By Andy Flury,  Founder and CEO of AlgoTrader
By Andy Flury, Founder and CEO of AlgoTrader

Jumping the Crypto-Chasm: How Can Institutional Trading Firms Offer Digital Assets?

What seemed highly unlikely a few years ago is now taken for granted: an increasing number of institutional players are looking to offer digital asset services to their clients. Recent high-profile examples include Goldman, JPMorgan and Citi, who are all reportedly exploring crypto custody services.

In the short term, with major cryptocurrencies like Bitcoin and Ethereum at or above historic highs in recent months, coupled with a low-yield macroeconomic outlook, digital assets have become an attractive alternative investment. 6 in 10 investors now believe that digital assets have a place in a portfolio according to the Fidelity Digital Asset Survey conducted last June, with respondents citing the perceived low correlation to traditional assets, innovative underlying technology, and high upside potential as the main appeals. An additional factor is that in the current economic climate of expansive monetary policy and inflation, digital assets are often cited as a hedge against potential devaluation of leading fiat currencies. Some financial institutions see this as an opportunity to broaden their client base by responding to a growing need and create a new source of revenue that to date, has been considered to be largely independent of traditional capital markets. 

In the medium term, it is also a strategic move. Foundational digital asset services, such as cryptocurrency custody storage, trading and settlement, can be seen as the first step towards tokenized assets, which are likely to be a much larger market in the long run. In addition, the huge expansion of decentralized finance platforms, which have witnessed a 25-fold increase in locked-in assets over the past year according to tracking website DeFi Pulse, offer a glimpse of the type of services that traditional players may seek to emulate and integrate into regulated offerings over the next 5 years. Thus, a digital asset offering can be used to foster a reputation as an innovative player, and signal to the market that you are ready to take advantage of technology-driven shifts in the industry in future.  

What are the key operational challenges for banks and financial institutions engaging in digital assets?

Despite the opportunity, however, financial institutions and banks currently face significant barriers to establishing digital asset offerings. Firstly, they need new and specialized infrastructure to manage transactions and ensure safe custody of digital assets. Security is of utmost importance to all players; especially to banks, who are generally seen as the traditional guardians of value. Such infrastructure can be time-consuming, costly and complex to develop in-house and requires specialized knowledge in cryptography and cryptosecurity.  

Once the infrastructure is in place, the lack of smooth interoperability between the traditional and digital financial worlds poses another stumbling block. Liquidity in the digital asset space tends to be highly fragmented across a myriad of venues such as market makers, exchanges, brokers and OTC desks. In fact, an estimated 70% of digital asset liquidity is traded off-exchange. In addition, the industry still lacks a commonly agreed standard for exchanging financial information (something akin to FIX in the traditional asset space), which makes syncing data with core trading and banking systems a major technical challenge.  

Beyond these infrastructural challenges, there is also a shortage of staff with expertise and knowledge about the underlying technologies. For example, a LinkedIn analysis last year found that blockchain was the most in-demand hard skill among employers on the site. Furthermore, as the market is relatively young and dynamic with many participants, choosing reliable partners and service providers can be difficult. Counterparty risk is a well-known source of concern even in more established markets and the risk that a contracting party might fail to fulfill their obligations is greater in a relatively immature market like digital assets. 

Finally, regulatory compliance poses an additional challenge. While all transactions on blockchain networks like Bitcoin or Ethereum are public, the identities of the transacting parties are not. Instead, each party is represented by a hexadecimal code, which is a combination of letters and numbers known as a public key. As a result, financial institutions need to analyze transaction histories and perform coin checks to comply with Know Your Customer (KYC) and Anti-Money Laundering (AML) regulations, among others. 

Digital Currencies
Highlights from the Institutional Investors Digital Asset Survey 2020

Source: Fidelity Digital Assets

What features and functionality do quants look for in a digital asset trading platform?

As discussed above, the digital and traditional asset space have some fundamental differences in terms of the underlying architecture and regulation. However, when institutional traders choose a digital asset trading platform, they want to be able to access secondary markets for this new asset class with minimal disruption to their existing workflows. In fact, the term “digital asset trading platform” is perhaps too narrow — traders simply want an order, position and execution management system that also offers connectivity to digital asset venues. This means that from the perspective of a professional trader there should be no difference between placing an order for a crypto asset like Bitcoin, and a traditional stock or bond. Moreover, manually managing multiple crypto wallets and keys, or querying individual venues on an ad hoc basis is simply not tenable for professional traders from both an operational and risk standpoint. Ideally, digital assets should be seamlessly integrated into established trading and custody systems and processes. Particularly for quantitative trading, this is important, because it means that crypto and digital assets are not siloed into a corner and can be incorporated into a broader trading strategy that also encompasses traditional assets. 

As digital asset venues have not yet established common connectivity standards and protocols, one of the most important functions of a digital asset trading platform is to provide reliable connectivity to a wide array of venues. This is essential in order to have access to a deep liquidity pool across many exchanges to fill large orders without incurring significant slippage or the risk of front-running by other market participants. This is also where smart order routing and execution algorithms come into play. Although it might be taken for granted in the traditional asset space, it is worth remembering that the best quantitative strategy will be useless without reliable access to liquidity and the right execution algorithms to tap into that liquidity inconspicuously. A good digital asset trading platform thus acts as the connecting tissue between the traditional and digital world, enabling the user to reliably interact with many market makers, brokers, exchanges and OTC desks through a single FIX connection. 

A growing number of digital asset trading systems are starting to provide tools to help ensure best execution. While this may not yet be a regulatory requirement for most crypto assets as it only legally applies to securities in most jurisdictions, it is seen as a way to introduce a familiar and trusted concept into digital asset trading in order to reassure clients that their assets are being managed efficiently. Smart order routing helps to improve execution quality by choosing the best route for each order across a complex maze of possible venues, while taking price, speed, liquidity and likelihood of execution into account. While pre-built execution algorithms can save time, some traders welcome the ability to access the underlying code and understand what is really going on. In order to make execution into a genuine unique selling proposition (USP), however, the option to deploy custom, proprietary execution algorithms is a must.

Finally, there is the coding environment. When developing any quantitative trading strategy, some computer programming knowledge is usually required. High-level languages such as Python, Java and R tend to be popular because they are comparatively easy to read, while the many pre-built “packages” of code enable quick deployment and parametrization of strategies. Traders will not want to reinvent the wheel here, so strategy development for any quant trading system should use a familiar language and logic. For back-testing strategies, access to good quality market information and signals is essential and this is another area where a digital asset platform can help by integrating connectivity to trustworthy data sources.    

Digital Currencies

What are the infrastructure, connectivity, and security issues involved in a digital asset platform?

The first decision for any financial institution or bank when establishing a digital asset offering is whether to develop the core infrastructure in-house or to work with partners. While it may be tempting to develop end-to-end proprietary infrastructure in a bid to capture profit throughout the value chain, it is worth bearing in mind the complexity and cost of such an undertaking. There is now a vibrant secondary market ecosystem of firms offering white labelled digital asset services ranging from custody storage, trading, brokerage and execution, to asset tokenization. Therefore, for a financial institution making a first foray into the digital asset space, it is possible to get up and running without starting from scratch.
          
In terms of connectivity, as mentioned above, the paramount challenge is establishing reliable access to liquidity venues. Unlike the traditional asset space, there is no commonly accepted principal exchange for specific digital assets. A number of global and predominantly retail-oriented exchanges like FTX, Binance and Coinbase compete to gain the upper hand while local firms typically act as brokers, resulting in a highly fragmented landscape in terms of liquidity. In addition, each liquidity provider uses their own API implementation, based on protocols like REST and Websocket. As a result, different code will likely be needed to query the same information or perform the same transaction on two different venues. In order to ensure stable connectivity and convert the information into a standard FIX feed for institutional traders, the only solution is to integrate each API individually and constantly monitor, test and keep abreast of changes. Maintaining this connectivity can be a labyrinthine challenge, as the quality of technical documentation and support from venues is highly variable. This can be avoided, however, by using secondary-market services which provide access to a variety of liquidity providers through a single FIX-API.

Finally, security infrastructure is also an important consideration. When $280 million in assets were stolen from Hong Kong-based digital asset exchange KuCoin last September, it showed that although such large-scale hacks are on the decline, the threat remains. For long-term custody, so-called “cold storage” — where the private keys to digital assets are stored in a place that is isolated from any internet connection — is probably the safest choice. For trading purposes, however, this is obviously not an option as the assets need to be quickly accessible. As a result, some form of “hot” on-exchange or self-custodial, exchange-connected wallet will need to be used while implementing a range of cryptosecurity processes and techniques to minimize risk. Here again, there are a number of secondary market players who specialize in this field.

What are the important factors in choosing the right platform for your needs?

As discussed above, digital assets offer unique advantages and challenges to banks and financial institutions. Indeed, both the opportunity and challenge could be considered to be two sides of the same coin: digital assets are attractive in part because they are somewhat independent of traditional markets and have novel fundamentals, which is also what makes them tricky to integrate into an institutional product offering. However, a rich and vibrant secondary market now exists through which most, if not all, of these gaps can be filled. Thus, when establishing a digital asset platform, the precise mix of in-house and outsourced features will depend on a number of factors:
Scope of commitment: How much are you willing to invest upfront in infrastructure for core functionality? If you are planning to build your digital asset architecture in-house, it will take sustained investment over multiple years. If the move into digital assets is more of a pilot project to test demand, it is likely to be more efficient to use a white labelled solution from a third party for core functionality like custody and trading.

Existing positioning in the market: How do your customers perceive your role in the market? Are you regarded as a trailblazing innovator or a safe pair of hands? If the latter, you may want to begin with services like custody storage and expand into selected tokenized assets (such as real estate and luxury goods) in a few years. If the former, you might want to offer custody and  trading as well as more complex products like spot trading and crypto derivatives straight away.
   
Competitive landscape: How many regulated players are offering digital assets in your jurisdiction? Is there a client segment that is currently underserved? While platforms offering retail clients access to crypto abound, digital asset offerings aimed at institutional players tend to be less prominent. The key here is to use your knowledge of specific client segments, including their pain points and workflow, to create a digital asset offering that adds value and can be adopted with ease.
 
Overall, the biggest advantages that financial institutions and banks have over the new crypto players are trust and market intelligence about how the landscape is likely to evolve as it matures. The sweet spot lies in creating digital asset offerings that are measured enough to be trusted, ambitious enough to be truly innovative, and tailored to the needs of a specific client segment.