A transcript of the Future of Finance interview with Alex Smith, crypto product lead at SIX Digital Exchange.
Dominic Hobson 00.13: Hello, I’m Dominic Hobson, co-founder of Future of Finance. My guest today is Alex Smith, crypto product lead at SIX Digital Exchange, SDX, which is developing a cryptocurrency staking service to enable holders of cryptocurrencies to earn an income from their portfolios. Alex, thanks for joining us.
Alex Smith 00.33: Thank you, Dominic. It’s a pleasure to be here.
00.36: The service SDX is offering enables holders of crypto-currencies to pledge them on the Ethereum network and so earn income by claiming rewards on the staked Ether for running software that validates or attests (i.e., checks) blocks of transactions under the Proof-of-Stake model. But what exactly is SDX doing for clients? Is SDX running validator nodes for clients?
Dominic Hobson 00:36: Now, let’s talk about the service you’re offering. It is going to enable, as I said a minute ago, holders of cryptocurrencies to pledge them on the Ethereum network, and so earn income by claiming rewards in the normal fashion on the staked Ether for running software that validates or a tests, i.e., checks blocks of transactions under the Proof-of-Stake model. But what exactly are you going to be doing for your clients? Are you’re going to be running the nodes for them or doing something else?
Alex Smith 01.06: Yeah, that’s absolutely right. We want to get into the staking business. And to do that the best opportunity, or the path of least resistance for us, is to provide infrastructure and that infrastructure is running validator notes, Ethereum being the first and the biggest network that we want to get into. So, yeah, so we’re keeping it very vanilla to start with. We are just running the nodes. We’re not looking into custody and broader crypto services. And that’s what we want to offer the clients. So the clients that hold Ethereum can use SDX infrastructure to stake or pledge their assets and earn rewards or yield in return.
Dominic Hobson 01:51: Now, validation, attestation … these are high volume, historically high volume and low margin businesses. So how hard is it for you – I’m talking here in the technical sense – to run the systems and processes as an intermediary at the required speed and scale?
Alex Smith 02:10: It is technically difficult. It does require technical expertise. It requires running validator nodes, the beacon node, but also the execution node. So there are three different types of nodes that we have to run on the Ethereum mainnet now. Not only that, we’ve also set up and prepared a number of test environments as well. So we’re running the [inaudible] network. We’re running Testnet as well. So these layer environments are all set up in order to support on-boarding of clients so they can test the integration. So yes, there’s a whole tech stack and team of engineers behind this that we will support clients [with]. So we will facilitate this and make it a lot easier for them to enter this market and to stake their assets.
Dominic Hobson 03:00: Now, in order for this to make sense for you, as well as the clients, you clearly need to build up scale and transaction volumes. How are you planning to do that?
Alex Smith 03:11: Yeah, we’re using Cloud. We wanted to be Cloud-native with this. We have also decided to fully automate the operations here. So when a client comes along, it’s going to be hands-off for SDX. The nodes will automatically spin up. So we will build it; we will be able to generate thousands of nodes in a day if we so wish. So we will be able to scale very quickly. The scaling was a primary objective for us when we went into this, knowing that a lot of the institutional clients we know hold significant volumes of Ether on Ethereum. And in order for them to stake, they need to be able to fully automate this process without having to interact with an operator. So, yes, that has been one of the primary objectives here. And hopefully this, this will facilitate not only a lot of clients on-boarding, but to be able to run the network for the Swiss clients.
Dominic Hobson 04:14: You said a minute ago that your initial focus will be on the Ethereum protocol That makes sense. It seems to be what your clients hold as well. But are you planning to extend this service to cover other protocols? We’re going to be talking about doing this on Polkadot and Cardano and others in the future?
Alex Smith 04:30: Yes, absolutely. So Polkadot, Cardano, Avalanche, these are three that we’re looking at now. What’s given us pause for thought, though, is the Terra Luna collapse. Terra Luna was on the list until a short while ago, but the complete collapse of that eco-system has made us think twice about how we choose and select new coins or new tokens. So we certainly don’t want to go down the avenue of offering staking services to coins that have got fragility in their eco-system. So we are now building a framework and a set of principles that we can use – that we that we can show that we have significant audits around how we choose and move forward with the next cryptos.
05.20: One risk created by this source of income is paying penalties (“slashing”) exacted by the network(s) for malicious behaviour, validating blocks on the wrong chain or falling behind the network so validations fall out of sync because of congestion – and yet clients will want to maximise their earnings. How will SDX balance the risk of maximising client earnings and mitigating the client risk of getting “slashed”?
Dominic Hobson 05.20: Fragility is obviously one risk. But another risk created by this source of income is the paying of penalties, so-called `slashing,’ which is exacted by these networks for untoward behaviour or validating blocks on the wrong chain or falling behind the network so the validations fall out of sync – you kind of get a congestion effect. Yet the clients are going to want to be maximising their earnings. How do you balance that risk of them maximising their earnings, while mitigating the risk of them getting slashed?
Alex Smith 05:50: Yeah, there’s a couple of things we can do here. And maybe it’s worth a few words around the difference between slashing and penalties. So slashing is put in place to prevent malicious actors from trying to subvert the network. Penalties are there in the form of reduced reward. So if your validator is offline, if you’re not able to attest to produce blocks, you will get penalised for that. So two different concepts have been built into the Ethereum protocol. Now, but along with that, we can provide technical solutions to mitigate against slashing, so we can put in slashing protection. And also with penalties, we can build in redundancy to the Cloud solution – so we can have failover. If a node goes down, we can have another one spin up. So there’s a number of services and technical solutions we can build in to prevent the slashing and penalties. But, on top of that, we can also offer insurance. We wouldn’t offer insurance ourselves as SDX but an insurance premium on or provision from a third-party insurance provider is something else that I know a lot of institutional clients are after and they’re looking for. So I think you’ve got those two different angles to come from.
Dominic Hobson 07:04: This is a world full of neologisms, and `tokenomics’ is one of the neologisms which has crept into use here. I think of it in terms of the financial incentives people have to do anything. Are the financial incentives to get involved in this new staking service powerful enough, especially given what’s happened in the market the last few months?
Alex Smith 07:26: Yeah, look, tokenomics is a fascinating subject. And you’re absolutely right, the incentives have to be there to make it worthwhile or commercially worthwhile to even operate and run the hardware. Operating the hardware, using a Cloud service, having the team around it and the test networks, doesn’t come for free. So it is important that the incentives make sense. You know, there’s a number of different levers here as well. We have to consider inflation, the burning of assets, but also the minting of tokens. I think there’s the underlying asset price that you rightly pointed out. I mean, there is a price point under which staking service or hosting services themselves will no longer become profitable. What happens then? And I think we’re seeing some of the Bitcoin mining providers starting to run into trouble with the price of Bitcoin falling. So yes, the tokenomics is an essential facet here for it to work. And then, you know, obviously, the governance as well comes into play.
Dominic Hobson 08:39: Now you’ve been very clear this is a staking service. This is about the validation, attestation process. Have you been tempted ever to go further? And maybe now’s not the right time to be thinking about this, but have you been tempted in the past to go further and actually help clients lend their cryptocurrency into DeFi [Decentralised Finance] protocols as well?
Alex Smith 08.57: So DeFi is an area that we are internally discussing, we are actively looking at. Is it something that we’re going to get into tomorrow? Probably not. Is it more a sort of a two-to-four-year time horizon? Potentially. So certainly, there’s a lot of activity. DeFi tends to be for the crypto natives at the moment. What we are looking at, though, is custody. Custody is going to be the next avenue and the next platform for us to move into once we’ve got the infrastructure services and the staking provision up and running. And we’re comfortable with that.
09.36 The service is non-custodial, which is counter-intuitive for a group with three CSDs and an international custody network. What explains the SDX decision to leave custody arrangements to the users?
Dominic Hobson 09.36: I was about to ask you about custody, actually, because the service is – you’re implying there – initially non-custodial, which struck me as counter-intuitive for, you know, part of a Swiss stock exchange group which has got three CSDs [central securities depositories] inside it. It’s also got an international sub-custody network. So what was your thinking about, at least at the initial stage, about leaving the custody arrangements to the users as opposed to providing them with that service as well? What was your thought process there?
Alex Smith 10.04: The staking in the infrastructure provisioning is just a beachhead. So with it SIX and SDX, or SIX particularly, having a rich history as a financial market infrastructure provider, we have a lot of expertise and technical know-how in provisioning the hardware and running the networks, so it just made a lot of sense for us as quite an easy move into this crypto space just to focus on the infrastructure. And that is running the nodes, operating the nodes, for asset holders. So you’re absolutely right. Do we want to get into custody? Yes, we do. Are there a few more barriers to get there? Yes, there are. So this was really just a [case of] looking at the roadmap of what do we do first, where does our expertise lie? What can we get into first? And what will come later? So watch this space, Dominic, because, you know, custody will be coming along later this year.
Dominic Hobson 11.05: And has your modified thinking about the custody side arisen from conversations with potential clients? When you got to talk to them about this service, did they say, `Well, we love your infrastructure. But why aren’t you giving us a wallet or custody service as well? We’d be ready to on-board with you if you provided that service.’ What have those conversations been like?
Alex Smith 11:26: That’s it. There’s there is a requirement or there has been demand for custody service and custody provisioning. You’re also right to point out that SIX has been a custodian, so this is an area that we also have expertise in. We’ve got a rich history of doing this. So it’s something that is a natural fit for for building out this service and moving forward not only with staking infrastructure, but also custody.
Dominic Hobson 11:57: Now what about the documentation of these relationships? Do you have a sort of standard document drawn up which a client can sign and then you on-board them quite quickly or do all of these have to be bespoked to each client?
Alex Smith 12:09: No. We have we we’ve drafted up a standard set of legal terms. We’ve standardised it as far as we can. The on-boarding of new clients should be very easy. Certainly, we hope so. Again, leveraging the expertise that we’ve got in-house. Knowing that, look, we’re not the first movers in this space. There’s a number of crypto-infrastructure providers already. So we are moving into a slightly busy market here. But we do think that we have got a value-add and a value proposition.
Dominic Hobson 12.44:One regulatory issue which we often forget when we talk about cryptocurrency and say it’s unregulated is actually cryptocurrency is subject to the Know Your Client (KYC) Anti Money Laundering (AML), Countering the Financing of Terrorism (CFT) and sanctions, screening checks laid down by the Financial Action Task Force (FATF). How are you handling that when you on-board clients? Are you running those checks yourselves or are you relying on a third-party?
Alex Smith 13:12: Yeah, we are running the due diligence. We will run the due diligence on the banks. It is worth pointing out at this point that this is a business-to-business operation. We’re not going to be going to retail customers here. We will be starting to service Swiss banking clients. They will go through the standard due diligence processes that they have to. We won’t, however, be doing due diligence on the end-clients of those banks. So that’s the process that we’re taking. Now, one point that’s worth highlighting as well is that we want to go one step further with this and we want to perform token checks on the assets that are being held in the wallets of those clients. So we do want to check for tainted assets. We do want to make sure that they’re not tainted, and they’re not being flagged up. So for that purpose, we will be using a third-party provider. Yes, so we have got this this eco-system support to make sure we abide by FINMA [the Swiss Financial Market Supervisory Authority].
Dominic Hobson 14:18: So just to be clear on that point, you will be running these customer due diligence checks on the private banks who you will be interfacing with but you will not be running customer due diligence checks on their customers – you’re in effect trusting them to introduce reputable people. But you will be looking inside those underlying customers’ wallets to make sure they’re not holding something which is untoward?
Alex Smith 14:42: Yes, exactly.
14.45 Will SDX also do due diligence on the wallet providers and custodians clients use? How will SDX manage the risk of allowing clients to choose their own providers? Are any providers off-limits for SDX?
Dominic Hobson 14:45: What about the … Because you’re not providing a customer service up-front, are you going to have to do customer due diligence on the wallet providers which the users or the custodians which the users use in the in the first instance? Do you have a sort of shortlist there of wallet providers and custodians you don’t like the look of?
Alex Smith 15:06: This is an interesting one. So we’ve got … Yes, we will be doing token checks on those – the wallets – the custody providers, probably less so. Although a lot of the clients that we have been speaking to – prospective clients that we’ve been speaking to – there’s a huge array of different custody solutions out there. They vary wildly in how they operate and how we would integrate with them. So that just adds a layer of complexity for us. There isn’t a one-size-fits-all here. We are having to speak to individual banks and understand that their set-up and how they would potentially integrate. Yeah, so that that is a difficult integration point for us. And something that is not maybe as easy as some people would first think.
16.01 How difficult is it to give clients who retain the assets and private keys and run their own wallets access to a node-operating infrastructure – would it be easier for SDX if it provided a full service including custody?
Dominic Hobson 16:01: And how difficult is it going to be to do that due diligence, peering into people’s digital wallets, see what they’ve got in there when actually you’re not providing the customer service yet? So they retain the assets, they retain the private keys, and they’re kind of running their own access to the nodes that you’re providing. It’d be a lot easier if you were providing the custody service. Is this a major obstacle for you – doing the customer due diligence at this point before you provide a custody service?
Alex Smith 16:31: I’m hoping not. The beauty of blockchain is it’s all on the blockchain so we can see the wallet addresses on the blockchain. We can use third-party providers to help us examine those tokens that are being held there. Have they gone through any illicit activity? Have they been tainted in any way? So we are pretty confident with the third parties that we’re using. We’re pretty confident that we are able to look at the addresses and examine the tokens; make sure that there’s been no money laundering or other tainted activity there. So, at the moment, no obstacle. In fact, if anything, you know, being able to rely on the fundamentals of blockchain, the fact that it is public, we do have access and we can view this. That keeps the pure infrastructure play that we’re looking at right now: segregated, separate and actually quite easy for us to manage.
Dominic Hobson 17.31: Now you’ve got all these private banks as clients. To deliver the service efficiently to them, you’re going to have to hook up to their internal systems in some fashion. How difficult, how heavy is the workload going to be, to actually accomplish that. Is this a very light implementation or is it going to be heavy engineering project?
Alex Smith 17.52: The integration we have found so far is reasonably heavy, right? Like I was saying, there’s so many different custody providers. They’ve all got slightly different solutions. Some don’t operate with certain test networks. Others have got very difficult integration with Ethereum smart contracts. Some have got very heavy security. So none of this is very easy at the moment. I think if we’re looking at the areas in the crypto or Web 3.0 eco-system that need work, it is going to be around inter-operability and useability. I think a lot of people that are in this space and work with cryptocurrencies can probably attest that the useability of wallets is not always easy. It’s certainly not standardised. It’s not always easy, and it’s not very intuitive. So these are areas that, yes, are difficult for us to work through, that we’re having to put it put effort into, [to] help standardise and align for our own internal purposes.
Dominic Hobson 18:54: And as you complete that integration, you are, of course, part of a stock exchange. And most, if not all, of these private banks you’re dealing with will have some sort of relationship with the stock exchange already. So there is presumably technical connectivity and account structures in place already. Are those any help to you, as you tried to integrate this new type of service with those clients?
Alex Smith 19:19: The tech stack that we’ve built is completely separate from, it’s isolated from SDX, it’s isolated from SIX. We are dealing with the public blockchain here, so we’ve made very conscious decisions to run a Cloud instance and a Cloud subscription, separate, completely independent tech stack. So in that respect, it’s all new. It’s all completely segregated. Is it an advantage working at SIX and having access to a lot of the SIX eco-system? Yes, absolutely it is. So we’re trying to benefit from the expertise that we’ve developed over decades at SIX, and also having the deep networks we’ve got within Switzerland.
Dominic Hobson 20:04: As you’ve said more than more than once this is a Cloud-based service. You’ve been pretty clear about what the advantages of that are. Is there a downside to the Cloud? And I’m thinking, `What if the Cloud provider falls over?’ The regulators seem to be taking more and more interest in in Cloud provision by financial institutions. Is there a downside to reliance on the Cloud?
Alex Smith 20.28: There’s a risk assessment in both directions, right? So we’ve examined the pros and cons. Cloud will provide regional redundancy. Cloud makes it a lot easier for us to scale. So we certainly think the benefits of using Cloud far exceed using bare metal and starting to run this separately ourselves. We’re also hoping it’s going to be a lot more cost-efficient as well. So, yeah, we’ve examined the risks, realising that they do exist. But we certainly think the benefits that Cloud brings us are worthwhile.
Dominic Hobson 21.07: Now SDX represents a substantial investment by the Swiss Stock Exchange, in the, not so much in the cryptocurrency markets as in the security token markets, in providing issuance, trading, settlement, custody services to those markets, which are not growing at a particularly high rate. I think I’m right to say that cryptocurrency wasn’t an initial focus of SDX but, clearly, you have now identified it as a service you want to provide. What were the attractions? I guess when you first started thinking about this, the cryptocurrency markets were a different place to where they are now, and so there’s a short-term but also a long-term strategy at work here. In crude terms, what really attracted SDX to providing this cryptocurrency service in the first place?
Alex Smith 22:00: I think that there’s two things that stand out. The first is client demand and then the second is the opportunity in this area. I think we’ve been listening to clients. We recognise that Switzerland has generated an eco-system that is very crypto and Web 3.0 service friendly. There is a lot of business in Switzerland and FinTechs. The environment there has been very positive. So, from one angle, we’ve got the client demand. We know that there are asset holders there and they would like somebody at an institution like SDX to enter this market. And, secondly, it’s the opportunity. Looking at the crypto space, seeing the FinTechs that are growing, the opportunities that they’re presenting, it just makes sense that we are we enter this, that we are part of this, that the narrative and the story as it plays out, and crypto becomes a bigger industry and a bigger asset class, not only in Switzerland, but it will be want to look beyond in Europe and the UK as well.
23.09 SIX Group services a lot of Swiss (and foreign) private banks, and it is the clients of the private banks in Switzerland that are driving interest in crypto-currency services. Will SDX be restricting its service to Swiss private banking markets or will it become a global service?
Dominic Hobson 23.09: And as you say, the demand is driven by the clients of these private banks that you’re servicing based, mainly I think you’re saying, in Switzerland, or is this service aimed at foreign, out-of-Switzerland private banks as well? You’re not discriminating in favour of Swiss private banks – this is open to any private bank that you like the look of on the planet Earth?
Alex Smith 23:31: We’re focusing on the Swiss market at the moment. That is our initial platform to enter this space. The reasons being, we know this market well; we have strong and existing relationships in Switzerland; and, also, we are a lot more comfortable with the legal and regulatory framework in Switzerland. So again, just as an ease of entering, as a beachhead into this market, operating within familiar frameworks where we have the expertise, is going to allow us to move fast and hopefully draw conclusions and make this a success. But yeah, in the longer term, you know, we’re certainly not going to just restrict this to Switzerland.
Dominic Hobson 24:18: And is it only banks that you foresee as clients or [do you expect to service] other potential non-bank users of the service, as you look forward?
Alex Smith 24:25: The banks are the first segment that we’re looking at. But I do well to point out that you’ve got crypto native hedge funds. You’ve potentially got further down the line sovereign wealth funds. So there are a lot of institutions that we may consider in the future – you know, family offices, high net worth individuals, so certainly the spectrum will increase, but our target, our segment that we’re really interested in at the moment, is the banks.
Dominic Hobson 24:57: One of the things I’m hearing you say is that, in fact, these private banks came to SDX, saying we’d like you to provide this service. Now, why were they coming to SDX to ask you to service their needs when they could have gone to Coinbase Cloud or, or Block Daemon? What was the attraction you offered relative to those other potential providers?
Alex Smith 25:20: A few things. We’re a Swiss firm. We run the infrastructure in Switzerland. So it’s hosted there. There’s not this point of operating in a completely different jurisdiction. The oversight is with FINMA. We’ve been on this journey with FINMA as well from the start, so they’re aware of what we’re doing. So I think for a number of reasons – the Swiss focus, the Swiss legal framework, and the Swiss regulatory oversight – provides a level of familiarity and comfort for the existing Swiss banks. And that’s certainly something that, like I mentioned, you know, we’ve got the knowledge there, we’ve got the experience and the expertise. And I think that’s proved attractive.
Dominic Hobson 26:15: And was what I might call `cybersecurity’ part of their thinking as well? It’s not just a solid institution with a with a good reputation, but it’s a safe environment for them too?
Alex Smith 26:27: Absolutely. Cybersecurity is a huge thing. So part of the risk assessment, the operational risk assessment, we’ve been through is identifying the different cyber risks [and] relaying to FINMA where we see these risks, as well, obviously, as relaying to the clients what we’re doing to try and address these risks. But yeah, you’re absolutely right that this is a big part of it. And we have got a good degree of confidence that the security that we put in place, the firewalls and the network protection, are adequate and are best-in-class.
27.05 SDX is setting up a separate entity to host the crypto-currency service. What are the arguments for placing the business into a separate entity from SDX’s point of view and from the client’s point of view?
Dominic Hobson 27:05: You said much earlier in this in this conversation that you’re setting the service up inside a separate entity, which will host the cryptocurrency staking service. But what are the arguments for putting the business into a separate entity (a) from the point of view of SDX but, secondly, and perhaps more importantly, from the client point of view?
Alex Smith 27:24: One of the strong drivers is that SDX is a regulated entity running the CSD [of the] exchange. Now, if we were to start running a crypto or staking business within that it is going to completely change the terms and the agreements that we’ve discussed with FINMA. So we would have to go through that process again, change the agreements and the arrangements that we’ve already got set up. So with staking being a non-regulated business, it makes a lot of sense to run this in a separate crypto, Web 3.0 entity, which is what we’re doing. So, from our perspective, it seems to make a lot of sense. On the client side, they can also use a non-regulated entity for lower barrier and lower requirements to using the services as well.
Dominic Hobson 28.18:So, in effect, you’re in a different regulatory environment to SDX as a whole?
Alex Smith 28:28: Right. That’s right, yeah.
Dominic Hobson 28.31: Now, where have you got to in terms of developing the service? You’ve got the entity set up; you’ve got the systems tested; you’ve got clients signed up; you’re ready to go. And if you are ready to go, when do you expect to go live?
Alex Smith 28.46:Well, the good news, Dominic, is that we are already live. We went live actually back in April. And we launched our first validator node in May. So we’ve now been running our first validator node for some time. With that, we’re obviously also running the execution node on the Ethereum mainnet, as we are with the beacon node. So technically we’re fully live, we’re fully ready, we’re operating nodes. Legally, we’re ready, we’ve got the terms all set up. And we’re in some advanced discussions with some Swiss banks as well in provisioning staking infrastructure for them. So we’ve made pretty good progress in the last couple of months.
Dominic Hobson 29:29: Now, assuming the service grows and scales as quickly as you’d like it to do, and becomes profitable, have you had time to think yet about what additional services you might like to develop? You’ve mentioned you’re going to provide custody, which wasn’t in the initial spec, but are there other services you’re thinking about providing in the future?
Alex Smith 29:49: A couple of things that we’ve touched on, and you just mentioned this – the crypto custody – there are the other tokens that we want to look at. I think there are the crypto yield products as well. You may have clients that want exposure to the yield and rewards offered by cryptocurrencies but they don’t necessarily want to hold the underlying asset themselves. So that is some ideas for a bit further down the line. Other infrastructure provisioning as well, across the crypto network. I think there’s the concept of Oracle nodes as well, that provide data for smart contracts. So, really, there’s quite a broad a broad spectrum of what to look at. And there’s a product roadmap that’s potentially spanning a number of years. So, yeah, and I think right at the start you mentioned DeFi. That’s something that we’ve looked at, and not actively exploring right now, but that’s certainly there. And NFTs. You know, really, there’s a buffet of opportunities here. And it’s just a case of how we navigate and where we see the client demand.
Dominic Hobson 31.05:One final question for you, Alex. It’s more of a personal one. I don’t know whether you’re surprised to find yourself at the Swiss Stock Exchange, heading up a cryptocurrency staking service. But what’s your own blockchain story been? I know you were involved with blockchain quite early on at UBS back in in 2014-2015. But as you look back over the last six, seven, eight years, is there a clear path you’ve been navigating on your journey towards this point? How did you end up here?
Alex Smith 31:39:I got into blockchain and Bitcoin back in 2015 at UBS. I spent some time working at the UBS Innovation Lab that took me to Level 39 and Canary Wharf. That later took me across to New York, where I set up a consortium of banks to run a data quality verification service, again, using distributed ledger technology, which then moved on to confidential computing. So I’ve been involved in this space for several years, working on different blockchain use-cases outside of cryptocurrencies, but with all of the opportunities presented in this space, SDX have got the right vision. They’re forward-thinking. They’re starting to offer all these different services. So, you know, when this opportunity presented itself to move across to SDX and immerse myself in the crypto world, and become a crypto native, yeah, I took that chance. And, yeah, I’m looking forward to the next few years in this space and moving on, building great new products.
Dominic Hobson 32:53: Well, at Future of Finance we’re looking forward to keeping up with the progress that you’re making.