Future of Finance


Rising institutional interest in cryptocurrencies could herald the greatest change in financial markets for centuries

There are many reasons why established financial institutions are starting to trade and invest in cryptocurrencies but their interest is certainly driving the development of services which match what they expect to find in the traditional foreign exchange (FX) and securities markets. Substitutes for the traditional means by which counterparty credit and settlement risk are mitigated are already in use. Service providers are seeking regulated status, and commercial law is catching up with day-to-day market realities. Traditional providers need to start thinking about how they can best adapt their existing services to what might turn out to be an epochal form of change.

When the Initial Coin Offering (ICO) bubble burst in 2018, the total value of all the cryptocurrencies in issue was less than US$130 billion. By the Spring of 2021, their value had climbed to US$1.9 trillion.

Institutional interest in cryptocurrencies lacks a supportive infrastructure

One reason for that surge in value was growing institutional interest in the asset class, initially from family offices, high frequency traders and hedge funds, and now from asset managers, through private banks and wealth managers, to corporate treasurers.

The challenge asset managers face is finding liquidity in cryptocurrency markets that are still relatively small, fragmented and capital-intensive because they are bi-lateral rather than centrally cleared.

They also lack price aggregation tools, standard contractual documentation such as the agreements published by the International Swaps and Derivatives Association (ISDA) and even an agreed legal framework.

The cryptocurrency markets are also short of familiar service providers such as clearing brokers and FX prime brokers and central counterparty clearing houses (CCPs) to provide counterparty credit intermediation.

FX prime brokers that are already shrinking the balance sheet they are prepared to make available to asset managers and non-bank liquidity providers (NBLPs) in the fiat currency markets are not enthusiastic about extending their services to the crypto-currency markets.

Counterparty credit and settlement risks create barriers to entry for institutions

This is lumbering institutional firms interested in the asset class with the counterparty credit and settlement risks.

The sheer difficulty of finding counterparties outside the centralised cryptocurrency exchanges and contracting with them safely inevitably deters the less adventurous institutions from entering the markets at all. Instead, they use the cryptocurrency derivatives contracts offered by the CME or invest via funds.

True, there are crypto-exchanges with active market-makers, and many of those market-makers honed their skills in the traditional markets, attracted by arbitrage opportunities they have not seen in traditional markets for years.

But using them entails keeping assets in custody at multiple exchanges and setting up credit lines with market-makers, neither of which appeals to buy-side institutional investors.

Transaction costs and high latency add further deterrents for institutions

Trading directly creates other problems for market-makers: high transaction costs and post-trade inefficiencies of a kind inevitable in a non-cleared market.

The Ethereum blockchain can support 15 transactions a second, with an at-best latency of about 20 seconds. In classical blockchain transactions, latency is around ten minutes. Trading off the blockchain is the obvious answer, but that creates settlement risk.

And as long as the direct crypto-currency trading process remains less efficient and riskier than the trading process in, say, the FX markets (where trades can be agreed instantly and, even if they take two days to settle, the settlement risk is minimal) the asset class will not appeal to institutions.

Lack of regulation is a deterrent and not an enticement for institutions

Even factors that might be thought to increase the appeal of cryptocurrencies are in practice problematic.

Best execution, for example, does not apply to cryptocurrency trading. Unlike FX, where best execution reporting to clients under Regulatory Technical Standards (RTS) 27 and 28 of the second iteration of the Markets in Financial Instruments Directive (MiFID II) apply, cryptocurrency traders face no such obligations. They can also ignore the stipulations of the FX Global Code of Conduct.

Yet it is precisely this lack of regulatory obligations and oversight that remains the insuperable barrier for some institutions.

Like the FX markets, the cryptocurrency markets are not regulated directly (it is – at best – the firms and not the asset class which is regulated). Which is why some cryptoasset custodians (and exchanges) have opted to be regulated.

Cryptocurrency custodial arrangements require institutions to adjust their expectations

However, unlike the FX markets, institutions cannot rely on even a regulated custodian to make them whole if the assets are lost. So safety of funds remains a significant hurdle for institutions. They cannot clear it without making a mental adjustment.

It is the private keys to the assets, not the assets themselves, which are safekept, though some countries (notably Switzerland) are addressing this.

In the short term, however, the practical problem is that private keys are linked to individuals, and this implies self-custody, which institutions must abjure. It therefore necessitates appointment of a third party and tight controls over who can use the keys to transact in the assets.

That much is familiar from the traditional world.

Asset servicing necessitates trust in legally uncertain, changeable and potentially insecure smart contracts

But the way in which assets are serviced could scarcely be more different.

Instead of entitlements being collected by a custodian bank in conjunction with issuers, data vendors, sub-custodians and others, the necessary business logic is simply written into the assets themselves as smart contracts. The assets are, in effect, self-servicing.

To the normal risk of being hacked, this adds the risks of the smart contract being litigated or hacked, and an entitlement stolen.

However, there is an emerging body of law that treats smart contacts not only as evidence that a contract is in place but as having separate legal personalities, with the same obligations as limited liability companies.

The risk of smart contracts proving faulty or being hacked is being covered by insurance products (such as Nexus Mutual) that can replace the balance sheet of a custodian bank. Inevitably, these policies cost less than bank capital.

But smart contracts do create a further risk that is unknown in the traditional markets. This is that code can be changed (usually to upgrade it).

This is not a new risk or necessity – no contract is ever definitive and even paper-based documents must have some means of alteration – but it does require effective governance to determine who is entitled to change the code, because the code is the documentation.

The necessary governance usually takes the form of so-called “proof-of-stake governance,” by which only large holders of a token can change the code.
In theory, large holders have no incentive to make changes to the code which would damage the value of the token, though reliance on material incentives does not eliminate residual risks such as a 51 percent attack through collusion between large holders, insider trading or straightforward defalcations.

The open-source nature of blockchain code is a strength not a weakness

In cryptocurrency trading, security software is also open source instead of proprietary, increasing the number of developers (and hackers) that test it. It is not surprising. Where trust depends on technology, users want as many people as possible looking for bugs.

This is one lesson the traditional markets are likely to absorb. In the long term, open source will probably become the gold standard in security software simply because of the number of people testing its defences.

Literally thousands of developers review and hack the work of their peers, creating a ferocious environment in which any vulnerability is exploited almost instantly.

Tokenisation of assets binds all market participants into a single network of networks that trades 24/7

But enhanced security is not the only benefit.

With the assets tokenised to a blockchain network rather than being marooned in an omnibus account at a custodian bank with privileged access to a central securities depository (CSD), interesting possibilities open up.

Instead of assets and transactional opportunities being scattered across custodians, exchanges and counterparties on separate networks, the blockchain creates a single network that is open for business around the clock.

Most importantly of all, tokenisation overcomes the latency inherent to trading on the blockchain, and the settlement risk associated with trading off the blockchain.

Assets can be put in escrow by an independent custodian and cryptographically proven to be there (as unspent transaction outputs, or UTXOs, to use Bitcoin terminology) and not on loan, or re-hypothecated, or simply bogus.

The linkages between tokens and assets in custody are what make trading possible

A custodian-agnostic technology layer then enables institutions to trade cryptocurrencies in tokenised form from their own custodial account (in practice, a digital wallet) with anyone else who has assets in a custodial account.

With the underlying assets tokenised on to a single network, liquidity can be sourced efficiently from both decentralised counterparties such as DeFi liquidity pools as well as centralised institutions such as crypto exchanges (what are now dubbed CeFi).

Tokenisation eliminates the need for assets to be listed in multiple locations, settled in further locations and moved between custodial accounts. Indeed, tokenisation makes the assets safekept by all custodians available for use by traders.

Tokenisation eliminates settlement risk (including, in this instance, the risk of counterparties selling cryptocurrency which does not exist).

With the assurance that assets are in custody, orders to exchange assets can be matched, cleared and settled in real-time between counterparties on the tokenisation platform.

The amounts that are actually settled are – as with CLS in the FX markets – a tiny fraction of overall trading volumes.

Interestingly, assets in escrow can still earn interest. They are lent through DeFI protocols. This is usually against collateral equivalent to 150 per cent of the amount on loan, to take account of the volatility of cryptocurrency prices.

Efforts are being made to use data to minimise the degree of over-collateralisation by checking the credit quality and asset portfolios of borrowers, and by ring-fencing particular assets for the benefit of the lender.

Collateralised token lending replaces credit intermediation by prime brokers

But the main value of collateralisation is to overcome the trading limits imposed – in the absence of prime brokers – by credit risk.

Tokenised assets can effectively be borrowed intra-day on the blockchain network. By this means, counterparties can ensure that they are always fully funded in time for settlement, in much the same way that stock borrowing is used to avert settlement failure in traditional securities markets.

The effect is to transfer the credit risk to the lenders of cryptocurrency, whose own risk can be collateralised without the need for the underlying assets to be transferred to the custodial account of the lender and cryptocurrency to the custodial account of the borrower.

The benefits of netting are not lost either. Transactions can be netted multi-laterally and underlying assets moved from seller custodial accounts to buyer custodial accounts on the basis of net settlement instructions derived from a cryptographically provable chain of transactions.

In principle, the assets that can be tokenised are not restricted to cryptocurrencies either.

Indeed, the soaring price of Bitcoin – which is driving the surging valuation of the cryptocurrency market – is likely to be less important in the long run than the creativity evident in the DeFi market, where whole new versions of traditional assets and ways of doing things are being designed, launched and tested.

Cryptocurrencies are only the beginning: the next big opportunity is security tokens

Security tokens and non-fungible tokens mainly from physical assets such as fine art, real estate and CryptoKitties, but also non-fungible commercial agreements and contracts, are gradually becoming available for peer- to-peer trading.

Security tokens in particular are likely to be the biggest opportunity, particularly in emerging markets, where blockchain-based networks provide a way around capital controls and currency restrictions.

Security tokens will also become steadily more important in developed markets, as legal, regulatory and infrastructural barriers are cleared and new issues become easier to accomplish (existing issues are unlikely to transition to a tokenised model).

It will be interesting to observe how well the major financial institutions currently servicing the traditional securities markets adapt to tokenisation. They may well encounter infrastructural obstacles of their own making.

For example, global custodians may well be forced to hold security tokens at sub-custodians, simply because their existing systems will not be able to accommodate them, and to reconcile the assets held on decentralised blockchains with their centralised ledgers via SWIFT messages.

But they will have to develop less clumsy services eventually, because major buy-side institutions are entering the cryptocurrency markets already – and the first tokenised debt issues are expected to come to market within one to two years.

If those expectations are fulfilled, the current surge of institutional interest in cryptocurrencies will prove to be the beginning of the greatest revolution in financial markets for hundreds of years.

Written by Dominic Hobson, Co-Founder Future of Finance, April 2021