Three Institutional Pain Points in Adopting Cryptoassets

Key considerations for realising cryptoasset trading potential

As cryptoassets continue their unstoppable integration into traditional finance systems, more questions than answers currently remain about just how, from a trading technology perspective, financial institutions (FIs) can optimise their exposure to the asset class in a way that is functional, secure and compliant. In fact, there is not currently a one-size-fits-all approach, or a standardised crypto trading framework that FIs wanting to trade in cryptoassets ‘should’ follow. Due to the unique nature of cryptoassets, it is not so easy for FIs to emulate existing, traditional infrastructures when trading in cryptoassets, although there are some similarities, outlined in our September 21, 2023 post. For example, crypto markets operate on a 24/7 basis, with most traditional matching engines unable to handle round the clock market operation, with the nature of this promising a different trade life cycle to traditional securities markets. Another example is the precision to which digital assets and more specifically crypto assets are denoted on trade platforms. For instance, cryptoassets are fractionalised to 16 digits, with foreign exchange contracts fractionalised down to only four digits.

In fact, GreySpark observes several key pain points that financial institutions wanting to trade in cryptoassets face, possibly preventing FIs from realising their true digital asset trading potential.

1. Liquidity Fragmentation

It is very difficult for buyside firms, specifically, to access enough crypto-native venues to get adequate coverage of the market. Liquidity in the crypto market is highly fragmented across hundreds of centralised and inconspicuous decentralised trade venues, OTC desks and brokers. This inevitably makes global price discovery more difficult than in the fiat currency world. For example, the Bitcoin spot price usually differs across exchanges at a given time. Thus, because these exchanges are not interconnected, the price discovery process must take place on individual platforms, which can be time consuming and inefficient.

Due to capital being distributed across multiple exchanges, a liquidity provider's ability to respond adequately to large orders on a single venue is restricted. If an entity sends a large order to one venue, market makers and liquidity providers can only respond to the extent that they have capital posted on there. After that capital has been used up, there are limitations on the speed at which they can transfer capital from another venue. As such, a large order can create dislocations between the price on that venue relative to other venues.

In order to get sufficient coverage, firms need to ensure they have sufficient infrastructure rails (namely smart order routing) to split orders and source liquidity across different platforms. At the same time, this calls for a flexible and modular order-execution management system that is able to orchestrate the trade execution process, from price discovery to execution. There are few such solutions currently on the market that are capable of achieving the liquidity standards required to serve institutional trading desks trading hundreds of billions of dollars daily. Currently, by their own standards, banks must thus deal with a highly underdeveloped institutional trading infrastructure, which emanated out of the hands of retail investors.

2. Market Data

Cryptoassets provide fresh data challenges for FIs. FIs want to be able to securely access dedicated crypto trading venues, market data providers and post-trade/custodial services using the same kind of solid, robust protocols and trade systems as they do for more traditional asset classes.

However, the lack of a standardised data framework across the myriad of crypto exchanges and venues means this isn’t always achievable, with data quality at risk of being compromised. Data from centralised and decentralised exchanges and OTC venues is incredibly diverse with each platform calculating price data in their own way, often providing significantly larger arbitrages than seen in the traditional finance world. There is also no standardised taxonomy for digital assets. For example, most exchanges, but not all, will use ‘BTC’ to denote Bitcoin. Substantially more normalisation is required in cryptoasset markets than for traditional markets. Another key consideration is extracting data from nodes. A node is a computer that is part of a blockchain network that maintains a record of transactions, while validating transactions on that particular network. Accessing this data can give insight into the current activity and trajectory of a specific crypto network, although obtaining data from these nodes is not standardised for FIs.

3. Trading Infrastructure and Custody

Cryptoasset trading presents a new paradigm for financial institutions. Currently, most equity trades are, globally, settled on a ‘T+2’ settlement period, where settlement occurs two day after the date of trade execution.

For cryptoasset trading, such a settlement cycle does not exist. Due to the blockchain technology underlying all cryptoasset trading, the trade date and the settlement date occur instantaneously when the trade is executed. Additionally, as stated, cryptoasset markets operate 24/7, with most existing traditional trade infrastructures not cut out for operating on this schedule.

As a result, pre-funding of a trading account with either fiat currency or other cryptocurrency is required for a cryptoasset trade to occur, unlike in traditional securities markets where margin trading is typically used. This pre-funding of a trading account is a key pain point for many large institutions in the digital asset market. The need to prefund trades can result in unproductive capital usage, because more capital has to be allocated to a specific transaction in comparison to an equity trade, say, while also exposing institutions to a greater degree of counterparty risk.

A professional execution management system that uses smart order routing and execution algorithms can potentially make a huge impact on the profitability of a bank that routes client orders to secondary markets.

Additionally, FIs need to give consideration to how they will custody their assets, which again poses issues. When purchasing cryptoassets, it is essential that the firm stores them in a personal wallet location that is denoted by private keys. A private key is a unique and secret alphanumeric code that grants access to the cryptoasset holdings in question.

Cryptoasset custody is still developing and arguably not currently advanced enough, globally, to instill universal institutional trust and adoption of cryptoassets. For example, American banks are largely absent from the cryptoasset custody sector at the moment, with just €11 million under custody across 11 banks. This can largely be attributed to the SEC accounting rule (SAB 121) that prohibits US banks from providing digital asset custody. However, this month, a Congressional Committee rejected the SEC rule blocking bank digital asset custody as it seeks to further integrate digital assets into the capital markets industry, meaning that cryptoasset custody could soon improve as regulatory initiatives improve.