Why institutional investors are not buying cryptos (yet)
LGO Markets is the first cryptocurrency exchange compliant with institutional investors needs.
For a few months now, one of the big drivers of cryptocurrency trading has been the expected entry of institutional investors in the market. While the market is still mostly retail-based, the first institutional investments could completely shift the paradigm of the market by rationalizing it, increasing the trade volumes and multiplying the overall market capitalization.
Institutional investors are currently getting exposure to the cryptocurrency market by investing in:
- BTC futures on CME and CBOE
-Exchange Traded Notes (ETNs) such as the Swedish Bitcoin Tracker
- Crypto mining farms that IPO
However, institutional investors are not buying the underlying product of all these instruments, which is the cryptocurrency itself. BTC futures are cash settled and still show quite small volumes compared to the overall market (14 million USD traded on the CME futures expiring in January 2018) and ETNs as well as Mining Farm stocks are trading way above their face value because of the overwhelming demand for BTC exposure.
The underlying reason is very simple: institutions are not entering the cryptocurrency market yet, not because of cryptos themselves, but because of the whole infrastructure around it.
To be more precise, the current market structure of the cryptocurrency universe doesn’t allow institutional investors to buy BTC and other cryptos directly for four main reasons:
- There is no transparent price formation
- Current crypto-exchanges show a counterparty risk that is too high
- The Fiat and Crypto-custody of crypto-exchanges doesn’t meet the level of service required
- The KYC (Know Your Customer) and AML (Anti Money Laundering) processes are not properly done
It is our belief that LGO brings a solution to these four issues.
No Transparent Price Formation
On March 10, 2017, the U.S. Securities and Exchange Commission denied a request to list what would have been the first U.S. exchange-traded fund built to track Bitcoin. In its statement, the SEC stated:
“The Commission is disapproving this proposed rule change because it does not find the proposal to be consistent with Section 6(b)(5) of the Exchange Act, which requires, among other things, that the rules of a national securities exchange be designed to prevent fraudulent and manipulative acts and practices and to protect investors and the public interest.”
In other words, the commission found that the proposed fund was too susceptible of fraud.
In their report on virtual currencies, the EBA (European Banking Authority) listed a detailed number of possible regulatory responses to the challenges posed by virtual currencies. One of the main proposals was:
“Transparent price formation and requirements against market abuse. To avoid market manipulation and insider trading, intermediaries must comply with existing regulation against such practices in the financial sector.”
It is crucial for modern exchanges to unquestionably prove that they cannot practice market manipulation. With its hybrid protocol, LGO Markets provides an elegant solution to this important issue.
Current Crypto-Exchanges represent too high of a counterparty risk
Either willingly or not, cryptocurrency exchanges have an important track record of hacks and thefts.
The Mt.Gox hack in 2014 resulted in a loss of 744 408 BTC, which represents today more than 8 billion US dollars.
More recently, Bitfinex — one of the largest and most used exchanges of the industry — got hacked and lost 120,000 BTC, collateralizing the loss on every Bitfinex customers.
Every other month, one or more exchanges get hacked, as they are easy preys. The overall IT security is low and authentication is weak (login — password authentication for most of the exchanges).
As the whole industry is not regulated yet, high suspicions of insider trading have weighted on the main exchanges. For instance, a BTC sell-off and a BCH increase started few hours prior to the announcement of BCH listing on Coinbase on December 19th, 2018, casting doubt on the exchange’s employees.
Furthermore, some exchanges just seem to have a hard time to handle the high throughputs of orders and transactions for pure technical reasons. In early January 2018, Kraken, one of the major exchanges, gave a 7 hour notice to release an upgrade that should have taken 2 hours. The result was a 3-day period in which the site was unavailable, and people were losing money in a bear market.
All these risks are simply unbearable for institutional investors, who need guarantees on the safe and proper execution of their orders. They need to know that their money is well kept, and that they’ll be able to transact seamlessly, especially when throughput and volatility are high.
LGO offers a solution to these 2 problems:
- By recording the order book and the matched trades on a blockchain, we guarantee that all the transactions are made in a fair and transparent way. Moreover, our protocol technology is certified by CertEurope, one of the leading code certification entities.
- Our partnership with institutional brokers allows us to implement the financial industry’s best practices and to develop a product in line with institutional expectations.
Fiat and Crypto custody
Both cash and crypto custody are huge barriers to entry for institutional investors. While a lot of work is being done in crypto custody (with companies offering their services in the field such as vo1t, Kingdom Trust or DACC), the fiat aspect is often underestimated.
As a matter of fact, no institutions will rationally transfer more than 1M USD worth of fiat currencies to any of the current leading exchanges, solely because of fiat custody. Institutions need to know where and how their money is stored as well as what guarantees and which insurances are put on these funds. These guarantees will be provided by banks which already provide them in the financial industry, and not by banks like Fidor (Kraken) or LHV Pank Bank, an Estonian bank which takes care of Coinbase’s EUR deposits.
Thanks to its partnership with renowned brokers, LGO will offer cash custody with top-tier banks, offering institutional investors a compliant and first class service.
Crypto-custody is also paramount to the whole industry in general, and institutional investors, as the latter have to safeguard their clients’ assets while investing on behalf of them.
LGO will offer its clients a bespoke cold storage solution, regarded as the safest way to store cryptocurrencies, in partnership with the best cold wallet providers.
KYC and AML
Know Your Customer (KYC) is critical for exchanges to comply with Anti-Money Laundering (AML) reporting standards. KYC is the exchanges’ way of taking ownership of all funds placed for deposit under their care. The KYC process includes a list of questions and justifications that have to be answered and provided by the exchange’s users.
For non-crypto exchanges, it is a duty to vet all users that transact on their platform, in order to prevent money laundering and the funding of terrorist states. It is unfortunately something crypto-exchanges have started to do recently, and not up to the standards needed by institutional investors.
The partnership between LGO and brokers will make it necessary for us to offer a KYC process up to the standards of the traditional financial industry.
Conclusion
Institutional investors are yearning to enter the cryptocurrency market, with all its opportunities for growth and rationalization. They haven’t done so yet because of structural reasons, which have not been overcome by current crypto-exchanges yet. LGO Markets aims to be the first platform allowing institutions to enter the cryptocurrency market.
About LGO
LGO Markets (https://lgo.markets) is a demonstrably fair, bank-backed premium exchange for institutional investors. It incorporates a decentralized ledger within its proprietary centralized platform in order to guarantee the inalterability, temporality and transparency of the order book and ensure a fair trading environment.
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