Crypto Capital Markets: The Arc of Maturation
This is a contributing article from Leslie Lamb, Head of Institutional Sales at Amber Group.
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We spend a lot of time thinking about crypto market infrastructure.
The development of market infrastructure is indicative of the institutionalization growth curve. The pace of building in this space has been astonishing. We are seeing the emergence of more institutional-grade market infrastructure from qualified custodians to trade execution platforms and derivatives exchange venues. We believe the more robust the infrastructure, the more investable crypto becomes as an alternative asset class. Institutional participation is really the amassing of retail participation and more retail will come as the building blocks get built. Indeed global adoption will increase at a measured pace (to borrow a popular phrase from the Fed). But as a young, growing asset class, crypto has already proven formidable and is rapidly forging its own path. The question is whether crypto evolves to mirror traditional financial market structures or whether crypto forms its own market structure tailored to the unique needs of the market.
We see the arc of crypto capital market maturation form over three stages:
- Growth and diversification of infrastructure providers in the crypto-asset ecosystem servicing the various needs of institutional and retail customers
- Consolidation and competition in global markets amongst infrastructure service providers
- The professionalism of the crypto capital markets and dominance of select sophisticated institutional-grade players replacing certain traditional financial intermediaries
Despite the race to the bottom on fees across platforms — custodians, trading platforms, exchange venues — we are still broadly in the growth and diversification stage of such platforms. There is healthy competition amongst these infrastructure players to create services that will meet the various needs of both institutional and retail customers. One growing trend we see is vertical integration. Coinbase and Blockchain.com are just a handful of examples. These digital asset companies started with one product offering (e.g. wallet) and, over time, increased platform functionality to include additional crypto on/off ramp solutions and “yield-capture” services such as lending and staking offerings. At one point, Coinbase Custody was the only custody solution on the market that had vertical integration with institutional liquidity and trading services. Then in September 2019 Gemini became a US qualified custodian. Their recently launched captive insurance company will provide additional regulated insurance coverage for segregated assets in Gemini’s cold storage. Additional insurance coverage is just one of many demands institutional users have from these diversified platforms. Others include better access to liquidity, better pricing, higher-yielding products, financing — the list goes on. The smart platforms are listening and growing to meet their needs.
One problem we face in the current trading environment is stale capital flow. We need new capital flowing through the crypto capital markets. How do we see this being achieved (and sustained) apart from the occasional tailwind from price appreciation? We think the answer lies in the piping. Since the typical crypto on-ramp gateway is through trading, we will focus on the building blocks of crypto trading.
As of YE 2019, volumes across the 400+ spot exchanges globally reached a total of ~$65B over a 24 hour time frame . The proliferation of spot exchanges has given rise to severe market fragmentation. We call it the more is less phenomenon. There are some merits to the growing number of spot exchanges, but the tradeoff to this “optionality” unfortunately means thin liquidity spread across a majority of the exchanges operating today. Spot liquidity seems to be concentrated on the same top few exchanges.
Building block #1 – Pre-trade infrastructure
The ability to efficiently utilize balance sheet is a key component to a healthy market. Yet trading in the spot markets is still quite capital inefficient. If you are trading on an exchange, it is standard practice to trade from a pre-funded cash account. This means that you need to put up capital prior to executing the trade. This, along with the exacerbating issue of fragmented liquidity, are reasons why large-size trades are still mainly done via over-the-counter (OTC), where post-trade settlement is the standard. That is not to say that the multitude of other crypto on-ramp channels like aggregators and brokers are not worth exploring. The key is understanding your preference for trading and what you prioritize i.e transparent price discovery (trading direct on exchange); capital efficiency (trading via OTC); security (trading direct from cold storage).
Building block #2 – Trade execution
Aside from lit venues (i.e exchanges that operate central limit order books), OTC venues have increasingly become the predominant channel for crypto-to-crypto and crypto-to-fiat trading. In fact, due to better liquidity access, OTC desks are the preferred venue for executing larger-size trades and liquidating illiquid tokens. Most desks trade bilaterally via voice trading — a manual, hi-touch service between the dealer and the counterparty. The advantage here?
Human-interaction for quotation/customer service. Some like Amber also offer electronic single dealer platforms (SDPs), a low-touch alternative that offers quick and direct access to product pricing via streaming. Our SDP offers a number of advantages:
- Multiple trading pairs at globally competitive pricing
- Capital efficiency with post-trade settlement option
- Operational efficiency via one-click trading and multiple order types
- Price discovery via our execution service where we act in an agency capacity
- Soon, automated access to Amber’s other secondary market services including financing and structured solutions
By creating a user-centric platform, we are changing the way our clients interact with us as an OTC dealer and more importantly, as a company. Amber is not only your counterparty, but also your trusted partner to service your needs anytime – 24/7/365. We recognize our clients are asking for diversified services and believe that our SDP is a critical first step toward a more holistic servicing platform.
Building block #3 – Post-trade infrastructure
Lack of proper post-trade infrastructure is unanimously agreed to be the biggest gap in today’s crypto capital markets. As the International Securities Services Association (ISSA) points out here, post-trade infrastructure must catch up with developments in pre-trade and trade before mass-market adoption of crypto assets can truly occur. To mitigate credit risk, we need better post-trade infrastructure for on-chain transaction settlement and clearing.
Central Clearing Parties (CCP) are a core part of the traditional post-trade infrastructure.
In crypto, each exchange acts as the direct counterparty, facing clients to clear and settle trades. While certain intermediaries have emerged to solve this missing part of the post-trade process, using third party providers is still not the norm. The industry is waiting for the emergence of central clearing for spot and derivatives to eliminate balance sheets and cross-margin frictions for market participants. But if the way of the future does not include CCPs, could non-custodial clearing services become the status quo to trade across these platforms, or perhaps a hybrid model?
Settlement finality is a well-defined financial market concept. There are multiple legal and regulatory structures surrounding the clearing and settlement of financial instruments . According to the Bank of International Settlements (BI S) , finality of settlement ensures that transactions made overpayment networks will, at some point, be complete and not subject to reversal even if the parties to the transaction go bankrupt or fail. The same concept of settlement finality, taken in the context of crypto and blockchain, opens itself to many questions. Tim Swanson argues that “a public blockchain by design cannot definitively guarantee settlement finality” and that, in fact, it is “self-defeating to build a network that is both censorship-resistant from traditional legal infrastructure and simultaneously compliant with legal settlement requirements” . The purpose of bringing up settlement finality is not to go down a rabbit hole of analyzing the best path to reconcile this conflict nor to start a broader philosophical debate. Rather, it is to present what we see as a risk unique to crypto trading. Debate aside – assuming proper rails for fund settlement is something that can be achieved in crypto – we see a number of platforms working to bring more certainty to the crypto-to-crypto settlement process.
It is worth noting that these risks around finality are extremely different amongst different blockchains. Bitcoin Gold (BTG), for example, recently was 51% attacked and $76K worth of BTG transactions were “double spent” i.e. reversed. Anyone who was counting on the finality of those BTG transactions is now at a financial loss. This risk is far reduced in top crypto assets with large and secure blockchains or assets that are tokens built on top of historically secure blockchains (ERC-20, SLP, etc). When it comes to BTC or ETH transactions, for example, the finality a financial participant obtains after 10 or 30 minutes is far greater than that achieved in the traditional banking system. This is very different from smaller crypto assets that have their own blockchain, not secured by much hashing power. For those blockchains, finality is much harder to achieve.
There are multi-platform settlement solutions like Fireblocks that now enable digital assets to be easily transitioned from any state of storage and primed for immediate settlement and transfer on the blockchain. Others offer solutions for derivatives settlements like margin calculation and cross-counterparty netting to enable better capital efficiency. Perhaps the most prominent fiat payment rails supporting the crypto trading industry today are Signature Bank’s Signet Platform and Silvergate’s Exchange Network (SEN). According to Coindesk, Silvergate is reportedly looking to support fiat-to-bitcoin settlement services for SEN participants this year. Should this materialize, it would be a positive step forward for the industry. But it will still take time before we see support for a majority of other crypto assets via their settlement service, much less other regulated banks launching crypto banking and bitcoin settlement services.
Crypto financing and derivatives: Improving risk management and asset price discovery The rapid growth of the financing (i.e borrowing/lending) and derivatives markets has enriched the number of risk management tools available for market participants like traders and miners. It was not long ago when miners had no option but to liquidate from their BTC portfolio in order to pay down operational expenses. Now, by working with firms like Amber, miners can choose to take out cash loans against their BTC balance sheet at competitive rates and put on various options structures to hedge their BTC exposure. We continue to see increasing demand for BTC-backed cash loans, which we believe has unlocked significant capital from the markets. We think increased participation in the financing market will lead to improved liquidity and price discovery across assets. As for traders, retail and institutional alike can now trade perpetual swaps and futures contracts with leverage across multiple expiries, enabling greater capital flexibility. These are all necessary advancements for the crypto capital markets.
We believe it is important to analyze the piping infrastructure that supports the current trading ecosystem. The so-called building blocks form the bedrock for a maturing crypto capital market. As market participants, we are laser-focused on doing our part to build a robust crypto finance platform for our clients. As specialists in the secondary markets, we aim to provide a suite of best-in-class services including OTC, trade execution, treasury management, financing, and structured solutions.
If you would like to learn more about Amber Group, please say hello to us at firstname.lastname@example.org.
Amber is a diversified crypto finance firm. Our core value is building strong relationships with our clients, helping them buy and sell cryptocurrency products, earn yield, manage risk and access liquidity. We operate around the clock and around the globe, with a presence in Hong Kong, Shenzhen, Seoul, and Vancouver.
: Coingecko. 2019 Q4 Report
/: Tim Swanson. Settlement Risks Involving Public Blockchains.