Moderator: Laurie McAughtry, managing editor, The TRADE
Panelists:
Taylor Cable, managing director, Cowen Digital Europe
Abeetha Pitigala, vice-president of digital assets, Goldman Sachs
Jenna Wright, managing director, LMAX Digital
Sabrina Wilson, COO, Copper.co
Clara Medalie, director of research, Kaiko 
The world of digital assets is nothing if not turbulent, and institutional investors have been cautious in getting too involved too quickly in a market unregulated, highly volatile, and dominated by retail influence. However, with the rapid growth of the crypto markets it is also an area where increasingly players are realising they must prepare for the future – and more and more we are seeing people dip in a toe, even if they aren’t ready to fully take the plunge.
But is all this just lip service? Can institutional traders, investors and providers realistically get involved or is the risk still just too high? And if they don’t, how long can they leave it before it’s too late? We are seeing prime brokerages set up, banks launch crypto platforms, and an exodus of talent from the conventional to the crypto space – but every time the market sees a correction, all of this screeches to a halt.
Are digital assets just too volatile and – if so – what will it take to precipitate real institutional involvement?
Laurie: It’s fair to say that things have been pretty turbulent recently. Where are we now?
Jenna: This year has been very different. In 2021 we were in a bull market, your mum and dad were ringing you asking you how to buy Bitcoin, and then 2022 came along and suddenly there wasn’t much price action – the market was flat, the volumes were down, everyone was a bit subdued. And then we started this rollercoaster ride of one-off events – We’ve had pockets of extreme volatility and then we’ve had lengthy periods of not much happening.
Crazy days of volumes are fantastic because it’s always nice to have good days but the reality is you don’t want it to influence the market too much because that has a knock-on effect. Last year we traded over $500 billion in crypto assets – this year we’re just under $200 billion. But for me really what is happening is that the dynamics of the client type is changing. Five years ago when we started we were fully retail, there was no sign of any institutional business. We are now in a position where we are seeing interest from real money asset managers, traditional hedge funds, we’re seeing a different client type that actually is not that impacted by the likes of recent events because the reality is they probably wouldn’t have been able to hold funds at these exchanges in the first place.
Sabrina: In my 20+ years in financial markets I’ve never seen an asset class that is so rooted in retail making its way to the institutions, typically it is the other way round with institutions getting involved first, creating the regulatory framework and all the guardrails that come with it. Here we’ve had a reverse journey, creating a parallel ecosystem. Initially, the asset class was entirely uncorrelated with traditional assets, but now we’ve moved to something above 50% correlated – at peak over 70% with big indices – which can only mean one thing: people have positioned it on their risk curve, they understand it as an asset class, they can measure it, they can benchmark it.
Clara: Correlations certainly hit all-time highs back in April. Bitcoin correlated to the S&P 500 was almost a 0.8 correlation which is a record high. You could interpret that as either a good thing or a bad thing – if you’re more crypto native maybe you’re looking for a less correlated asset class but I do think it’s the strongest indicator so far that institutions are very much positioned in crypto markets much as they’re positioned in equity markets.
On the idea of trade volume as indicator of institutional activity, a lot of people compare 2022 volumes to 2021. It’s true they’re down, you can’t deny it, but what’s more interesting is comparing 2022 to a year earlier. You see that volumes are still an order of magnitude greater they were in 2020 and that’s a difference of just two years. It shows that even though we may be in what many people think is a bear market, volumes overall are more than three times higher than what they were across all exchanges back in 2020.
Taylor: I think that’s right and we’ve also seen digital assets trading in lockstep with the dollar some days – that means one thing, it means that the machines are involved. It’s completely changed the dynamic.
Abeetha: I think it’s important to define what we actually mean by digital assets. At Goldman Sachs you know we look at crypto sitting within digital assets, but we also look at traditional finance arrangements represented on blockchain and DLT as well, so it’s about trading but it’s also about trying to put traditional markets onto blockchains, we think there would be huge interest from institutional players, from issuers as well as clients, basically trying to digitise the full end-to-end spectrum from pre-trade to execution to post-trade and put those onto DLT. So for us it’s been extremely busy period relative to what’s going on within the crypto asset class itself.
Laurie: A number of apple carts have been upset recently. How has that impacted the nuts and bolts of institutional involvement?
Sabrina: When you look at digital assets and the way they trade, the market structure of exchanges and their positioning mean that for institutions it’s very difficult for them to face counterparty credit risk with some of these jurisdictions. Also the markets are pre-funded, which means you lock collateral everywhere. The vision from our founder was always that we need to be collateral efficient, capital efficient, and hold institutional collateral preferably in one place. We entered this space of digital currencies with the goal of being a trusted party that can hold the collateral and offer capital efficiency and collateral management. Solutions such as our product [ClearLoop] allow clients to delegate their balances on exchanges without taking counterparty trading risk on the exchanges themselves: safekeeping and safeguarding the assets on their behalf. That playbook that I’ve is incredibly common with infrastructure players on the traditional finance side so our business model is inspired by that. It is a replica of what’s happening in traditional finance for very good reason: because this is a very well-trodden path.
Taylor: To note, we have not seen any withdrawal of interest from large real money asset managers or the slower moving methodical type clients that have been interested in this space for couple of years now. What we have seen is a vast uptick in interest from institutions that are valuing our pedigree. Crypto native firms actually in particular are very pleased with the variety of services that Cowen offers. So I think the answer here is to provide institutional grade coverage.
Laurie: Are we going to see the world of digital assets be absorbed into traditional market structure, rather than the revolution everyone was expecting?
Clara: I think we’ll get two versions. I think we’ll still see continuation of the more DeFi side which is completely trustless, it’s just a bunch of smart contracts executing code and that doesn’t require any centralised intermediary. But we’re also going to see a permissioned version of decentralised finance that will be incorporated by these more institutional actors and this has to do with tokenisation. You can’t really have the fully automated DeFi side when you’re talking about traditional finance because there is the risk component, there’s compliance, there’s regulation, and so I think it will be a combination of both depending on what the actual use cases are.
Market events show that knowing and trusting who you work with is more important than ever. At Kaiko we offer a cryptocurrency exchange ranking that is designed to give investors a better idea of what is considered a safe and transparent exchange to transact on.
Abeetha: In order to have crypto assets and digital assets transacting seamlessly on a set of rails such as blockchain you need to have your security representation as well as a cash representation on-chain. At the moment you have your fiat payment routes driven by the SWIFT mechanism and then you have your stablecoins and so on. Crypto is an asset class on its own but there is a whole financial market that is currently on payment rails that are 30, 40 years old. We see huge potential in technology that streamlines all that post-trade infrastructure.
Jenna: What this year has taught us is that being conservative is okay. Asking for clients to fund their account to trade is the right thing to be doing. We could all offer leveraged products or we could do it properly.
I think it is tough to sell at the beginning when it’s so retail and we don’t have the right players in the room. But now I think you’re going to get the grown-ups collaboratively working together to try and come up with infrastructure. Up till now, you’d get offshore exchanges offering custody, prime brokerage every part of the system all in one and making loads of money from all the different elements of the services. Whereas if you break it all out and everyone owns their own part of the infrastructure and builds it in a way that institutional investors are used to, with the same plumbing that they would use for other asset classes, that helps to get them comfortable.
Laurie: What role can incumbent financial institutions play in supporting and developing industry?
Taylor: It’s indisputable at this point, based on recent events, the direction of travel, and every individual within the ecosystem that I’ve spoken to is working incredibly hard at trying to figure out: OK how do we reorganise and re-engineer the trade flow that’s going to be using DLT, it’s going to be using solutions like ClearLoop but trading a derivative. You’re no longer in a position where you can just put funds in offshore exchanges where the majority of options trade. That has to be reworked and will be reworked, and the industry will be better for it.
Sabrina: When you look at the collection of actors that we have here around the room it’s quite representative of how you build an ecosystem today. That ecosystem is being incredibly integrated and there’s a danger that the whole industry is being addressed as one. I think we need to be very careful when we look at cryptocurrency as an asset class – yes it is an asset class and there are technical means by which we can address the markets of tomorrow, but that’s separate, that’s an enterprise technology venture rather than the market structure aspect of it. We need to be clear on what portion of the ecosystem we are talking about: trading versus custody versus collateral management, data, research – they are all different. All of these pieces need to fall into place and at the end, we will see an ecosystem that is much stricter in terms of the boundaries of its business models.
Taylor: And this will accelerate what Abeetha’s team is working on. You’ll be able to leverage this infrastructure across all tokenised assets. Previously, there was so much price volatility when it came to profits that no one was interested in taking the time to build anything. It was like OK, we’ve got great liquidity in these offshore places, we’ll figure out how to access that. Now it’s a different paradigm, which will bleed into an infrastructure that will increase efficiency across financial services by an order of magnitude.
Clara: There are two components when it comes to institutional adoption. We have the infrastructure side but then we also need to look at the investor perspective. What do they need to change about what they are doing? Recent market events have shown the importance of balance sheet management. How do you understand the risk profile of every cryptocurrency you hold on your balance sheet? You need access to good data, you need to understand the liquidity across all markets, you need to do basic risk metrics like value-at-risk and I think that’s what a lot of the more crypto native firms failed to do, maybe just through lack of experience. They have never worked in traditional finance so did not understand the importance of understanding each individual asset’s risk profile. So investors need to take it into their own hands when it comes to risk management. Carefully selecting your infrastructure provider while also leveraging liquidity and risk data – these two things combined will ultimately create a safer trading environment for everyone.
Laurie: Adoption of crypto regulation and would a stronger regulatory framework help or hinder?
Abeetha: Regulation is definitely a good thing, and I think we need it for the industry. Regulation brings clarity, institutional adoption, scalability. For us, looking to put traditional securities on blockchains, there is lots going on in this space. In the UK and Europe there are multiple sandboxes trying to put digital assets onto DLT, and amending the current sets of regulation to accommodate that. The EU DLT pilot regime which will kick off next year will basically streamline the post-trade environment using DLT rails and that will be a very positive step in the right direction to make the post-trade and eventually the pre-trade environment much more efficient and scalable. In the 1970s we went from paper to electronic trading and I think right now we are seeing a similar shift from electronic to digital.
Taylor: It’s arguable that the reason liquidity went offshore was due to a lack of clarity from the regulators and that didn’t need to happen. We are massive proponents of regulatory clarity, we work with the regulators to the best of our ability and want to ensure that there is clarity in as many jurisdictions as possible so financial services benefits worldwide and we can increase the velocity of progress.
Laurie: Are there things that you can’t do right now because you don’t have the permissibility, the approvals, or perhaps even just the client confidence to do them?
Jenna: Less so for LMAX but for our clients, absolutely. We look after banks and non-banks: all the non-banks trade crypto on LMAX digital but all the banks absolutely cannot trade, it’s a spot offering. Our upcoming launch of a centrally cleared cash settled future next year will bridge a gap, because banks will be able to use general clearing via their CCP. It will be the same plumbing, it will look and feel like a grown-up traded futures product, and this will definitely bring confidence.
The more regulatory determinism we gain in the next few years the better, and believe me there will be a ton of pressure to get frameworks out there now.
Abeetha: As a U.S. regulated investment bank we cannot hold the physical, either spot or on our balance sheet, and that basically prohibits us from providing ancillary activities or solutions to our clients. I’m looking at regulation for crypto very closely and we would like to and hope to see some advancement in this space.
Laurie: What role can other market participants play in driving the institutional space forward?
Abeetha: The issue of netting I think is very interesting. If you look at the role of CCPs for example, they sit in the middle of that post-trade environment. We have trading houses at the top, CCPs in the middle and then the CSDs at the bottom who provide the settlement. Now by and large all the markets around the world are typically T+2 settled, if you are trading traditional securities on-exchange. In the crypto world there is no concept of clearing, when you look at purely native assets. The reason for that is atomic settlement on-chain. So what is the role of CCPs in the future? Could we move the market to T+0 settlement and essentially eliminate the role of CCPs? We think that would actually be detrimental to the market because you’d end up grossing up all your settlements, it would have an impact on funding and liquidity, and so on. We think there is a sweet spot for settlement, especially when it comes to netting. There is benefit to reducing that settlement cycle from T+2 to T+0, but perhaps T+0 end of day, or intra-day. This is where custodians and clearing houses can play a big role. We think we’ll see a world where different platforms inter-operate. Interoperability is key. We don’t want to create the same set of problems in a new space, where platforms don’t talk to each other because the token on platform A can’t talk to the token on platform B. So there’s work to be done in standardising this space, defining what is a digital asset, how can we define a token and how can they transfer and interact. That will help tackle some of the big issues we have like netting, counterparty credit risk, reduced settlement cycles, and make the market much more efficient and scalable.
Taylor: With regards to netting there are a couple of different people, Copper being one, working hard on creating a clearing house-type solution based on Layer 1, or using a permissioned chain, and effectively what that will do is enable T+0 at mid-day or end of day so that traders and market makers can synchronise. Right now you have an issue where a client may want to settle T+1 but your liquidity provider wants to settle at the end of the day. All of a sudden that creates a mismatch. What can we do? Getting together and trying to enforce some level of unanimity across standards will really help facilitate the way things transact. Solutions like Copper are a huge step in that direction.
Sabrina: The standards issue is very interesting. In traditional finance, there are certain windows and agreed standards around settlement. With digital assets there is as yet no real consistency. The market is also 24/7 so choosing the right point in time, when everyone wants to be aligned, is an art rather than a science. We don’t want to replace one problem with another.
Jenna: But everyone has to buy into the concept, otherwise it doesn’t work. Today, we typically settle T+1, because clients fund, and then we give them a line to use intra-day. That works, but it’s balance sheet-intensive. To support that next wave of institutional clients, the piece where everyone comes together and follows suit in the same settlement network is key. That hasn’t really happened so far but we’re starting to see some momentum. Now we’ve got all the grown-ups in the room, how can we work together, how can we now build something truly institutional?
Laurie: Our discussion has centred around some key areas – reputation, regulation, risk management and efficiencies of capital. What else is important to highlight?
Taylor: It’s important to stress that recent events have nothing to do with the underlying technology, or with crypto as an asset class. It has to do with human behaviour. It’s getting a lot of press, but it’s important to recognise that distinction. It’s human beings who decided to make those decisions, and a bad outcome was the result. Crypto as an asset class remains unchanged.
Laurie: Bad apples, not bad assets. What would you like to see in 2023?
Jenna: Same as the last few years. Regulation and credit intermediation. We will struggle to grow our spot offering without it, because until the regulation comes in, banks can’t trade physical crypto. Even with futures offerings, all roads lead back to cash, and everyone will want to trade the underlying product in the end. I think we’ll see frameworks start to appear from next year.
Taylor: We’d like to see liquidity coming onshore, in a variety of different products. That would be a large win for a wide variety of market participants. In 2023, I think the timeline of adoption will speed up in certain cases, while in other cases it might take longer than it otherwise would have. But I’m excited.
Clara: What we’re looking for in the future when it comes to overall risk management is increased data and transparency standards for service providers so we can monitor and collect that information.
Abeetha: I’d like to see greater institutional adoption, and I think that will be driven by engaging with the likes of us and our competitors. Understanding the technology, understanding the asset class. I think there are still a lot of institutional players who are not yet fully engaged in the product itself, and there is a huge amount of potential there. What will drive that adoption is the push from banks, from FMIs and from regulators, making it a safer environment to play in. We are going to see a convergence of financial market structures and new players coming into this space that is going to make it more efficient.
Sabrina: Regulatory clarity but also regulatory consistency. When we are looking at the markets we know and love, there is one element rarely talked about, which is the concept of equivalence. This is what really allows 24/7 markets to function.
I am very optimistic for 2023, I think it will be a coming of age, and a very big year for digital assets.