Talking Our Book: The State of Cryptocurrency Trading Infrastructure
By Paul Sacks & Ari Pine
Frequently it is considered crass, especially outside of finance, to be promoting an idea that is self-serving. However, in the investing world, speaking well of an asset for which one has a position is often presumed, and discounted as such — so one may as well. In that spirit, we present to you our current view on where the state of the marketplace for cryptocurrency trading infrastructure. It is true that this perspective will ultimately point out how Digital Gamma is positioned to benefit, but that does not make it any less (or more) accurate. And we can assure you, to an uncomfortable extent, we have skin in this game.
One of the beauties of getting caught up in the excitement of cryptocurrency is the rapidity with which one becomes a veteran in the space. Back in December when we became sucked into the crypto vortex, the fragmentation of the marketplace and the immaturity of the trading technology jumped out at us. So, while our most immediate expertise is trading — with a strong minor in development — providing tools and services to the institutional trading community jumped out as the clear path to take.
Particularly at that time, it was clear that the exchanges ruled the roost. Trading was volatile, and pricing on various exchanges could be very different. It is not that market makers did not exist. They did, but at that time, at least by appearances to the public at large, exchanges were at the center of it. But it was also clear that exchanges as they were, or the system within which they operated, had to change. For the most part, interest and activity far outpaced the infrastructure that it was built to support. This includes both the security and the capacity of the technology.
At that time, savvy investors saw the outsized profits and opportunity in forming an exchange — building exchange infrastructure, especially one that has to account for new types of customers (institutions), uncertain regulations, and new kinds of security needs. It took time to build. Now it is about six to nine months later, and new exchanges are seemingly popping up every other day. Many are describing themselves as being of “institutional quality.” We have named this phenomenon “peak exchange.”
In the seeds of this, the builders looked a step ahead. Exchanges in capital and derivatives markets don’t handle the storing of their assets. In fact, they don’t even deal directly with clients: client facing firms are members of various exchanges and guarantee the trades of their customers. Which, no doubt, led the teams and backers of these exchanges to look ahead a step to handle this need. Institutions are now perceived to be the necessary group to bring cryptocurrency (and its trading) into the mainstream. Institutions, unlike individuals, have rules put in place to ensure their customers (the “other people” of “other people’s money”) are protected. The rules include requirements that a regulated, trusted third party entity has to hold the assets of said institutions: a custodian. So during the building phase for exchanges, the powers that be realized that they needed custody solutions.
We learned, after attending a few conferences, that the state of things was that 1) exchanges are being launched and 2) custody solutions were being built. Even though there are some custody solutions out there (BitGo, ItBit, Xapo, Coinbase, etc.), they are mostly not sufficiently complete for either regulatory reasons or are not yet built out.
The same thing that occurred with the building out of the exchanges is now occurring within the custody world. After putting their heads down to focus on custody and speaking with upcoming clients, there is a realization that storing crypto assets securely is necessary for wide-scale institutional adoption. And of course, those customers want to do something with those assets: invest, trade, earn interest on balances, etc.
Those are precisely the sort of services that prime brokerages provide. Spoiler alert: this is where we are talking our book. While we would like to pat ourselves on the back about our great prescience in planning out both an offering and its timing, the truth is that we are here in the great excitement of it all, too. After 20+ years (each, help us) of trading capital and commodity markets, we’ve seen traders come and go. The brokers (usually) were a more permanent fixture — collecting tolls on each transaction.
But whether it is Digital Gamma or a competitor, prime brokerages are all about providing access to markets. In a marketplace, as fractured as cryptocurrency, this is more urgent than in a world of centralized exchanges. PB is known for more than market access, of course. Securities lending and position financing are essential. Possibly even more important is providing a competent (or even excellent) level of service as a larger scale intermediary with trading partners and venues — or even a magnet for customer opportunities. After all, a prime broker’s customer base represents a large source of order flow or distribution capabilities. This is why it has been at the center of investment banks.
While you look around and see what we call “peak exchange” all around you, consider what is next. The forward-looking people in crypto began building out custody solutions early this year. Now those solutions are beginning to get launched in earnest and seeking appropriate regulatory approval. Figure that “peak custody” is coming soon. The natural step for the smart money is to ask: what’s next?
What’s next? Prime brokerage is next.
