Nicola Tavendale
Nicola Tavendale

Platforms, Liquidity and Connectivity Gateways - Exploring the world of high-end institutional crypto trading solutions

It is now nearly a decade since the initial launch of bitcoin, but in terms of both technology and infrastructure, the cryptocurrency market is still very much in its infancy. Yet growing institutional demand for crypto trading will require a new breed of institutional grade solutions to match, Nicola Tavendale writes.

First Published: e-Forex Magazine 81 / Trading Operations / July 2018

Platforms, Liquidity and Connectivity Gateways - Exploring the world of high-end institutional crypto trading solutions

Growth over the last year has been phenomenal in terms of interest from the institutional market, according to Monica Summerville, head of European research & senior analyst, TABB Group. “There’s a lot of interest and investment in this space, particularly over the last five to seven months –- despite the fact that the actual price of cryptocurrencies has come down a lot,” Summerville adds. “Many feel this is a good thing and less volatility would be beneficial from an institutional point of view.” Yet while institutional appetite for cryptocurrency participation has notably increased, significant barriers remain, according to the findings of Summerville’s recent TABB Group report, Crypto Trading: Platforms Target Institutional Market. 

Monica Summerville

Monica Summerville

“It might have taken FX 15 years to get to where it is today, but the view is that it’s going to happen a lot faster for the cryptocurrency world.”

The key challenges facing institutional players are commonly compared to those facing the FX market some 15 years ago during the early days of electronic trading. Most of the existing crypto trading technology was also only ever intended for retail users and, as such, is far too basic in terms of API connections, order types etc to meet the needs of the institutional market. Even the definition of institutional participants is much broader in the cryptocurrency world than other markets, Summerville explains. Institutional traders at the moment include hedge funds, family offices, miners and early crypto adopters, while some VC firms that are backing crypto entities are also now getting involved. “But the large, traditional institutions haven’t really yet entered this space - although we know a few are thinking about it and nearly all the big banks have teams looking into this,” adds Summerville.

Kevin Beardsley, Managing Director, B2C2, agrees, adding that the pace of uptake and change in general mindset among institutional players regarding crypto “has been staggering”. “Up until mid- to late-2017, crypto was a dirty word in most institutional circles,” he says. “It’s been a really impressive transition over the past few months, with seemingly every major institution in the world now running some kind of crypto or blockchain programme internally.” However, Beardsley warns there are currently two major hurdles to be overcome before institutional trading can gain a more significant foothold, namely the absence of a major custodian and regulatory uncertainty. 

Rosario Ingargiola

Rosario Ingargiola

“A technology solution to the counterparty and settlement risk problem like OTCXN’s digital asset trading network will help the crypto markets mature and scale”

Turning the tide

“Storing cryptocurrencies is a completely different ball game to traditional assets – because they function as bearer instruments, storing and accessing them is extremely difficult at an operational level,” explains Beardsley. “There are a number of storage solutions available, but nothing which will meet the needs of a global institutional player.” In addition, there is a relatively limited upside for institutions in the near term, but a significant downside if they get into operational or regulatory trouble, Beardsley adds. He believes that most institutions are being extremely cautious in how they approach this category and, as a result, greater regulatory clarity would be welcomed. 

Yet according to TABB Group’s findings, OTC crypto trading is already two or three times the total volume that is being traded on crypto exchanges. Institutional platforms such as LMAX, as well some FX brokers, are also starting to offer crypto CFDs and spot deliverable pricing to their end clients, says Rosario Ingargiola, CEO, OTC Exchange Network (OTCXN). “Margins are so favourable that the traditional institutional side is now getting involved,” he explains. “There’s also a whole new breed of hedge funds who invest, trade and even hold crypto inventory for lending purposes,” he adds.

According to Ingargiola, some of the biggest crypto liquidity providers in the world are the non-bank market making shops in Chicago that are also dominant players in the FX markets. “That will trickle down to some of the traditional trading firms. Goldman Sachs for example, recently announced the launch of a crypto trading desk, starting with non-deliverable forward contracts.” he adds. “We’ve also seen CME and CBOE launch futures products around bitcoin in addition to their index products - and they are now moving towards deliverable products as well.”

Michael Unetich

Michael Unetich

“Because it appeals to a broad audience, many people also need more education around the trading and post-trade aspects of crypto.” 

Demand for change

However, this rapid pace of change creates additional challenges for the crypto market, observes Alex Nekritin, Managing Director, Nekstream Global. “Since there are more business participants, things are moving very fast,” he warns. On the institutional side, this includes a growing number of HFT shops that are doing a lot of volume and pricing for tier 2 liquidity providers, according to Nekritin. “Certain custodial firms are making it easier for these HFT shops to take advantage of arbitrage opportunities by letting them have money in one place while accessing multiple venues,” he explains. 

Institutional growth continues to be very strong overall, with frequent launches of new exchanges, funds, payment processors and coins. “Although the crypto market is not as mature as FX in terms of infrastructure, there are far more new concepts and creative ideas in this space,” Nekritin says. “I believe it has much more potential.” Even so, infrastructure improvements are now urgently needed, asserts Michael Unetich, vice president of cryptocurrencies, Trading Technologies. “With over 200 exchanges worldwide, crypto is very fragmented, which only magnifies its status as a less mature market,” he explains. “Because it appeals to a broad audience, many people need more education around the trading and post-trade aspects of crypto.” 

In addition, Unetich warns that the ongoing need to “run the masses” through exchange or counterparty KYC/AML is a daunting task that is currently inhibiting growth. “This is because resources are being devoted to onboarding that could otherwise be used for scaling exchange or trading venue infrastructure,” he says. There are also a number of specific issues preventing greater institutional adoption, according to Unetich. These include the difficulty exchanges typically have in performing well at peak volume times, exchange fragmentation, high trading fees, lack of regulatory clarity on what crypto assets may potentially be deemed securities, customer support and, finally, a scarcity of professional-grade trading tools.

There is a lack of regulatory clarity on what crypto assets may potentially be deemed securities
There is a lack of regulatory clarity on what crypto assets may potentially be deemed securities

Attracting liquidity

Despite these factors, coupled with the lack of a major custodian for the crypto market, institutional interest in cryptocurrencies has been significant, according to Unetich. “Growth is progressing, although institutional trading involvement and volumes have been slow to gain traction,” he adds. “This growth is likely to continue, even though the price of crypto has been in a bear market this year.” Trading firms are also connecting to and trading on more exchanges by the day – while new cryptocurrency exchanges are being launched by the month. Companies like Trading Technologies help “tie it all together” and are hard at work building better crypto infrastructure, Unetich says.

Some exchanges have already introduced block trading to attract institutional players, but the crypto market has limited liquidity supply and much smaller capitalisation than other mature markets. This, in turn, causes higher volatility, as bigger players and larger trade size can move the market by few percent or even more, warns Michael Karczewski, head of business operations, Match-Trade Technologies. “The game changer will be the ability to offer higher leverage which will increase turnover, liquidity, and attract new entrants,” he adds. “Higher leverage and rebates will attract high-frequency trading companies to crypto trading, which will further increase liquidity in the market.” 

But the main problem on the institutional side is the poor standard of APIs used by exchanges, according to Karczewski. Request limits can be so low that even a basic algorithmic trading app will cause a bottleneck, he explains. “Institutional traders are used to a large quantity of data flowing through their servers, but on crypto exchanges they are limited to just over a dozen or even fewer requests per second on each symbol,” Karczewski explains. “Even if some exchanges use FIX API, they are still behind capabilities of FIX API used in the forex industry.” The other problem of APIs is their poor reliability, he adds, with API’s sometimes not working while the exchange GUI is fine. 

A big barrier to institutional adoption of cryptocurrencies is the reluctance of banks to convert major cryptos to fiat currencies.
A big barrier to institutional adoption of cryptocurrencies is the reluctance of banks to convert major cryptos to fiat currencies.

Early solutions

Institutions also tend to opt for crypto CFD trading at present rather than spot, which they do mostly through forex brokers. This enables the brokers to use leverage, not hold real coins in assets and hedge short positions, says Karczewski. “Hedging positions on crypto CFDs is done in the same manner as on all other instruments offered by forex brokers and, as a result, integration can be done very quickly,” he adds. “Our clients can now also accept deposits in cryptocurrencies and use our data feed for cryptocurrencies CFDs.” 

Summerville warns, however, that the issue with bitcoin futures and some other exchange-traded contracts such as CFDs, is they are often restricted to a limited set of cryptocurrencies, and so participants are missing out on the wider token market. “They will be a stepping stone for institutions to get involved without the custody issues,” she adds. “But to be fully involved in the underlying market then the custody issue will need to be addressed.” Yet there are a number of technical solutions being developed, such as tokenising collateral, to tackle key issues, such as the lack of prime brokerage, according to Summerville. “A lot of these ideas are quite similar to what happened in FX,” she says. “It might have taken FX 15 years to get to where it is today, but the view is that it’s going to happen a lot faster for the cryptocurrency world.” 

Even so, crypto market technology and infrastructure remains very basic from an institutional point of view, according to her findings. Most exchanges only support basic order types, while transaction cost analysis is virtually non-existent and there is very little transparency in terms of the market data available. It should also be remembered that cryptocurrencies are still experimental technologies, with software that is being developed and improved in real time, explains Beardsley. “They are not by any stretch of the imagination finished products,” he adds. “The exchanges that exist today are also not like traditional exchanges. They needed to cobble together quite a few different functions. For instance, most will take care of the custody of the asset for you, which is not a traditional exchange function.” 

Kevin Beardsley

Kevin Beardsley

“Storing cryptocurrencies is a completely different ball game to traditional assets – because they function as bearer instruments, storing and accessing them is extremely difficult at an operational level,” 

Experience and innovation

Crypto exchanges are also primarily retail-user facing, as opposed to traditional exchanges, which are for mainly institutional clients. Therefore the quality of the exchange technology, while it has improved rapidly, is still nowhere near what you would expect from a major exchange like CME, Beardsley warns. “We are a top five market maker in the CME’s bitcoin futures contract and we are a top trader on most of the major cryptocurrency exchanges – and there is still a noticeable difference between them,” he explains. Liquidity provision in cryptocurrencies globally is also very patchy. According to Beardsley, large firms run into issues finding high-order throughput liquidity on exchanges because the order books simply don’t have the requisite liquidity to support hundreds of large trades per second 24/7, 365 days a year.

“We are plug and play with traditional financial infrastructure, with a FIX 4.4 connection, a REST API and a web socket that streams prices,” says Beardsley. “We also have voice traders who can handle larger block trades and a website where they can log on and trade, which all looks and feels more like a traditional FX liquidity provider.” 

Ingargiola agrees that most of the current crypto exchanges have really poor technology, which results in a high number of flash crashes in the market. Institutional players are also concerned about loss of assets, the newness of these entities and the ambiguity around who the beneficial owners of some entities are, he explains. 

“Many exchanges are using web-based technology for their API connection and any exchange that has a REST API is not set up for any kind of latency sensitive trading,” Ingargiola warns. “You cannot algorithmically market make at scale against a REST API.” Another major barrier for institutions is the counterparty risk and capital inefficiency of posting assets at each exchange to access these islands of liquidity. This can be drastically improved with a technology solution that makes it possible to post assets with a custodian for safekeeping, with digitized fiat and crypto assets being issued onto a high-performance private blockchain network with trading performed as atomic exchanges with instant clearing and settlement on-chain, according to Ingargiola. This has the added benefit of exponentially increasing the velocity of capital – providing immediate re-tradability of the assets – because transactions on the slow public blockchain ledgers, such as the Bitcoin Blockchain, are removed from the real-time trading pipeline, with public ledger transactions only occurring upon client redemption from the custodial wallet out to a third-party wallet. 

“Most people consider the FX market to be fragmented, which it is, but if you have prime brokerage you can effectively trade across many liquidity providers and liquidity pools and treat it as one single market,” he explains. “That doesn’t exist in the crypto space and there doesn’t appear to be a traditional prime brokerage solution anywhere on the horizon. 

Alex Nekritin

Alex Nekritin

“Although the crypto market is not as mature as FX in terms of infrastructure, there are far more new concepts and creative ideas in this space”

Clarity at a cost?

Instead, institutions would have to incur some counterparty risk directly to interact with these fragmented liquidity sources. “The fact that there is no prime brokerage in the space is one of the biggest problem in the crypto market today. Some would argue that lack of custody solutions is a bigger issue, however that problem is quickly being resolved. The technology for safe crypto custody exists already and many regulated and global financial institutions have announced plans to offer a custodial solution,” Ingargiola explains. “That’s why OTCXN is launching a technology equivalent to prime brokerage comprising a proprietary blockchain network, real-time collateral management of assets on the network and the full suite of trading technologies to support the entire trade-to-settlement lifecycle. This makes it possible for institutional trading firms to keep their assets at custodians of their choice while trading with any other counterparty, liquidity provider or exchange on the network with no trading counterparty or settlement risk. By digitizing the assets held in safekeeping at the custodian, the crypto assets can remain in 100% deep cold storage and trading on the network is safe with no risk of losing assets in the event of the network being hacked. Trading with real-time pre-trade credit checks against blockchain provable assets is far superior to the post-trade-based, fiat only settlement solutions which some are preparing for the market.”

According to Karczewski, however, the biggest barrier to institutional adoption of cryptocurrencies is the reluctance of banks to convert major cryptos like bitcoin, litecoin and ethereum to fiat currencies. “Fortunately, there are some forward-thinking banks, which understand that cryptocurrencies are the future and who also want to participate in this technology revolution,” he adds. “For mass adoption, we strongly believe that major banks must change their attitude towards cryptocurrencies and let their depositors engage in this new asset class.”

Greater regulatory intervention can also be a double-edged sword, Karczewski warns. For example, regulatory changes to crypto trading in Poland forced the biggest exchange in the country to move and several smaller companies to close their operations. On the other hand, without reasonable regulations institutional investors like hedge funds or investment banks will not be willing to enter the market, according to Karczewski. “Governments must work with the crypto market to find solutions that help the industry grow, but which also protect market participants against fraud and misuse,” he adds.

Unetich agrees that this level of greater regulatory clarity is what the markets want first. Even if the regulatory intervention is slightly unfavourable, he argues that certain crypto assets may respond with positive price moves, because uncertainty is worse than many regulatory outcomes. “Intervention would certainly help with marketplace evolution,” he explains. “Every mature market has many components, and a clearly defined regulatory framework is imperative.” Looking ahead, Unetich believes that crypto spot exchanges will continue to become more stable and better able to handle bursts in volume. “High-quality trading user interfaces and exchange aggregators, like Trading Technologies, will become more commonplace as professionals start to enter the market in bigger numbers,” he adds.

Michael Karczewski

Michael Karczewski

“The game changer will be the ability to offer higher leverage which will increase turnover, liquidity, and attract new entrants”

Institutions driving change

Unetich also expects a major FCM or institutional player will ultimately emerge as a full-service provider of execution, clearing and custody. “In turn, the number of crypto exchanges will start to decline as they begin to consolidate through mergers and acquisitions,” he says. But because the market is still very much in its infancy, Nekritin warns against the need for significant regulatory intervention at such an early stage. 
“Regulators need to see where there are truly issues and then act,” he argues. “Right now, the market needs to evolve on its own with minimal intervention.” Going forward, however, he expects even more new tokens will emerge in addition to new token promotion. “More and more HFT and market making shops are providing liquidity offerings, while a lot of payment processors are also starting to use crypto exchanges,” he adds. 

Yet in the US there are currently significant issues around custody services for the crypto market. The SEC requires funds of a certain size to use a qualified custodian, but according to Summerville, big firms also only want big-name, established custodians. 

“Legislation can take a long time in the US, so we’ve heard that some firms are pushing for a no action letter from the SEC so mutual funds etc. have guidelines to follow,” she explains. “Before larger institutions will start using the exchanges, they want much greater regulatory oversight of security practices and how platforms structure their governance etc. to be sure of their resilience.”

As a result, Summerville believes that the first movers will begin to look at non-physically settled contracts such as CFDs, NDFs or listed futures. “Then as more large hedge funds get involved, they are likely to ask the big sell side institutions to provide them with services, so that will help drive it forward,” she adds. “Ultimately, more traditional institutional players are likely to get involved in the crypto space this year.” But Ingargiola also warns that regulatory intervention needs to be “based on a real understanding of some of the new market models that are made possible with blockchain.” Instead, he argues that the most effective way to protect market participants is the solution OTCXN is bringing to the market. “Because our solution is built on a private permissioned blockchain, you have proof mechanisms confirming the existence of the assets at a neutral custodian and full provability of every transaction which can be permissioned for regulatory reporting,” he says. “These things are missing when you trade on a crypto exchange at the moment.” 

Most crypto exchanges only support basic order types
Most crypto exchanges only support basic order types

Market evolution

By approximating prime brokerage functions, he claims that anyone will then be able to access these liquidity pools - as long as those liquidity providers use the network. “FX market knowledge will help to marry real world technology, processes and risk controls with this new world of crypto and digital assets,” according to Ingargiola. “This makes it possible to organize liquidity behind a single high-performance FIX or binary API and make it actionable with assets at any custodian on the network. In addition, the private blockchain layer delivers real-time provability of assets as well as provability of each transaction, both of which are essential features to fund administrators and auditors. Solving these factors is likely to lead to a significant increase in institutional funds flowing into the cryptocurrency markets.”

Karczewski says the crypto trading community can also expect the first ETFs to be created in the coming months, once a traditional exchange has secured regulatory approval. He also believes that some FX MTF/ECN venues will join the crypto space soon, and they will offer either CFDs or spot liquidity on cryptocurrencies. 

“Transparency and accessibility is still one of the biggest hurdles in this market, so if reputable companies participate it will bring a lot of additional credibility,” explains Karczewski. And aside from the move towards institutional finance infrastructure, according to Beardsley, two additional trends are also evolving. Firstly, a subset of centralised exchanges are playing a “very aggressive game” of regulatory arbitrage right now, he observes. At the same time, there is a move towards more decentralised exchanges, which enable trading without having to provide any KYC information, regulatory oversight and so on. “DEXs are developing some very innovative technology and are certainly worth watching in the coming months,” Beardsley concludes. “In fact, the crypto market in general is increasingly resembling the FX market and its infrastructure, while there is also a very strong move towards providing a more institutional type of service.”