The Future of Capital Markets
a CoinShares work-from-home series
In this series, our team at CoinShares will speak with three technology entrepreneurs building new types of market infrastructure, and our CoinShares Capital Markets desk. We explore the fundamental technology innovations driving new applications in cryptocurrency markets and how they might apply to capital markets more broadly.
At CoinShares, our mission is to expand access to the digital asset ecosystem while services as a trusted partner for our clients. We achieve this by building regulated investment products and financial services, including exchange traded products, managed investment strategies, and capital markets services.
CoinShares invests in innovative companies building the digital asset ecosystem, focusing on making early stage equity investments in financial technology companies. Note that CoinShares, associated group entities, or the directors of the firm may be investors in one or more of the companies or assets discussed in this series. We have made an attempt to note instances where a relationship exists between a company and the Group.
In this fourth installment, we're excited to have an in-depth discussion on the evolution of one trading desk - our own - over the last seven years, and to reflect on how various changes in market landscape have impacted the business of market participants. In this fascinating discussion with my business partner and CoinShares CEO Jean-Marie Mognetti, we discuss how the trading business has changed and continues to change, and where technology innovation is driving both opportunities and challenges for capital markets desks like ours.
Note that CoinShares and its directors are investors in some of the companies mentioned in this post, which are denoted with a * in the post below.
Building a Bitcoin Trading Desk in 2013
As a reminder, we’re using the trade lifecycle as a general roadmap for this series. We covered price discovery and trade execution in Episode 1, clearing and margin management in Episode 2, and settlement in Episode 3. In this fourth installment, we’re exploring what this all actually looks like for a trading desk managing billions of dollars of notional trading volume every year.
CoinShares Capital Markets, previously known as GABI Trading, is a proprietary trading desk and liquidity provider. Before diving into bitcoin, Jean-Marie (JM) worked with Danny Masters and Rus Newton on Global Advisors, a commodities hedge fund, and the four of us now work together as the directors of CoinShares. They started trading bitcoin at Global in 2013. In 2013, trading bitcoin was very different from the world of trading commodities in a regulated hedge fund where everything was executed electronically and “on screen” trading of listed instruments. Moving to crypto - no more brokers, no more FCMs, no more very limited number exchange, no more wall street banking partners - nothing left of the old world, and had to build a new world.
- Price discovery was challenging - Coinbase was the first unofficial yet widely accepted index price used by the market, but Tradeblock stepped in pretty quickly with the XBX index which is a volume weighted average across several exchanges.
- On the execution side, it was mostly bilateral execution, and there was no technology to buy so JM, with a very small team at that time, started building his own technology to support execution.
- On the clearing side, until you have your bitcoin you don’t own anything. It was very much a relationship driven by trust.
- On the settlement side, it was really a dance to see who would settle first. JM couldn’t really trade with people he didn’t know or didn’t trust, and there were a lot of different styles and practices.
- On the trade reconciliation side, each exchange still provides very different types of reporting. If you want to trade a block on NYMEX, for example, there is a standard for how you enter your order and all FCM reports look the same and have the same information. In crypto, everyone has built their own standard, but we’re starting to see a slow move towards normalization of a standard across platforms. The other issue is auditors and accountants can’t always agree on how to book digital assets, and the regulatory guidance available from regulators isn’t always consistent from one country to another or within the same country.
One of the key advantages for CoinShares was our commodities background, where a focus on risk management and operational efficiency was key to survival and success. JM lays how these two factors impacted his decision making in the early days of trading bitcoin.
- Risk management - Managing risk in the early days of bitcoin was much more challenging than it is today - it required managing counterparty risk, venue risk if on exchange, managing custodial risk without any of the solutions that exist today, and dealing with a volatile, sometimes illiquid asset where the memory pool can be capricious.
- Operational efficiency - In the early days of bitcoin, what helped us survive where many others have failed was the quality of our infrastructure and being able to deploy the right capital at the right time at the right places. We had to have the right bank accounts, money and coins on the right exchanges or as close as possible, and the ability to move fast on a 24/7 schedule when arbitrage opportunities presented themselves.
How Trading Needs Drive Technology
The technology CoinShares builds or buys is always driven by the need we have. As a rule we don’t buy, we build ourselves, and always build in open source languages. We are all ‘cypherpunks’ at heart, and while we don't write bitcoin core code, we do build in Linux, Python, Go and C++. When CoinShares first started expanding its trading technology, we had a very unique set of needs. We needed to provide liquidity to the XBT Provider notes which were traded on Nasdaq Nordic. Most ETP providers would just hire a market maker, but at the time, back in 2016, none of the usual market makers would touch bitcoin, let alone a bitcoin to Swedish Krona or Euro trade. So we had to figure out how to do it ourselves and build a system able to deliver orders on Nasdaq OMX while hedging on a bitcoin market venue like Bitfinex, Bitstamp or Kraken. As fate would have it, most of those market makers now do trade bitcoin and provide markets in our products, just a few years later.
We had to build a platform that could make a market in the legacy world, on Nasdaq, and then buy a hedge in the crypto market in real time. That meant building technology that could integrate with a prime broker environment and on the crypto side, trade in a market that was completely disorganized and fragmented. Prime brokers aren’t used to seeing money moving in and out accounts, and our prime brokers weren’t used to seeing a small and unknown client called CoinShares constantly requesting to wire money to banks to unusual jurisdictions, since most mainstream UK and EU based banks didn't want to touch crypto at that time.
The growth of CoinShares Capital Markets mirrors the growth of the crypto ecosystem in many ways. Because we are facing off against other counterparties, we can't always move faster than the market does from a technology perspective. For example, in the early years, the biggest challenge for us was connecting all of the different markets and creating one screen for our trading team, and then facilitating trade execution across all of these venues on one screen. We built that capability internally, and just now are we starting to see the growth of technology firms and trading firms replicating that electronic connectivity and offering it to the market.
Where the Trade Lifecycle is Today
If we step back and look at the trade lifecycle, JM observes that in his experience, there won't be one part of the lifecycle where technology development and change will move faster or happen more quickly, because the entire lifecycle has to move in tandem. This said some parts of it are easier to transform than other.
Price discovery is changing very quickly - just look at Paradigm* and AiX, which are very active in facilitating RFQ or requests for quotes in a more efficient manner and enabling execution across multiple venues and dealers in one screen. It will be interesting to see how it evolves side by side with legacy players like ICE Chat.
On the execution side, exchanges are continuing to improve but are focused on internalizing as much of the lifecycle as possible. Brokers and dealers are starting to move towards electronic connectivity, which makes it easier for trading firms to connect to many venues and markets via APIs. Voice is getting less and less interesting even in crypto, but it is still challenging to move to electronic for non-linear products.
When it comes to clearing, margin is managed bilaterally, and there isn't yet a central clearing solution which enables efficient cross-margining. Given the counterparty risk that's introduced when posting collateral with a clearinghouse. JM is interested by solutions like X-Margin* which could eliminate the need to move coins and allow traders to cross-margin using an escrow wallet under their own control rather than having to trust a central clearinghouse.
On the settlement side, the problem of who sends coins or cash first is one that still persists. Today, custodians are effectively building network effects around settlement and netting in their own siloed systems, but in the future, solutions like Arwen* could help connect these different networks and facilitate atomic swaps. However, there are still a lot of issues to resolve and retail consumers will behave very differently than institutional ones.
Lastly, the reconciliation of trades is still a challenge, especially for firms that are audited and have to submit their accounts to regulators. Each trading venue or exchange has its own way of providing trade reporting, and the level of granularity and detail in these differs greatly.
Furthermore, there is little global consistency in how cryptocurrency should be treated from a tax perspective, and this makes it challenging to manage reporting. For now, reconciliation is very much an internal problem for trading firms themselves to resolve, as JM has learned through doing numerous audits.
The Impact of Regulation on Standards and Technology
While regulation hasn't been a focus of this series, JM has some interesting observations on how regulation influences industry standards and how technology gets built.
The moment you leave spot trading, which is, in JM's words "quite boring", and get into derivatives trading, you get into some very serious legal agreements and contractual obligations. CoinShares has used the example provided by entities like ISDA, the options standards body, in the regulated capital market to create a starting point for our industry. But over time, the crypto trading community has, and will continue to, develop its own unique standards.
In terms of standardization, there are really two approaches.
- Regulators could push top down which forces standards by fear of sanction.
- Or the industry could build bottoms up by forming standards over time and as a reaction to inefficiencies or structural weaknesses in the market, and that forces standards by excluding participants who don't adopt those standards.
At the moment, regulation has been inconsistent from jurisdiction to jurisdiction and although there are several industry bodies attempting to introduce self-regulation, a single regulator can't implement standards as easily because of the global and digital nature of the industry. This said, there are now several cross-border working groups on the subject and digital assets are a point on the G20’s agenda. Like the open-source development of cryptocurrency protocols themselves, most of the standards in the industry have been set by the market itself and re-enforced by the leading firms in the market choosing to only do business on certain venues or with certain counterparties.
On the custody side, while there are solutions being developed to evolve custody from centralized cold digital vaults to more distributed solutions, JM believes well-connected centralized custodians will be important for trust when it comes to integrating the crypto market with broader capital markets. The idea of a cryptocurrency in your pocket is interesting for a consumer, but it doesn’t get crypto into the diversification mix of a portfolio manager. They need to work with counterparties they understand and they trust. For example, companies like Coinfirm* and Elliptic* can provide real time analysis and can flag coins that need to be monitored and can’t be moved because they’re associated with a hack.
How Crypto Trading Technology will Impact Capital Markets
As a trader who has worked in both legacy markets and crypto markets, one of JM's observations is how much scale and volume crypto trading platforms can handle. For example, CME serves a limited number of members who serve their own clients. Crypto exchanges directly serve millions of clients every day. For example, BitMEX is often in the top five exchanges worldwide in terms of volume, serving more customers and doing more volume than large equities and derivatives exchanges. If you look at any top exchange in the crypto space right now, the number of direct clients pinging them on a second per second basis is so massive, it's not even comparable to the legacy markets. As a result, banks and trading firms are starting to look at this new infrastructure much more seriously.
When it comes to tokenization, where JM sees opportunity is in places like the bond market, where there are standard contracts, a lot of volume, and a lot of mid and back office overhead. The bond market already has robust infrastructure and processes and standards that can be easily replicated in this new model. This would be a true success to open the door of the bond market to SMEs, not only Blue Chip companies.
Anyone who tells JM they’re tokenizing private capital or equities, he worries about because people keep forgetting about the step of the trade cycle after the primary issuance, which is how is the secondary market will function in assets where they don't exist today. These are complicated, bespoke contracts and markets that don’t have an established trade lifecycle in legacy markets. It’s going to take much, much longer to see markets start to get formalized, as there isn’t standard structure today in most parts of the life cycle.