Some institutional investors have written off cryptocurrencies as a bubble. Others may be taking their first steps to allocate money to a new, uncorrelated asset class.
Wherever they fall on the spectrum between dismissal and enthusiasm, many investors are probably conducting due diligence on how to buy and hold cryptocurrency tokens in a cost-effective, safe and efficient way.
But where should they start? Many participants in the cryptocurrency market may be unfamiliar, such as the majority of exchanges, trading firms, custody and other service providers. Most banks—the main trading counterparties of many investment firms—have so far shunned bitcoin and its offshoots.
Trades involving the physical delivery of cryptocurrencies require prepayment, the opposite of the trade cycle in traditional asset classes, where you trade first and settle later. There’s no central record of ownership, no central clearing of trades and no established custody model.
So how should institutional investors approach the trading of cryptocurrencies and what pitfalls should they avoid?
In a 30-minute podcast, New Money Review founding editor Paul Amery asks two cryptocurrency specialists to throw light on these topics: Max Boonen, founder of specialist cryptocurrency market maker B2C2 and Paul Gordon, CEO of Quantave, a firm specialising in the trading infrastructure surrounding this emerging asset class.
Here are some highlights from the recording:
You need to prepay physically settled purchases of cryptocurrency
“To invest $10m in physical bitcoin, an institutional investor will have to make a bank transfer for the full amount to a counterparty, whether a trading venue or OTC market participant, and receive the bitcoin sometime later.” [Max Boonen]
“People have to jump through hoops and do their own due diligence. Exchanges are more reputable than they were once considered. But it’s not very streamlined at all.” [Paul Gordon]
No financing or prime brokerage
“Exposure to your trading counterparty is typically not collateralised. Having to pre-fund your bitcoin exposure has been a bottleneck to bitcoin adoption. There’s a lack of a sophisticated clearing and settlement infrastructure.” [Max Boonen]
“Counterparty risk is a big thing, as is banking support (or the lack of it) and custody. There’s no prime brokerage model.” [Paul Gordon]
“Banks have told some of our clients, ‘We know you’re active in cryptocurrencies and we really don’t like that’.”
Lack of support—or active hostility—from banks
“We’ve had clients that are well-known financial institutions, whose banks have told them ‘we know you’re active in cryptocurrencies and we really don’t like that’. Those institutions have sometimes have had to switch banks for the purpose of their crypto activity.” [Max Boonen]
Improving market liquidity
“Bid-offer spreads in bitcoin have been moving in one direction—tighter. As electronic trading in cryptocurrencies becomes more widespread, we should be at the level of the FX market in a year or so.” [Max Boonen]
“Money talks at the end of the day. There are probably quite a few traditional exchanges looking over the fence with envy at some of the revenues being generated by some of the larger crypto exchanges.” [Paul Gordon]
Mismatched payment confirmations
“There’s more efficiency on the crypto side. If you’re trading crypto against fiat, the slow component is still the leg passing through the traditional banking system. On the crypto side, once a transaction is made it’s instantly visible and you can see if it’s been confirmed or not.” [Paul Gordon]
“The banks are only slow in processing payments for smaller customers. For institutions, you can often see fiat payments being made in real time. The fiat may arrive before the crypto.” [Max Boonen]
“It’s crazy you have to put up $100m in cash to buy $100m of bitcoin.”
The custody challenge
“Custody is a very tricky problem because bitcoin transactions cannot be stopped. Possession is the same as title and if you have control of the private keys then you control the wallet. It’s a completely different paradigm from traditional custody, which is about processes, four eyes, database redundancy and so on.” [Max Boonen]
“The cryptocurrency custody model for institutions is still very immature. You’re trusting relatively young, unknown companies with large sums of money. For institutions, it’s not what they’re used to in other markets, where you can just walk in and trust a firm based on its history and market capitalisation. But in cryptocurrencies there’s nothing to say that established firm will do a better job than a start-up.” [Paul Gordon]
Insurance is extra, if you can find it
“There are no standard insurance policies around custody. In gold, for example, insurance would be packaged into your storage contract.” [Paul Gordon]
The need for a cryptocurrency finance market
“It’s credit that’s missing from the cryptocurrency market. Even though crypto purists might not like it, it’s crazy you have to put up $100m in cash to buy $100m of bitcoin. We’re going to look more like the repo market, the FX swap market or the equity lending market. We’re going to start seeing collateralised credit markets to support trading activity in cryptos.” [Max Boonen]