More Than Meets the Eye: Some quick thoughts from a former Wall Street trader on the Goldman crypto news
Prices on liquid listed crypto are in a bear market and are largely sentiment driven right now. Negative headlines will have a decently large effect on prices in that environment. Positive headlines tend to be dulled, glossed over, or reinterpreted with a pessimistic lens. Said another way, in a bear market, good news is bad news, and bad news is very bad news. Of course, the opposite is true of bull markets. Bad news is good news (the worst is out the way! Or, That’s not nearly as bad as we thought!) and good news is great news. Such is the case with markets that are not strong form efficient.
Stripping out the above, let’s look at the headline on the surface: “Goldman reportedly drops crypto trading plans”. GS represents a large endorsement from traditional Wall Street for an emerging asset class. An endorsement from someone of their caliber (who, in theory, could be partially disintermediated as a result of a successful crypto movement) goes a long way for an emerging technology and asset class in its early innings. A full endorsement and move into the space would engender FOMO in the hearts and minds of the other large banks and financial institutions who wouldn’t want to miss out on any profits or opportunity or lose future market share to a competitor. Goldman is also seen as a first mover in many ways and their tacit endorsement via involvement would portend a financial and technological paradigm shift that others would want to follow.
Therefore, I am not surprised on the surface how the market has reacted to this headline (bitcoin down ~10%, “alt coins” down ~10–20%). I’m not sure the market dropped entirely due to this announcement, but for the sake of this article let’s make that assumption.
Goldman is actually indirectly already involved in crypto trading via their ownership stake in Circle, a global crypto finance company with a large crypto OTC trading business called Circle Trade that transacts over $2B each month. Additionally, Goldman-backed Circle, agreed to purchase crypto exchange Poloniex back in February. At the time, Poloniex was the 14th largest crypto exchange by volume according to Coinmarketcap. I point this out, because I believe this is how Goldman is getting smart about the details of trading in the space, without having to put their direct brand name on the line with their own OTC trading desk.
It is my opinion that they have been carefully studying the particular intricacies of trading crypto OTC and via exchange and observed how current “institutional” trades are done via OTC currently. The current crypto OTC market does not have the normal infrastructure that GS or others would be familiar with in traditional assets. There is not a Bloomberg-like terminal to use for most of trading (which is most commonly used across equities, rates, credit, mortgages, and other products). Instead, most OTC trading is done via Skype messaging, Whatsapp, or other messaging platforms. Then, comes settlement of the trade. Once a price is agreed upon, the exchange has to interact with specific whitelisted wallet addresses of the counterparty. Exchanges themselves often have to roll over their own public wallet addresses frequently to ensure privacy and security, otherwise these transactions would be easily viewable on the public ledger. In traditional markets, once a trade is confirmed, it is usually settled with the institution’s prime broker. Since prime brokers largely don’t yet exist in the crypto space, it makes settlement difficult and increases counterparty risk due to a potential failure to deliver situation. Additionally, trading direct puts the onus directly on GS for proper AML/KYC and onboarding of new clients. This increases reputational risk, is labor-intensive, and is time-intensive.
Given all the above, my guess is that GS has come to the conclusion in the short term that they can’t get comfortable enough with the existing infrastructure of the trading business and the risks associated with it at the current time to move fully into the space directly. They would prefer to continue with their indirect involvement. They, instead, smartly see an opportunity to create the infrastructure solution first so that they only have to trust themselves (reducing counterparty risk and settlement risk significantly). How do they do this? Work on developing the “prime broker” or the custody solution for the space. Control of the custody/prime broker essentially makes trading easier. For the tech inclined crowd, think of this as the software stack. The base level software protocol is the custody/prime broker solution and the OTC trading business is the application on top that interacts with the base level protocol. If GS knows how it works and is comfortable with this base layer, they have more comfort operating on top.
But that’s not all. There are additional benefits to this structure. If you control the Prime Broker/ Custody business, then you can actually charge counterparties when they “trade away” from you (trade with other OTC trading desks or exchanges) because it then requires a transfer of custody out of GS prime broker to the other counterparty (which adds risk and time and comes at a cost). This effectively drives more trading business to the OTC desk because funds, institutions, clients, etc are incentivized to execute trades at a lower cost. This is not a new concept. In the bank loan market, certain banks act as agent on the loans. When trading the loan with the bank who is agent on the loan, there is no charge since it is effectively “in house”. If it is “traded away” with someone else, there is an assignment cost to that trade and the agent bank is notified as well. A similar idea used to apply in the early days of the credit derivatives market before there were large central clearinghouses. When a CDS contract was traded with a new counterparty, there was an assignment of new counterparty risk since the contracts needed to be bi-lateral between two parties. You would need to be notified of this change in counterparty as it was a change in risk. While this didn’t come at a direct cost, indirectly it disincentivized clients from trading away since it would notify the original counterparty.
Therefore, solving the custody/prime broker/OTC infrastructure problem allows for entry into the OTC trading business on top with added incentives for clients to trade. It is ingeniously solving one major industry problem and through that solution creating a huge tailwind for its trading business when it decides to enter. In the meantime, they will continue to learn indirectly through their investments in the space. Classic, smart Goldman. Don’t read the announcement too bearishly. There is a lot more going on in this new asset class than might appear on the surface.
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Scott Army is the Founder and CEO of Vision Hill Advisors, a cryptoasset and blockchain focused fund of funds. Prior to founding Vision Hill, he traded high yield corporate bonds and credit derivatives for 11 years at JPMorgan Chase.
