Three hurdles to overcome if crypto is to be traded institutionally

Crypto is in a bear market. So says pretty much every market commentator for the past few months and the 2018 November slump was a low point in a market that was already low. Is there any upside to this? For anyone? Certainly not if you’re a small investor who has ploughed their savings into Bitcoin or Ether and dozens of other currencies whose value has gone through the floor. Not if you’re a struggling startup conducting an ICO and hoping for investment from investors, who aren’t feeling nearly as flush when their digital assets were worth several times what they are now.

But who is feeling good in the world of crypto? The answer is those who aren’t in it – yet. If you’re an investor or asset manager and your assets are all in fiat currencies or other established asset classes, you look over the fence and see a market selling cut price items and you know that, in there somewhere, must be some bargains. The issues are firstly that you have to be able to identify those bargains and secondly that there’s a large “caveat emptor” sign over the entrance to the market for those fiat investors who are suspicious of the whole environment and how reliably they could then get their money out if they chose to.

To call the institutional crypto markets “fledgeling” would be generous, considering how small, under regulated and young they are compared to more established markets and asset classes. These markets haven’t undergone the slow evolution of, for example the London futures markets, that saw East End barrow boys agree a price for a commodity before they brought it into the city. Such a slow evolution allowed rules to be discussed and agreed to fit the trade but crypto doesn’t have the luxury of time.

So, what are the hurdles that crypto rapidly needs to overcome if it is to be traded institutionally?

  1. Trust

Ironically, for investors that distrust cryptocurrencies due to their lack of regulation and government backing, it was distrust of state institutions that made cryptocurrency popular for early investors. Trading Bitcoin meant you weren’t being spied on or taxed or otherwise inhibited by “the man” – the state and was therefore much liked by some “citizens of the world.” But the inherent anonymity that attracted early investors also attracted criminals who saw its potential to move money and pay for illicit items on the dark web. MiFID II and other directives, like Dodd-Frank from the US, require that trading participants comply with a number of Anti-Money Laundering (AML) and Know-Your-Customer (KYC) standards. Essentially, they have to prove who they are and that they are a respectable company.

So the idea of trading with a counterparty who is a shadowy presence on the web is an anathema to the world of institutional trading. Trade reconstructions must include structured records (such as counterparty and trade identifiers), as well as relevant unstructured records (such as emails, voice communications, chats, electronic messages, and social media) as they pertain to a trade. Agile jurisdictions are already looking at these challenges in concert with crypto market infrastructure providers and are starting to apply regulations taken from traditional capital markets to their markets. Recent examples include Malta and Gibraltar, where small, agile financial market specialist jurisdictions have stolen a march on slower moving countries. Closer to home, nimble market entrants are challenging the status quo. Archax, for example, is a new, institutional-grade exchange for trading asset-backed tokens which is in the process of becoming regulated by the FCA. The company is utilising technology that has already been authorised and regulated to become the first regulated institutional crypto exchange in London.

  1. Price manipulation

Price manipulation is a constant threat in the crypto world and a common form of this is spoofing. Spoofing involves the placement of orders that are filled by those in league with the seller; so people selling to themselves, essentially.

Spoof traders firstly place orders significantly larger than the market average, at above market price, then below market price, then at market rate, followed by further adjustments to create an image of an active market. The results can include ensuring margin positions and futures positions, leveraged short or long positions, controlling direction of a market and to get people to trade in a given range.

However, these tactics are also be seen in mainstream trading, a good example being the “flash crash” of 2010. As that showed, traders do get caught out and, with the right regulations and oversight, can be held liable and prosecuted. The extension of international financial services regulations to the current grey areas of crypto trading will help eradicate this, as will the application of KYC and AML measures. In addition, there is an operational risk; spoofing could involve orders being filled by another, unintended counterparty and could result in losses for the spoofer when their manipulation goes awry.

  1. Speed

If cryptocurrency is to emerge from the fringes of financial trading and work in the real world, it needs to do so in real time. At the moment, settlement times for Bitcoin transactions can take as long as ten minutes due to the sheer number of participants and the limitations of Bitcoin itself, allowing only 7 transactions per second, while fiat currencies are traded thousands of times per second. Institutional investors require the ability to trade currencies fast and to get their money in and out of markets if they are to take the risk of involvement in the market. As luck would have it, the technology to assist with bringing crypto into the mainstream lies within its own make-up – blockchain. Distributed ledger blockchain technology is rapidly being popularised among the financial markets of the world, reaching asset classes far removed from cryptocurrencies, from hydrocarbons to foreign exchange. We’re not talking about the Bitcoin blockchain here – that would be like lifting the hood on a Robin Reliant and expecting to find a rumbling V8. We’re talking about supercharged blockchains, built from the ground up to match the characteristics of existing high frequency trading environments. As well as being fast, this technology will provide KYC and AML compliance as native, thereby removing these three principal hurdles to the adoption of cryptocurrency trading by institutions.

This is a contributed article by Terence Chabe, Capital Markets Specialist, Colt