I hear hundreds of reasons why cryptocurrencies are an investment fad that will fail. One of those reasons is that this is the investment vehicle of wild eyed libertarians, and millennial programmers. And, I hear that ‘the bankers’ are going to try to smash cryptos out of existence, and along with it those freedom loving, young crypto traders. And, in this process, they’ll collaborate, or should I say corroborate, with government regulators who don’t want to see a competitor currency to their sovereign.
This article is going to challenge that notion, focusing on recent developments in the institutional crypto trade. In my opinion 2018 was the year institutions came to this market in force. And, as the infrastructure for these traders develops, this side of the trade will grow.
I have no personal experience in institutional crypto trading, other than one hedge fund manager who asked me in late 2018 to help him safely purchase and store $1M in Bitcoin. And I know that a couple funds are quiet members of my service on Elliott Wave Trader. All other information is second hand from reading. However, it is a fact that there is a cottage industry forming to help institutional clients use crypto as an investment.
The infrastructure has not existed prior to 2017 for institutions to long crypto as far as I know. But it exists now. While data on institutional purchases of crypto is murky, I’ll discuss the forming infrastructure. Just as you can see the effects of wind, but not the wind, so it is in this space. The growth of this infrastructure, reveals the demand for crypto from institutional clients.
Some may consider the launch of Bitcoin futures on the CBOE (no longer offered) and the CME as a move by these two groups to monetize retail Bitcoin fever in late 2017. Given the time it took to prepare these product offerings, work with the CFTC to get them approved, I don’t believe these products were intended to capitalize on a so called investment fad.
While evidence is circumstantial, I believe these products were created with the institution in mind. And, it is entirely possible that the lobbying of institutions played a hand in their creation. For some institutions, this was a way to play speculatively in the crypto market without opening new accounts, and changing operations drastically. But for some this offered a means to hedge off risk to spot exposure.
Most institutions exposed to real crypto keep their crypto in cold storage. Cold storage involves keeping wallets offline so they cannot be hacked, as is the best approach to secure for large amounts of digital assets. But this slows the ability to move crypto in turbulent markets trapping holders in the trade. Futures offers such traders and investors an easy way to quickly hedge exposure through dollar settled accounts.
The OTC Trade
When I spoke at a crypto event at Trader Expo in Vegas last November, one of the panel discussions focused on the institutional trade in cryptos. Josh Lim, a trade director for Galaxy Digital, an ‘institutional liquidity provider’ for crypto stated that the OTC, or Over the Counter trade in Cryptos is roughly $10M per day, a very small market.
With the risk of being remedial, let’s define some terms:
Most investors understand the term OTC. But if not familiar, I’ll define it. This is a term used to define trades not made in the open on public exchanges but prearranged, negotiated and off exchanges. OTC markets exist for everything from CDO and Credit Default Swaps, to stocks, options and now cryptos.
In cryptos, the OTC helps funds make large purchases of crypto safely. Most crypto exchanges simply do not have the liquidity to handle a $100K+ purchase without price moving drastically. So, the OTC market exists to keep those large crypto purchases private, and off public exchanges. This is typically not a problem in equities, as most large stocks are highly liquid.
Institutional liquidity providers are the businesses that facilitate these OTC trades. Galaxy Digital is one large player, founded by Mike Novogratz, formerly of Goldman Sachs and is publicly traded on the Venture exchange.
Two large players also in this space are Cumberland Mining, a division of DRW, and Acuna Capital.
These businesses make trading cryptos more convenient for institutions. I’ve followed many directors and traders at these businesses. They operate much like prime brokers do in stocks. Trades can be made by phone call or web platform, and the liquidity provider takes care of the trade, finding counterparties, or pulling liquidity from public exchanges as needed. And, then they secure the cryptos in secure ‘cold wallets’ so the client doesn’t need to.
If true, the $10M figure represents only 0.8% of Bitcoin’s market cap, so this is still quite small, but is expected to grow over time.
Other components of the OTC market include over the counter options and other hedging derivatives.
Another set of businesses bill themselves ‘custody services’. These businesses provide secure storage of large amounts of cryptos with insurance. They may or may not offer trading or liquidity services. They in effect take the risk of cyber security so the institutional client doesn’t need to.
These businesses also meet transparency and regulatory requirements, operating largely as a bank. Most will hold licenses with New York, the state that has taken a very aggressive role in regulating the crypto industry.
Coinbase, Bitgo, ItBit are a few known players in this space. Also, Fidelity announced recently that they are adding custody service for cryptos.
High Frequency Trading
High Frequency trading has been around a long time in the equity markets. In the crypto space, algo trading is home grown, and the purview of small groups of programmers. Further, the exchanges and their technology are quite unsophisticated for such operations. But this is slowly changing.
Groups of high frequency firms, such as Acuna Capital have sprung up. I’ve heard a director at Acuna say they have been operating on some of the normal crypto exchanges. Slowy, we’ll see new exchanges born which offer less latency for these operations. Two are coming: the long expected Bakkt exchange, and the San Juan Merc (SJMX). The latter’s stated focus is to serve the high frequency crypto firm.
The Bottomline is, from what I can tell, institutions started entering the crypto market en masse in 2017. But the infrastructure for such clients was poor. These early institutions were quite intrepid indeed. I can imagine there was much bootstrapping back then.
But that has changed since 2018. The creation of this trading infrastructure came on the back side of strong demand to serve a growing client base of institutional crypto traders and investors. As this infrastructure continues to develop and grow in sophistication we’ll see more institutions consider crypto as an asset base.
Note we cannot expect all cryptos to garner institutional support. Only highly liquid coins are going to meet their needs. Just as institutions have policies on what stocks their trade regarding market cap and price, the same exists in crypto. Most institutions are interested in Bitcoin. It’s market cap and daily volumes reign supreme in this market. Further, the hedging mechanisms for Bitcoin are sophisticated. In following some of the players in this space it seems there is some interest from institutions for Ethereum, Ripple, Litecoin, and EOS, which are all large cap coins.
Sidenote: I mentioned that I often am told that the government is going to kill crypto as a competing currency. Never-mind that crypto is not actually a currency in the normal sense. But I just don't see the current state of things as supporting this, at least in the US. To the contrary, the US government has been quite conciliatory and practical. Other governments have been very aggressive in making their nations leaders in the space. I'll discuss that in the future.