The steady growth of professional trading activity in the cryptocurrency markets over the last decade is undeniable but opaque, hard to interpret and full of risks. The experienced traders from the FX and hedge fund markets that dominate cryptocurrency trading have encouraged the emergence of “prime brokerage” services akin to those they have long used in the traditional financial markets. Though there are many suggestive parallels, not least in supporting trading activity across multiple liquidity venues, but there are differences too. It remains to be seen whether cryptocurrency prime brokerage can remain true to the decentralised, un-inintermediated character of the asset class despite the looming prospect of regulation and its long-term reliance on institutional money.
As the cryptocurrency markets recovered from the collapse of the Mt Gox exchange in 2014 one of the most noticeable trends was the steadily growing increase in trading activity. It reflected both the ambition of holders of cryptocurrency to earn a return on their investment other than a rising price, and an influx of professional traders, especially from the hedge fund and FX markets.
Trading is now a distinctive feature of the cryptocurrency markets
In a classic FX “carry” trade, traders borrow in a low interest rate currency and invest the proceeds in a high interest rate one. Profits are also made by buying currencies expected to rise in value and short-selling ones expected to fall. Derivative instruments such as futures, forwards and swaps, and contracts for differences, allow traders to add leverage to their positions.
Professional traders brought these techniques to the cryptocurrency markets, where trading Bitcoin and Ether against the US dollar, for example, could be treated as just another currency pair. The major derivatives exchanges – CME, Eurex and ICE – also listed Bitcoin and Ether futures contracts, drawing into the market institutional money nervous of trading on “native” cryptocurrency exchanges.
Retail trading on centralised cryptocurrency exchanges such as Coinbase, Binance and the now failed FTX surged in 2020-21. Decentralised exchanges (DEXs), which transact on-chain using smart contracts to support trading in un-intermediated “liquidity pools” fuelled with cryptocurrency supplied by liquidity providers, also began to garner a steadily rising share of cryptocurrency transaction volumes.
Traders profited further from staking (pledging cryptocurrency holdings to liquidity pools in the hope of getting paid to validate transactions in proof-of-stake blockchain protocols such as Solana and Cardano, and especially Ethereum 2.0) and lending (lending cryptocurrencies to lending pools such as Aave and Compound that on-lend to other traders in return for interest payments).
To move successfully between these trading opportunities and (highly fragmented) liquidity pools and store profits safely without having to return to fiat currency, traders gave life to a series of Stablecoins linked mainly to the US dollar. The algorithmic variety of Stablecoins even provided a further trading opportunity, since they rely on arbitrageurs to correct movements away from their currency peg.
Cryptocurrency trading is opaque and generates risks
Yet fully understanding exactly how cryptocurrencies are traded, in the absence of serious regulatory obligations and (the publicly listed Coinbase apart) any transparency into the business models and financials of a bewildering variety of intermediaries, is impossible. What is becoming clear now is that a variety of risks built up as cryptocurrency trading burgeoned and evolved in 2020-21.
Most trades depended on unsecured, bi-lateral credit lines between the parties. Client assets held in custody by cryptocurrency exchanges were on the balance sheet of the exchange, exposing them to being seized by creditors if the exchange got into difficulty. Loans of cryptocurrency were not always collateralised and consisted mainly of other cryptocurrencies even when they were.
Centralised and decentralised exchanges offered margin trading, allowing traders to place leveraged bets on the future price of a cryptocurrency. Unlike the traditional markets, the cryptocurrency markets developed no netting capabilities – aggregation of offsetting transactions or positions between counterparties – either. This denied traders economies on capital, liquidity and collateral.
These risks, hidden until the cryptocurrency bear market started in November 2021, came vividly to life in 2022. In June 2022 the cryptocurrency hedge fund Three Arrows failed, its collapse precipitated by the collapse of the Terra algorithmic Stablecoin, to whose sister LUNA tokens (the arbitrage mechanism worked by making Terra exchangeable for LUNA at US$1.00) the fund was exposed.
The collapse of Three Arrows Capital in turn damaged a string of cryptocurrency brokerage platforms and exchanges that it had borrowed from. The cryptocurrency brokerage firm Voyager Digital and a major centralised exchange (FTX) failed, with the collapse of FTX in particular spreading contagion to other firms. The publicly listed and regulated Coinbase has been forced to cut 2,000 jobs.
Yet transaction volumes in major cryptocurrencies have remained surprisingly robust since the crisis began in July 2022 – and not only because of surging sell orders. Since July, the volume of confirmed trades in Bitcoin, for example, has hovered within a narrow range of 200,000 to 300,000 a day even as the declining value of the coin has cut income from ad valorem fees on trades.
Institutional money is still enthusiastic about cryptocurrency trading
So it is demonstrably premature to declare the end of cryptocurrency trading. This is true even of institutional money that has until now largely steered clear of “native” cryptocurrency exchanges of both the centralised and the decentralised kind in favour of trading derivative cryptocurrency instruments and funds on established exchanges such as CME, Eurex and ICE.
A December 2022 survey by Eurex of 191 institutional firms on both the buy-side and the sell-side found only one in three not interested in the cryptocurrency markets at all, and that just one in seven had shelved plans to get involved because of recent events. Of the remaining two thirds, 62 per cent had not changed their plans to get involved, and 21 per cent had actually accelerated them.
That means a residue of less than a fifth of the firms surveyed are deferring engagement in cryptocurrency trading. And the split in favour of firms that prefer trading derivatives on established exchanges (60 per cent of respondents) to spot trading (49 per cent of respondents) or derivatives trading (46 per cent) on cryptocurrency exchanges was not that large either. (1)
1 . Eurex, Digital Asset Trading 2022, December 2022, page 4.
Interestingly, the Eurex survey also shows that trading cryptocurrencies is actually more of a problem for sell-side than buy-side firms, because of the regulatory uncertainty and especially the high capital cost of holding cryptocurrencies on the balance sheet. Recent proposals from the Basel Committee on Banking Supervision attach a 100 per cent capital charge even to holdings that are hedged.
Cryptocurrency prime brokerage services reflect fragmentation of liquidity
The likely buy-side bias in trading does, however, create an opportunity for those sell-side firms that can offer what in traditional markets would be described as a “prime brokerage” service – namely, the ability to execute trades at multiple venues while clearing and settling trades with a single provider, which can also provide safe custody of assets and access to finance to leverage trades.
The Eurex survey duly finds that access to the cryptocurrency markets via a “prime broker/clearing firm” is one change that nearly half respondents expecting to enter the market (48 per cent) now see as a critical challenge. An even larger proportion (61 per cent) emphasise the need for “security of third party crypto custodial services/security of asset custody.”
Which prompts the thought that cryptocurrency traders are now at much the same point in their development as hedge funds were at the time of the 25 January 1994 “no-action” letter of the Securities and Exchange Commission (SEC) that allowed cash trades executed by hedge funds with executing brokers to be “given up” to a prime broker for clearing and settlement.
The SEC “no-action” letter of January 1994 is often seen as the foundation document of the classic prime brokerage industry because it enabled prime brokers to extend margin loan credit to hedge funds above the regulatory limit set by the longstanding Regulation T, according to which credit advanced by brokers to customers could not exceed 50 per cent of the value of securities purchased.
In a system in which hedge funds rely on (prime) brokers to settle their trades with executing brokers without fully funding the trades, the extension of credit inevitably risked violating Reg T. The SEC decision to look the other way initiated a process by which the manufacture of credit to support trading positions gradually came to outweigh the clearing, settlement and custody of trades.
Suggestive parallels between traditional prime brokerage and crypto prime brokerage
By 2007, when the great financial crisis began, aggregate leverage in the hedge fund industry was 3½ times the net asset value (NAV) of funds. By then, margin loans made up perhaps a fifth of the financing hedge funds sourced through prime brokers. A third was raised synthetically, via margin-based instruments such as contracts for differences and Total Return Swaps (TRS).
But at least half came from repo transactions. In fact, the prime brokers themselves became heavily dependent on daily repo transactions with cash-rich banks and money market funds. Client assets were freely used (“rehypothecated”) to fund the investment banks not just in repo transactions but in reverse repo (or securities lending) and collateral upgrade transactions as well.
This was the system found out in 2007, when the commercial bank money repo market closed and had to be replaced by central bank money. At Bear Stearns, for example, the repo desk was borrowing US$75 billion a day. “It’s of course insane,” as Paul Friedman, COO of the fixed income division at Bear Stearns later put it. “In the normal world it would be insane, and in this world it’s really insane.” (2)
2 .William D. Cohan, House of Cards: How Wall Street’s Gamblers Broke Capitalism, 2009, page 32.
Cryptocurrency credit manufacturing has yet to be certified insane. But the sell-side of the cryptocurrency markets has now reached a point at which its proposition is evolving into something akin to what traditional prime brokerage became in 1994. Back then, hedge fund managers wanted to trade with multiple venues but clear and settle the trades using the creditworthiness of only one.
Likewise, trading successfully in cryptocurrency markets depends on accessing liquidity in multiple locations: cryptocurrency exchanges, over-the-counter (OTC) brokers or brokerage platforms, market-makers and even directly at other buy-side firms. Traders want to avoid the need to fully fund every blockchain settlement and skip the costs and delays of settling directly on underlying blockchains.
Which is why a variety of firms providing “prime brokerage” to participants in the cryptocurrency markets (see Table 1) have two things in common. First, to earn the title of “prime” at all they offer access to multiple trading venues. Secondly, they offer clearing and settlement services that do not have to be fully funded – in other words, they offer credit just as prime brokers did from 1994.
A Selection of Institutional “Prime Brokerage” Offerings
|Name: Anchorage Digital Institution type: National trust bank chartered by the Office of the Comptroller of the Currency (OCC)||Best execution agency brokerage at multiple venues without pre-funding, staking services, lending and borrowing services, reporting, exercise of rights in governance tokens, in-house custody|
|Name: BEQUANT Institution type: Cryptocurrency exchange||Direct access to a list of 18 cryptocurrency spot and derivative exchanges, margin finance and collateral management services, intermediated access for block trades and in-house custody with BEQUANT Exchange (though the firm will support independent custodians soon).|
|Name: Bosonic Cross-Custodian Net Settlement (CCNS) Institution type: Technology vendor||The service enables users to keep their digital assets in custody with members of a network of c. 30 independent custodians (including First Digital in Hong Kong, Terra Trust in Canada and Vast Bank in the US) which can tokenise them to a blockchain-based network where trades on multiple venues can be netted and settled atomically between the custodian banks using smart contracts|
|Name: Coinbase Prime Institution type: Cryptocurrency exchange||Trading algorithms, automatic order-routing to spot and derivative multiple venues, efficient transfer of digital assets between trading on Coinbase Exchange and in-house custody at Coinbase Custody Trust Company, data, reporting, staking infrastructure and services and financing|
|Name: Copper Institution type: Independent digital asset custodian||Users can trade digital assets on-chain within a “walled garden” made up of 60 white-listed cryptocurrency exchanges or with a smaller set of exchanges with assets remaining in custody at Copper (ClearLoop) but “delegated” to the exchanges, with trades settled post-execution and exchanges always remaining the counterparty, plus staking services|
|Name: Falcon X Prime Offering Institution type: Trading, credit and clearing platform||Automatic order-routing to multiple spot and exchange-traded and OTC crypto derivative venues with FalconX as counterparty, staking services, cross-margining (via FalconX 360) and reporting, with a custody service in development|
|Name: Floating Point Group Institution type: Agency broker||Agency brokerage for cryptocurrency execution at multiple venues using trading algorithms to achieve better execution, plus a digital wallet for custody and integrated staking and lending and borrowing services for DeFi applications via a MetaMask Institutional wallet|
|Name: Galaxy Institution type: Platform covering trading, asset management, investment banking, mining, research and venture capital||Access to a network of cryptocurrency exchanges and market makers through an electronic OTC desk plus margin and other forms of lending against cryptocurrency collateral|
|Name: Genesis Prime Institution type: Market-maker and custodian||Cryptocurrency market maker offering two-way prices for execution of cryptocurrency spot and exchange-traded and OTC derivatives, borrowing and lending of cryptocurrencies, always facing Genesis as the counterparty, plus in-house custody and reporting|
|Name: TP ICAP Digital Assets Platform Institution type: Inter-dealer broker||Execution of cryptocurrency (Bitcoin, Ether, US dollar only) and exchange-traded cryptocurrency funds and derivatives via voice broking or electronic trading via the Fusion Digital Assets platform, settlement of crypto derivatives at CME, Eurex and ICE and settlement and custody of spot trades at a closed network of independent custodians (initially with Fidelity Digital Assets though BitGo, Komainu and Zodia Custody have also been linked with the TP ICAP service)|
The importance of custody to cryptocurrency prime brokerage services
But the most telling common feature is a safe custody service. Institutional money values reassurance that assets will be kept safely. Indeed, in the instance of American asset managers, institutional money must (under the Investment Company Act of 1940) use a “qualified custodian” (a “Bitlicense” from the New York State Department of Financial Services is the commonest form of qualification).
The custody offerings are not always independent, though independence matters. In 2008, following the failures of Bear Stearns and Lehman Brothers there was a flight of assets to bank-owned prime brokers and independent global custodian banks which stand-alone investment banks such as Goldman Sachs and Morgan Stanley countered by establishing ring-fenced custodian businesses.
It also turned out that hedge fund managers which custodied assets with American broker-dealers in the United States were better off than those which used banks in other jurisdictions, such as London. That was because their assets were ring-fenced from creditors (under SEC customer protection Rule 15c3-3) and insured (by the Securities Investor Protection Corporation).
Though custody in cryptocurrency prime brokerage is sometimes independent(as in the case of TP ICAP) and sometimes not (Anchorage Digital, Coinbase and Genesis) it is in every case at the heart of the prime brokerage offering. This is obvious in those cases (such as Bosonic and Copper) where assets are tokenised or delegated within secure networks by custodians instead of moved.
The value of delegating or tokenising assets-in-custody
Delegation or tokenisation within networks of white-listed liquidity venues and custodians solves operational problems such as needing to be fully funded on blockchain networks and the high costs and slow speeds of settlement on blockchain protocols. It also minimises counterparty credit and cyber-security risks. It creates room for transactions between members of the network to be netted.
Though cryptocurrency prime brokerage is still hard to define, the model likeliest to survive is one in which institutional firms trade within secure networks of approved counterparts, delegating (or tokenising) assets in custody rather than moving them and settling trades on Blockchain Layer 2 applications before they are booked to the underlying Layer 1 blockchain protocol.
A crucial aspect of the service is helping users avoid the need to be fully funded when settling transactions on blockchain protocols. Institutional firms trading on multiple liquidity venues cannot afford to be fully pre-funded on every single one in order to settle every trade (slowly and at high cost) on the underlying blockchain protocol “atomically.”
In classic blockchain transactions, traders must settle in full, which places expensive demands on capital and liquidity. In traditional financial markets, on the other hand, an old-fashioned prime broker would enable traders to offset long and short positions in exchange for a net margin charge. Cryptocurrency prime brokers understand this and are developing forms of netting.
Prime brokerage in the cryptocurrency markets is a work-in-progress
But is this actually “prime brokerage”? Yes, in the sense that buy-side firms are using multiple execution venues with trades cleared and settled through a single entity (a “prime” broker) which custodies digital assets and makes margin loans against them. But also not yet, in the sense that the industry has limited capital and has still to settle on a standardised modus operandi.
Regulation encourages standardisation, but is absent here, save the NYDFS “Bitlicenses” and bank charters obtained by some providers and patchily enforced obligations to avoid doing business with financial criminals. In 1994 the SEC adopted a hands-off approach, but the investment banks were at least fully regulated. In cryptocurrencies, a more hands-on approach is probably warranted.
What form regulation might take is hard to predict. Cryptocurrency regulation in general has focused on regulating cryptocurrency marketing, financial crime, funds and derivatives because these represent the biggest threats to (especially retail) investors and financial stability. It is reasonable to suppose regulatory priorities will be the same in prime brokerage – possibly plus capital requirements.
Either way, regulation might help existing cryptocurrency prime brokers. Without regulation, banks will be wary of offering services, or acquiring existing providers. That in turn will continue to deter the more cautious forms of institutional money from engaging in cryptocurrency markets, where familiar names are largely absent and the trading and operational infrastructure remains immature.
Cryptocurrency prime brokerage mirrors this immaturity. Its current structure is the outcome of a medley of infrastructural work-arounds and entrepreneurial initiatives and adaptations in a near- unregulated environment in which roles – investing, trading, execution, clearing, settlement, custody, financing, even venture capital – are blurred, within as well as between institutions.
An unknown is whether the ironic corollary of cryptocurrency prime brokerage – that an industry founded on the principle of decentralisation is solving its trading problems by rediscovering centralised intermediaries – remains just an irony, or whether those blurred roles can be transformed into smart contracts or some other algorithm that fulfils the function without the form.
A conservative view is that, if cryptocurrency prime brokers are to survive the tightening regulation of their markets, they will need better defined roles and more capital. To grow beyond cryptocurrencies and embrace their likely future of tokenised securities and funds, a more standardised, transparent, regulated, better capitalised and comprehensible crypto-prime brokerage will need to emerge.
The alternative is a hybrid of decentralisation where possible and centralisation where necessary. But ultimately what will determine the future shape of cryptocurrency prime brokerage is two forces. The first is the demands institutional investors make of trading firms and service providers. The second is what regulators decide is consistent with investor protection and financial stability.