Clearing, crypto and wooing big investors

Hello and welcome to the FT Cryptofinance newsletter. This week we’re taking a look at traditional finance’s approach to crypto.

A common refrain is that fund managers have not been put off crypto by the collapse of coin prices, the endless stream of bad news and the crackdown by US authorities.

To a return-hungry fund manager, crypto is once again an attractive proposition. Shares and bonds are still struggling for direction after another uninspiring quarter and commodities are becalmed. Meanwhile bitcoin has jumped by more than half since its lows only three months ago to more than $30,000 as fears over inflation ease.

But this isn’t a market investors are jumping into with abandon. It is very thinly traded — crypto data provider Kaiko last month estimated that the depth of the market, or ability to trade easily close to the prevailing market price, in bitcoin has dropped 50 per cent since FTX’s collapse in November. Things have improved slightly but Kaiko found little evidence of fresh sources of liquidity.

What traditional investors need, according to Arnab Sen, chief executive of UK marketplace GFO-X, is a “safe, regulated venue where large financial institutions can trade at scale, while keeping their clients’ assets protected”.

His comments came in the week GFO-X teamed up with the London Stock Exchange Group’s LCH clearing house to clear digital asset derivatives in Paris. They are not alone. Nomura’s digital assets subsidiary Laser Digital last month invested in ClearToken, a clearing house for private over-the-counter digital assets deals. Komainu, a crypto custody provider, has set up a crypto collateral management service.

Services such as LCH DigitalAssetClear, ClearToken and Komainu are pitching themselves as trusted sources for investors, banks, brokers, market makers and custodians.

Dip a toe into crypto waters and reasons to be cautious quickly surface. Many investors cannot hold crypto tokens, either by investor mandate or regulation. Putting money in a crypto exchange is something of a leap of faith. You may or may not be facilitating money laundering or trading against sanctions-hit entities. Your assets may not be as safe as the company promised. In a bankruptcy filing your money may well go into a pot alongside everyone else’s claims. Then there are issues such as cold wallets and private keys . . . the list goes on.

On the other hand clearing houses and collateral management are well-tested concepts. A clearing house sits between a buyer and seller, insulating the market from a default and overseeing the transfer of deals from one owner to another. Komainu keeps the customers’ collateral but lends it out for trading on exchanges via a series of tri-party agreements. Risk managers can be more reassured that these projects come in a regulated and well-tested wrapper.

It sounds dull but offers a sharp professional contrast to the amateur, do-it-yourself efforts of crypto. Ethereum this week upgraded its system to give holders of ether more flexibility to withdraw their assets when they wish.

Yet Binance, the world’s largest crypto exchange, was among those warning that it could take an initial “15 days to several weeks” before it could fully process requests from users to withdraw their ether from a staking programme. It will mainly depend on the size of the withdrawal and how loaded the Ethereum network is, Binance added.

What’s on offer are two competing visions of how the crypto market should work on a daily basis.

At present crypto customers largely have to pre-fund trading of crypto tokens, either with cash or other crypto tokens. Exchanges offer customers leverage and can draw in buyers but they can exit just as fast. Using tokens based on a value that can rapidly change doesn’t make for a deep, stable and liquid market.

In traditional markets to lubricate trading there are windows of temporary credit, such as the period for a customer to meet margin calls or a two-day window for settlement. It’s not easy to marry the two concepts.

“If you go back to basics, clearing on a blockchain doesn’t work. It assumes you have the cash,” said Ben Stephens, chief executive of ClearToken.

Moreover those credit windows are offered uniformly to all. In crypto markets credit is much more at the discretion of the exchange, as it acts as trade facilitator, broker and custodian. One has to trust that it is not trading against the customer.

US charges against FTX and Binance have alleged crypto exchanges are far more centralised than supposed. Wholesale financial markets, with independent clearing houses and custodians, are more decentralised than painted. Fund managers and banks are not comfortable with the co-mingling of roles, or holding so much capital in a black box.

The unknown question is the extent to which an institutional, perhaps over-the-counter market, is dependent on centralised crypto exchanges for a reference price. That could leave the market as exposed to thin or manipulative trading as the current system.

But the building blocks for a two-tier crypto market are emerging, which may turn it into something resembling the vast foreign exchange market. Retail investors can find an easily available money changer — although the rate on offer is dreadful — but the substantial business takes place elsewhere, in a radically different world.

But that is years away. For now the challenge is to persuade big investors to join in.

What’s your take on institutional adoption of crypto? Email me at philip.stafford@ft.com.

Join me and FT colleagues at the FT’s Crypto and Digital Assets Summit on May 9-10 as we discuss where the digital assets market is heading. Also appearing at the event will be UK Treasury secretary Andrew Griffith and Hester Peirce of the US Securities and Exchange Commission. Register for your pass here.

Weekly highlights

• Ethereum undertook its so-called Shanghai software upgrade, which allows holders of ether to stake their assets without being forced to lock them up for a set period of time. Optimists suggested it could unlock interest from institutional investors. The much-touted “Merge” on Ethereum last September also promised to prepare the ground for more use of crypto technology in mainstream finance. It hasn’t.

• Lawyers for FTX told a US bankruptcy court that the company had so far recovered $7.3bn in “distributable assets” at the cryptocurrency exchange founded by Sam Bankman-Fried.

Soundbite of the week:

Bitcoin’s resurgence this year has attracted many theories. Michael Novogratz, chief executive and founder of crypto financial group Galaxy Digital, suggested it was the collapse of several midsized US banks and a wave of US enforcement actions that had “energised” the investor base, according to a Bloomberg report.

“Crypto started as the little person’s revolution — they didn’t trust governments,” he said. “You’re picking a fight with a crypto community that loves this technology and believes it almost with religious fervour.”

Data mining

What a difference a lawsuit makes. Last month the US Commodity Futures Trading Commission accused Binance of operating illegally in the country and its trading volume and profitability had come from “extensive solicitation of and access to” US customers.

Research from Kaiko shows volume sank in the five days between Binance ending most zero-fee trading in bitcoin and then the impact of the CFTC lawsuit.

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