Along with alleged ties to cyber criminals and fraudsters, several financial factors, not least extreme price volatility, illiquidity and a concern they lack intrinsic value, have prevented professional investors from seriously considering cryptocurrencies as investible assets. But after many years spent on the fringes of financial markets, attitudes to cryptocurrencies have started to soften with a recent upsurge in interest among institutional investors who have started to invest in and trade them. Eric Wall, Cryptocurrency & Blockchain Lead at Cinnober outlines the current developments in cryptocurrency trading.
To run in parallel with this ‘institutionalisation’ of cryptocurrencies, there needs to be a concurrent development of a robust market infrastructure that supports the buying, selling and clearing of these assets as well as the creation of an effective regulatory framework to protect investors.
Crypto exchanges, which have historically catered primarily for retail investors, are starting to diversify their revenue streams by evolving to accommodate the very particular demands of banks, investment firms and other financial institutions, for example by extending credit. This creates huge challenges for these exchanges, however, particularly in relation to their in-house technology which often isn’t fit for purpose nor capable of estimating risk with any degree of sophistication.
In order to attract institutional investors, crypto exchanges need to be able to provide the same capabilities as established exchanges, ensuring that cryptocurrencies can be traded in the same way as traditional asset classes. This includes giving access to post-trade processes such as trade compression, netting and clearing. Currently, however, cryptocurrency exchanges are hampered by significant inefficiencies, largely stemming from the fact that most operate on a pre-funded basis and as a result liquidity is spread over many different orderbooks.
The pre-funding requirement, however, hasn’t limited the industry’s ability to leverage products. In order to de-risk the exchange from leveraged trades, they have adopted margin trading models in which positions are collateralised and automatically liquidated at pre-determined price points. This means traders must maintain pre-funded collateral with each exchange they want to trade at, with no ability to net positions, as well as face wipe-out of their collateral in the event of sudden market moves.
Established exchanges will need to make sure they truly understand the operational aspect of blockchain assets, which can split into multiple sub-assets or morph into an entirely different asset altogether, as a source of data.
As the crypto world becomes home to larger numbers of mainstream financial institutions, there are a few things that existing exchanges need to address to gain their confidence and trust. Firstly, as stated earlier, cryptocurrencies are extremely volatile and so there must be a clear strategy in place for managing this risk in the event of wild and sudden valuation swings. This means that many established players looking to cater for cryptocurrency trading will need to re-think their risk management practices in order to provide margining models that meet an institutional standard.
The crypto market is still in its infancy and to date most trading has taken place on unregulated exchanges where market manipulation such as wash trading is known to have been commonplace. In addition, it is especially complex and so established exchanges will need to make sure they truly understand the operational aspect of blockchain assets, which can split into multiple sub-assets or morph into an entirely different asset altogether, as a source of data. This understandably requires an entirely new skill-set which leads to another key challenge established players are currently faced with – talent acquisition and the limitations of the existing talent pool.
Despite this, mainstream exchanges continue to see the potential of cryptos. We see two main strategies here. Some of them, such as CME and CBOE, have created instruments that give exposure to cryptocurrency assets. Others, like Eris Exchange’s ErisX, have launched subsidiaries that exclusively focus on crypto assets. The common thread here is that through such initiatives, these firms seek to capitalise on the momentum building around cryptocurrencies.
To some an irony may be seen in all of this. Cryptocurrencies and the technology that sits behind them, the distributed ledger (DLT), set out to circumvent what some saw as an outdated, dysfunctional and self-serving financial system. However, what we now see is that cryptocurrencies have started to become an ‘accepted’ part of the very system they were going to disrupt. While this process is still in its infancy, the institutionalisation of the crypto world looks set to run and run.