A lack of market infrastructure for digital assets

Anthony Ferrenbach
Aug 6, 2018 · 10 min read

In this paper, we will cover what is in my opinion, the three most significant barriers to mainstream adoption of digital assets, specifically to institutional investors. People tend to take time in adopting new technologies. The more uncertainty and absence of a friendly UX, the harder it is to get broader acceptance.

First, we will talk about the regulatory risk, which is incontestably one that institutions and investors don’t want to take lightly. Then we’ll look at the lack of market infrastructure in comparison to traditional markets, such as OTC trades and Custody services.

Regulation in digital assets

The biggest threat to institutional money coming in is regulation and its unpredictability. Three sets of approach exist around the world. The first is a very crypto-friendly environment; the second is banning it, and the third is the wait-and-see approach. This regulatory risk is one that institutional investors aren’t willing to take especially given how fast some countries tend to change their mind about digital assets.

Given the early stage of digital assets, many countries don’t have the same definition. It is noticeable within the US, where the Commodity Futures Trading Commission (CFTC) considers digital holdings as commodities while the Securities and Exchange Commission (SEC) regards them as unregistered securities. This is concerning because it creates more doubts amongst investors wondering in which direction regulation will go.

How long will it take for government bodies to agree on a universal definition?

If this wasn’t enough, the absence of a benchmark is making countries even more cautious in their approach. To give some clarity, the members of the G20 meeting in Argentina had agreed that each country’s prime minister would have to present a specific set of recommendations for cryptocurrency regulation by July 2018. However, most would rather adopt a wait and see approach, see how things evolve and use current regulations and laws in the meantime. As always, technology grows at a faster pace than regulatory bodies which lags in keeping up with the trends. We can only hope that this time, because of its popularity, digital assets’ regulation will keep up with its growth.

The EU has released their Action Plan defining its proper angle on regulating blockchain and fintech, which will necessarily create a testing environment letting innovation flourish while limiting risk. However, some EU countries have already taken a strong position as a crypto-friendly space, such as Malta by hosting Binance since it left South Korea, as well as OKEx.

Switzerland is also having a very welcoming approach and is already home of the “Crypto Valley”. For example, storing clients’ digital assets do not qualify as taking deposits; therefore, companies don’t need a banking license. Finma, Switzerland’s financial market regulator released principles-based guidelines that will be applied on a case by case basis as opposed to prescriptive rules, making it a much more progressive approach.

In the US, the situation is more complicated because they have different definitions for digital assets and need to juggle between federal and state regulations. This leads to no company having a money transmitter license. Such a complicated regulatory system might delay the US in providing clearance regarding regulations, especially nationwide. There is still no common ground explored as to how to regulate this market. Some lobby for a private cryptocurrency oversight body, others for a self-regulatory organization, but no definitive position has been taken.

Moreover, regulations for cryptocurrencies can be very diverse. Bans can apply on ICOs, trading exchanges and mining of cryptocurrencies, each requiring a certain level of understanding and knowledge. This complicates regulators tasks’ as to what they’re comfortable accepting and what they are not, and if one can be accepted without taking the others. This environment is delaying the understanding of digital assets, and the potential consequences of each stage (ICOs, mining and exchanges). China, for example, has banned all of them at a certain point in time.

Given its complexity, regulators have cited many reasons as to why cryptocurrencies should be banned, such as excessive electricity usage, financial risks, money laundering, data protection, tax evasion and fraudulent activities. One common stance has been the one toward the ICO market. China, South Korea have banned it.

Japan, the largest cryptocurrency market with around 60% of the world’s trading volume is also looking at regulating it. They launched the Japan Virtual Currency Exchange Industry Association to create and enforce rules and set fines, and eventually develop standards for ICOs. On the other hand, while these countries take firm stances on regulation, others are profiting from it. France, Switzerland and Belarus are slowly becoming global hubs.

This uncertainty is scaring away institutional investors from penetrating the market.

In the following section, we will explore the market structure of digital assets and its characteristics.

Over-The-Counter market

According to bitinfocharts.com, as of 1st of June, the average transaction value was $41,000, and the median transaction was only $399, meaning that half of every bitcoin transaction was below $399 and the other half above. This shows that higher value trades are pulling the average up. Larger transactions tend to be executed in the OTC market.

For institutional investors, the simple cryptocurrency exchange doesn’t offer a satisfying option. In fact, the exchange platforms have too many pitfalls. The Mt.Gox, Bitfinex and Youbit hacks have not been forgotten, and the idea of holding their money on an exchange is rightfully freighting them. Imagine institutional investors pouring hundreds of thousands or millions of dollars in these exchanges, the incentive for hackers would be too high.

Another inconvenience is liquidity. Some investors would take the whole order book down with only one trade, thus moving the market and making them pay more than they expected. According to Blockchain.info, a trade of 339.85 BTC required 2,383 individual transactions to process. In 2013, a single customer bought $15 million worth of bitcoin, and this single trade increased the BTC price from $527$ to $753. These slippage problems penalize high volume transactions within thinly traded markets. Inadvertent price movement is more noticeable in less-widely-used currencies, such as the ones in digital assets.

Moreover, some exchanges have a maximum daily trade limit order of $50,000 per day, have restrictions on transaction methods and incorporate several verification levels and so on.

The OTC market addresses some of these issues. Instead of placing a trade on a regular exchange, OTC trading is done directly between the two parties. The OTC broker either supplies the trade with liquidity or finds someone willing to take the other side of the deal. OTC transactions are settled through bank wire transfers and by sending cryptocurrencies to digital wallets, thus never involving an exchange. This way, the customer knows the price in advance and benefits from anonymity.

OTC trading is nearly impossible to quantify because the details aren’t made public. However, the number of OTC firms have been increasing significantly, as well as their volume which shows large players’ appetite.

Genesis, an OTC broker, handles on average 80$ million in trades daily, ten times more than last year. It hit a record monthly volume in December with $1.5billion. Circle, another OTC broker, handles $2billion OTC trades monthly and has been increasing its minimum order size since Q1 of 2018 to $500,000, previously at $250,000 (the average order size is $1 million, and they’re said to be processing deals worth over $100 million). Cumberland has been hiring and opening offices across Asia and Europe. Even Coinbase and Kraken, some of the world most popular exchange platforms are adding OTC platforms to their offerings. With that in mind, it’s entirely possible that the value of OTC trading has already surpassed regular exchanges.

Even with the price drop in Q1, the OTC trading demand is not slowing down with growing interest from investors. It’s important to say that this also comes from the fact that this form of trading is very accommodative, it accepts virtually any payment method (people in China are paying with Wechat Pay and Ali Pay), and orders can go through smoothly, with a tendency to use Skype.

Another reason why OTC trading is growing in popularity is a government crackdown on cryptocurrency trading. Let’s look at the Chinese example.

When the People’s Bank of China stopped private cryptocurrency exchanges in February 2017, the Chinese ran to OTC firms. The two first weeks of February have seen the volume on Localbitcoins (P2P transaction platform) quadruple.

The same thing happened again when the Chinese government decided to shake up the crypto market in October. OTC platforms registered in China only exited to a friendlier jurisdiction such as Hong Kong and Singapore. These type of threats from the Chinese Government in February and October have shown how people were able to counter the regulation with the OTC market and keep on trading cryptocurrencies. In October, 70% of OTC deals on Localbictoins, Paxful and Coincola were settled in CNY.

However, even though people were able to make their way around regulations, they did it at a cost. Premiums paid by customers were as high as 20%.

An inconvenience of the OTC market is that it’s very opaque. This means that you don’t know what spread the broker is charging you and what the outlook of the markets is. In the cryptocurrency market, due to a lack of competition, premiums are still quite high, especially during government crackdowns.

Finally, even with OTC trading, only a few coin/tokens are subject to institutional investors’ attention due to their market capitalization. Indeed, even with more than 1,600 digital assets, Bitcoin still represents 47,5% of the market, which explains the quote “Bitcoin is king”.

Custody Service

Once the investor has decided that he wants to invest in digital assets through an OTC dealer, he now has to figure out how to safely store these assets, which requires custody services.

The fact that anyone can be their own bank with cryptocurrencies sounds fantastic, but it also gives people numerous responsibilities that many would rather not have. In fact, you can have your wallet on the blockchain and hold your public key and private key. If you lose your private key and forget your seed phrase (12 to 24 words to recover your private key), your funds are lost. This responsibility plus the technical barrier involved with the technology does not make it appealing at all, especially for someone holding large amounts of money.

Therefore, the second step after having bought a cryptocurrency OTC for the institutional investor is to find a way to store it safely.

When money is on an exchange, you are essentially sending money to the exchange’s account which then credits your account for the amount you’ve transferred. Thus, the money is stored on the exchange’s account, exposing anyone who’s saving digital assets on exchanges to counterparty risk. This risk has been shown many times, starting with Mt.Gox.

One of the solutions provided was the multi-sig wallet. Essentially, instead of having one single private key, there are 2 or more sets of keys that are required to sign in. In this configuration, the owner of the funds has one key, and the custody service has the other/s. This lowers the risk of losing your private key as a client and no one can manipulate your fund without your consent. However, there is still a technology barrier to this approach.

To this issue, a growing number of companies are trying to respond and bring peace of mind to institutional investors. Among these are Coinbase Custody, BitGo Custody, Gemini Segregated Custody and Kingdom Trust. These companies are trying to deliver the usual custody services that customers have in traditional markets into the cryptocurrency world and eliminating the technology barrier. These services, however, can be costly. For example, Coinbase Custody service has a minimum deposit of $10 million, a $100,000 setup fee and a 10-basis point per month storage fee. This is because the nascent technology requires substantial technical expertise, which is very scarce at this point, plus insurance rates can be high or unavailable.

Custody services have also caught the eyes of non-crypto companies willing to profit from the emerging technology. State Street, the second largest custody bank in the world is considering offering its services to the market; this is mainly due to the growing demand from its most significant clients. The list goes on with Nomura joining Ledger and Global Advisors to create Komainu, a custody consortium. Bank of New York Mellon Corp, JP Morgan and Northern Trust are all working on custody solutions for digital assets.

The struggle here for traditional custody firms is that this time around digital assets are exposed to hackers, and if funds are lost, it can be tough to recover them. Besides, many different forms of storing exist, each with its set of tradeoffs. Cold storage is considered the safest one and keeps the keys to digital assets holding offline, even storing them in a vault, beyond the reach of hackers. This method would be viable for holding assets, but not for trading, as you would need to go to the vault every time you want to trade which can take up to 48 hours depending on how safe the vault is. Hot storage is another viable option, linked to the internet (like a Ledger Nano or Trezor). This method is faster but riskier.

Institutions are researching for solutions to know which provides the best option for its clients. For instance, BitGo is offering three different services to its clients, depending on their risk tolerance. There is the qualified custody which provides secure storage through Kingdom Trust, institutional Custody which enables clients to manage wallets linked or not to the internet and finally, a self-managed custody service.

The lack of trusted custodians, which are defined as being safe, trustworthy, insured and independently audited is representing a big red flag for institutional investors.

Conclusion

As with any new technologies and services, costs will decrease over time as new players enter the market and create healthy competition. As the OTC cryptocurrency market and custodial services mature, more companies will enter the market; expertise will increase which will enable offering services that are cheaper and more efficient.

However, the cryptocurrency market has a long way to go and is very unpredictable when it comes to regulation. The proper infrastructure and adequate system still need to be built.