Crypto Prime Brokerage: Size and Urgency
By: Paul Sacks
Digital Gamma just spent an enjoyable and successful week in the Bay Area meeting with exchanges, investors and old friends. Of note was learning about the different methods applied when evaluating an early-stage investment. One such insightful investor distilled it down to a single salient sentence, “tell me about the size and urgency of the problem you are addressing.” Not the size of the addressable market. Not milestones on our own projected roadmap. The size of the problem and the urgency of the problem. As soon as he said it, we knew that was it.
This is especially applicable in crypto — a new(ish), rapidly expanding market going through technological, operational and regulatory growing pains. On-shore, off-shore, varying degrees of transparency, retail, professional, institutional — it seems there are nearly more platforms than one can count. But what problems exist? And for whom?
One way to think about Wall Street (insert global financial market of choice) is that it’s built primarily on one thing: Order Flow. Capital markets, money markets, cash/spot markets, derivative markets, forex/interbank markets, primary/secondary markets, etc.… it boils down to order flow. (One of the ways) Wall Street makes money is as an intermediary, as order flow is generated by market inefficiencies, often (narrowly) described as edge. Over time, the amount of edge decreases and trading volumes increase. Today, in many traditional assets, there is essentially zero edge, and trading volumes appear quite high, though they may be overstated by the inherent opacity of an electronic marketplace. The firms that participate in these markets are not charitable endeavors; they are profit-seeking machines (these days literally machines). With no more edge upon which to feed, they must migrate to fresh pasture.
Wall Street professionals cannot (properly) access the crypto markets. It is, in no uncertain terms, a problem. Access and security must improve dramatically. Further, these companies are used to a certain level of service, and they have a fiduciary responsibility to uphold. Some problems will take time to resolve like an SEC-approved custody solution. Smart people are working on it; it’s coming. But there are many glaring problems that can be solved now. Think of it as an absence of financial plumbing. Best execution, the duty of an investment services firm executing orders on behalf of customers to ensure the best execution possible for their customers’ orders, requires access to a multitude of venues, which are currently fragmented. To be ready to buy at an exchange where the price is low or sell at an exchange where the price is high, fiat and crypto have to be ‘pre-loaded’ at the various locations. That means funding hot wallets at exchanges, as many as possible. The list of family offices that are going to open and maintain 18 hot wallets is small. Very small. This is why OTC desks have flourished, but be aware of their basic business model — with each transaction, the more you lose, the more they make.
Professional traders need access to coin to short, arb and execute a host of other strategies. However, there is no traditional crypto repo market (think cost of borrow), at least in the sense that Wall Street would recognize. Yes, you can borrow and lend coin out there, but margin requirements are punitive for the borrower, and rates insufficient for the lender — and they preclude best execution. A non-starter.
Wall Street needs new sources of order flow, and it needs it now. An institution cannot just wait while a competitor seeks solutions. Traditional distribution channels need to be made “crypto-ready,” and they need to be fed. The crypto market is one that begs for structured products. But first, the recognizable plumbing and suite of tools must exist. They don’t. These are large problems. Our San Francisco investor asks how large? Hard to precisely quantify, but we’d start with all institutions with discretionary trading desks and alpha-seeking funds that have been trailing their benchmarks in recent years. How urgent? For institutions that look towards the horizon — does the opportunity set look better with crypto, or without? It takes time to build plumbing. If you think it seems extremely urgent, Digital Gamma agrees.
