Evolution and shaping factors: mirroring FX?
Digital assets are already emulating the evolution of FX in the institutional context. Perhaps the main difference is speed, with many commentators expecting the transition to an electronic market for institutional digital assets to be considerably quicker than it was for FX. “For vanilla spot trading of digital assets such as crypto we are already there,” says Lars Holst, CEO and founder of GCEX. “However, for derivative instruments and fractionalisation we may see a period of manual or voice negotiation.”
“I think we could see huge growth in institutional activity over the next three years, because everybody wants a new asset class to be exposed to…”Sanjay Madgavkar
Despite the similarities, an important distinction between digital asset trading and FX is the way that credit and settlement are handled. At present, digital exchange trading is conducted on a pre-fully-funded basis, which is not feasible for long-term sustainable institutional-scale market activity. If an institution wants to trade on ten different venues today, it has to try and predict its notional exposure on each one and pre-fund them all, which is simply untenable. The emergence of specialist credit intermediaries to address this is also potentially problematic, because they are unlikely to want to assume all the operational settlement risk associated with digital assets.
Where we see a lot of similarities between the two markets is the role of intermediaries. “In the OTC FX market, intermediaries like banks and brokers play a critical role of enabling their customers to achieve their business goals – hedging, risk management, or speculation. As these customers enter the digital asset class, banks and brokers need battle-tested workflow automation technology to continue to serve them; this evolution is the driver behind the tremendous demand we are seeing for Integral Digital technology,” says Sanjay Madgavkar, CSO of Integral. A further factor shaping the market is regulation. “Governments and regulators around the world are becoming more focused on developing rules and guidelines to govern digital asset trading,” says Vinay Trivedi, COO of MaxxTrader. “We expect to see increased oversight in areas such as AML/KYC compliance and fraud prevention.”
This regulatory influence will probably also favour the use of standardised derivative products, such as futures, but given their proven utility with hard to settle assets, non-deliverable forwards (NDFs) also look likely to play a part. Some institutions are also trying to create baskets of digital assets that can be traded as an asset class in their own right.
Elsewhere, institutions are already looking for the same sort of full suite prime brokerage services they currently have for FX. Apart from robust clearing infrastructure, significant balance sheet will also be required to support serious institutional volume.
Right platform, right speed
Digital assets are effectively following the inverse of FX’s timeline. In the early days of FX, commercial demand from corporates and asset managers meant that institutional FX activity led the way, with retail activity following later. In the case of digital assets, retail has been the first mover, so as yet there are none of the institutional-grade trading venues found in FX. While there are listed futures contracts available for a few cryptos, institutions are ultimately looking for a far broader range of digital assets with appropriate liquidity and infrastructure resilience.
In the short term, this means that latency is not much of an issue, given the fragmented and retail nature of the industry. However, once institutional traders start moving large volume this will change and (as for FX) the emergence of low-latency connectivity services is likely to have a transformational impact on market access.
Data, analytics and liquidity management
The institutional trading of digital assets will inevitably drive demand for associated data and analytics. As in FX, quants will require data for model building and calibration, risk/compliance functions will need it to monitor exposures, while regulators will want it for monitoring capital ratios. In anticipation of this demand, companies such as GCEX, MaxxTrader and Integral already include comprehensive data and analytics for digital assets in their product offerings.
Analytics and associated technology also have an important role to play if enhanced liquidity management of digital assets is to emulate the efficiencies achieved through flow aggregation in FX. Again, entities servicing this space are already using similar or identical FX technology to achieve this. “Obviously there are some tweaks but it is essentially the same,” says Lars Holst. “Dealing with things such as airdrops makes it a little more complex as they don’t have an exact counterpart in conventional assets.”
Ultimately, proven FX technology – such smart order routing – will provide access to a larger pool of digital asset liquidity, which will make trading more efficient and reduce transaction costs. Coupling this with institutional-grade risk management solutions will also help deliver the requisite stability to an institutional digital asset marketplace.
“Regulators may impose stricter rules on HFT, and market participants will need to adapt their strategies to new liquidity pools and market structures,”Vinay Trivedi
HFT and microstructure
Some institutional market makers are already active in digital assets, typically the same names already prominent in FX. “They already have excellent technology, which is key to their profitability, but they will still need prime brokers because they can’t have trading lines with everybody,” says Sanjay Madgavkar.
Nevertheless, the growth of HFT activity generally will be influenced by various factors, including regulatory oversight, market structure, data quality, and platform security. Some see regulation and analytics having a major influence. “Regulators may impose stricter rules on HFT, and market participants will need to adapt their strategies to new liquidity pools and market structures,” says Vinay Trivedi. “Access to high-quality data and analytics will also be essential if participants are to be able to monitor and maintain profitability.”
A related question is how market microstructure will evolve. At present, it seems probable that it will diversify across OTC and listed venues, plus new platforms catering for specific market segments. However, one reaction to CEFI failures has been growing trading activity on DEFI and P2P networks, which might potentially result in a fragmented market structure. This is not necessarily an insuperable problem if aggregators and SOR providers are able to provide seamless order book access across CEFI and DEFI.
Growth yes, but where?
Rapid growth in the market for institutional digital assets is seen as a given by many participants. “I think we could see huge growth in institutional activity over the next three years, because everybody wants a new asset class to be exposed to, especially as some of the correlations break down,” says Sanjay Madgavkar. “At present, digital assets seem strongly correlated with a “risk on” environment, but ultimately they could become more of a safe haven – especially if inflation continues to rise and there is more government fiscal and monetary uncertainty.”
However, where that growth will concentrate geographically remains an intriguing question. Regulation again appears a strong factor, with many commentators drawing parallels with how regulators have influenced the growth of retail FX trading. Some have found the geography of their business model heavily influenced by the attitude of regulators. “In our case we are focusing on the Gulf Cooperation Council countries, where we find regulators very welcoming and open to business,” says Lars Holst. “For us, Dubai is the hub to south-east Asia and Africa, plus we can hire the necessary talent there. Longer term I definitely think we will see strong growth in Asia.”
Various fundamental factors are seen as key to Asia’s growth potential for institutional digital assets. These include a tech-savvy population, an established financial industry, and supportive regulatory and governmental environments.
This is one reason some do not see digital assets following the same geographic maturity cycle as FX. “APAC is taking a lead over some major developed markets,” says Vinay Trivedi. “This is reflected in broad user adoption, plus new blockchain and tokenization-based use-cases, new ventures, and traded volumes.”
“In our case we are focusing on the Gulf Cooperation Council countries, where we find regulators very welcoming and open to business,”Lars Holst
Conclusion: lessons to learn
The institutional market for digital assets has the opportunity to learn from the mistakes and challenges of both institutional FX and retail digital assets. Robust risk management and settlement procedures, plus the development of scalable solid trading infrastructure are obvious examples.
With necessary adaptation, much of the technology – such as cloud – that is increasingly used in institutional e-FX can be (and is being) redeployed. Elsewhere, best market practices (such as the FX Code of Conduct) can also be imported to improve trust and reduce friction.
However, institutional interest in Digital Assets will also drive the need for significant changes to something that does not have a counterpart in the FX market – the blockchain. Higher capacity and lower cost blockchain technology will be required to support institutional activity generally, but also to facilitate innovation such as the use of smart contracts to support bilateral trading.