Institutional interest in crypto trading is growing exponentially. However, firms face numerous challenges in accessing liquidity pools and optimizing exposure. Eurex talked to Thomas Uhm at market maker and electronic liquidity provider Jane Street about how firms are accessing the market and what needs to change for institutional crypto trading to realize its potential.
We hear a lot about engagement from institutional firms in the crypto market - how much of this activity are you seeing and where is it coming from?
We see a bifurcation in the institutional marketplace. The split is between, on one side, firms that either have lean decision-making structures, such as family offices and certain hedge funds, or firms that have to be very responsive to customer demand, such as retail brokers. On the other side are institutions that require the approval of multiple departments such as tax and accounting, compliance and cybersecurity etc, to make investment decisions.
Of the former, the family offices and the retail brokers, many are active in crypto now and they're active across the crypto ecosystem trading multiple coins, including many that would be defined as “alt-coins”. The firms with more complex approval processes are still in the process of understanding how crypto can fit within their existing infrastructure and looking to trade in a more limited way.
Ultimately, at pretty much every institutional investment firm, there is somebody on the team who is fascinated by cryptocurrencies simply because it is driving innovation in one of the most interesting, challenging and potentially revolutionary technologies that has emerged in financial markets in living memory. These people are driving the knowledge levels at institutions overall but the level of engagement currently still varies greatly depending on who is making the investment decisions at a specific firm.
How are the institutions that are trading across the ecosystem approaching market structure and the multitude of venues?
It is very hard for the buy-side to access enough crypto native venues to get adequate coverage of the market. Liquidity in the crypto market is highly fragmented so in order to get sufficient coverage, you need to navigate many different exchanges and exchange structures. That raises privacy and security concerns, as well as the challenge of setting up on exchanges, which historically have been domiciled in jurisdictions outside the core regulatory environments. That is the main reason why we see large institutions currently focusing on products that are listed on traditionally regulated exchanges.
Do you see that changing in light of recent M&A activity in the US?
What is happening in the US with spot crypto markets buying exchanges with regulated derivatives licenses is very interesting. It is also going the other way with traditional derivatives exchanges buying crypto exchanges.
One of the main ways that institutions like hedge funds have been accessing the market is by having distinct pools of capital at spot and derivatives exchanges. For instance, they might have an account at a native venue, and they might clear futures on a traditional market via a prime broker, which is obviously very capital inefficient.
If we can get to a world where firms can trade spot and derivatives in the same place using the same pool of capital, I think that could meaningfully change the way that institutions access the market and significantly reduce the cost for participants.
How does that impact Jane Street and other liquidity providers in the market?
By far the biggest challenge for a trading firm like ours is capital. The crypto market is extremely capital inefficient because there is no prime broker with sufficient balance sheet to offer the netting and clearing and settlement services that are common in the traditional space.
For a trading firm to be able to provide liquidity across all of the different venues, they have to post distinct pools of capital at each of the different exchanges. This poses multiple challenges. Because capital is distributed across multiple exchanges, it restricts a liquidity provider's ability to respond adequately to large orders on a single venue. If somebody sends a large order to one venue, market makers and liquidity providers can only respond to the extent that they have capital posted there. And after that capital has been used up, there are limitations on the speed at which they can transfer capital from another venue. So a large order can create dislocations between the price on that venue relative to other venues.
There are multiple initiatives underway to address this issue - some on the settlement side, and some with regards to clearing. There are, of course, native prime brokers that offer many of the services of traditional prime brokers, but these firms are still building the balance sheet and access to credit to provide funding at the size needed in the market.
What other challenges are there for you today?
A major challenge we face is that it is very difficult to gain short exposure in crypto markets owing to the settlement process. There are ways for trading firms to do this, for example using some sort of future perpetual swap or pre-borrowing inventory. However, because capital is expensive, liquidity providers try to minimize capital usage by reducing the inventory that they need to maintain on every exchange. This is something that greater prime broker intermediation would be able to help with but financing for a bank is difficult currently because of the Basel III risk weighting rules for crypto assets.
There is a lot of interest right now in cash-settled derivatives, whether through an NDF, a total return swap or other instrument such as a repo, as a result of the fact that banks can’t hold crypto on their balance sheets. The sell-side is very active in finding solutions but they are currently restrained by the lack of regulatory clarity.
Greater sell-side participation in the market is clearly linked to regulatory certainty. How do you see that progressing?
I think everybody on the institutional side is very much aligned that we need greater regulatory clarity before they can fully devote resources to growing the ecosystem. What that regulation looks like and how quickly it will be introduced, I don’t think anyone knows.
But we are seeing some clear approaches from regulators. One is support for the underlying technology. A lot of countries want to support their local fintech industry that is working with DLT and other related technologies. At the same time, regulators have expressed very clearly that there is a need to protect consumers.
There is a lot of frustration in the crypto market about the slow pace of regulation but I think that some of that frustration is misguided. Regulators are not trying to stop sophisticated investors who are already in the crypto space from expanding - they are trying to protect less sophisticated retail investors from getting involved in something that they fundamentally don't understand and are therefore unable to assess the risk of. The fact that regulators are trying to protect those people, I think, is sensible and defensible.
But at the same time, there is clearly the potential for a framework that can encourage Fintechs to innovate and access funding while still retaining consumer protection. I think today there is a risk that innovation will be stymied by the focus on consumer protection. If, for example, you don’t allow anyone to invest in crypto until the product is listed on a regulated exchange, then you do set the bar unnecessarily high.