that thrive on volatility.
Besides volatility and regulation, custody is probably the major issue for institutional investors looking at the crypto space. An institutional investor has to address the question of how they trade these across multiple markets as custody is typically performed by the exchanges. Not all crypto exchanges are equal, and yet they hold your assets. If you look at how conservative asset managers are in terms of counter party risk, it’s a much greater issue with sometimes smaller and occasionally less-than-transparent exchanges. For the larger institutional investors to get involved it will probably take firms such as Fidelity, who have announced their entry into the space, to provide a more traditional model. Nonetheless, custody will continue to be a big issue until there is a large custodian that can move assets quickly and has relationships with most exchanges to facilitate this.
CONNECTIVITY, EXECUTION, FRAGMENTATION
Connectivity was the first challenge in preparing for institutional scale investors. The native exchange platforms are web interfaces, and institutional investors will not want to run multiple web interfaces at once in order to trade. Most crypto exchanges do not have FIX which may be because they began their lives as a retail interface. This means that to create this connectivity in unified way there is a huge amount of work, which makes platforms such as Caspian essential.
Connecting to comprehensive sources for markets data and trading APIs remains a massive time investment. The same is true for reconciliation. Currently, investors cannot realistically always rely on exchanges for historical trade reporting, so the need to have an intraday reconciliation to check with the exchange is vital.
For those hedge funds already trading in this space, they are looking for a consolidated price feed across exchanges. Risk, reporting, an Order management System and execution are chief priorities for hedge fund trading desks trading in the crypto markets. Ben Roth, global head of trading at proprietary trading firm, Kenetic Capital who are already trading in this space said: ”As a firm, the majority of us all came from the traditional asset management world, so in the early days we struggled with the technology component. Before firms like Caspian there was no solution to cover execution, order and portfolio management. The market was crying out for this and advanced execution tools. If the custody space can make the same advances then the future looks bright for the institutional market”
A hedge fund has investors, and while they might not have stringent best execution regulatory requirements, those investors still expect to see reporting, operational
In the next few months, investors can expect new execution tools. In particular, the market has been crying out for a smart order router to address crypto fragmentation as well as pairs trading. The overriding message in the space is that the tools required are very similar to those in the traditional space but there are key differences that make this technology shift a challenge.
This will not be a problem that can be solved by throwing people at it. There is a lot more to it than just adding headcount because the market is not reflective of any traditional market. There are many different variances and idiosyncrasies that a trader or compliance professional would not have seen in traditional asset classes. Crypto markets are learn- able for an experienced trader, but for portfolio managers at traditional asset managers, there are other elements that may make it harder to make the switch.
Caspian is a crypto asset manage- ment platform that connects the biggest crypto exchanges in one single interface. The platform also offers compliance, algorithms, portfolio management, risk and reporting. Led by an experienced team of developers, and leverag- ing the capabilities and resources of two existing, successful finan- cial businesses as its partners, Caspian is building an ecosystem that enables sophisticated traders to operate more efficiently to protect and generate alpha.