Lynn Strongin Dodds looks at the development of crypto trading in the derivatives world and why it has been such a slow burn.
Three years ago, market participants believed digital derivatives had truly arrived with the first wave of products from the Chicago Board Options Exchange (CBOE) and the Chicago Mercantile Exchange (CME). ICE’s Bakkt’s digital assets trading and payments platform soon followed but the number of regulated offerings is still far and few between.
“There has been a flurry of activity around digital assets and we have seen a growing issuance of traditional assets move into this space,” says Stephan Dreyer, Managing Director at the Association of National Numbering Agencies (ANNA) which set up a taskforce to explore ways of extending its standards to digital asset trading identification. The view is that leveraging Distributed Ledger Technology (DLT) in financial services will make markets more efficient, but the ecosystem is still evolving although the interest is there.”
Overall, digital assets remain a fringe market with the total market capitalisation of crypto assets standing at roughly $211bn, according to a report on the “Institutionalization of cryptoassets” by KPMG. This is still a drop in the proverbial bucket compared to the staggering $300 trn of traditional asset markets.
A separate special report by Acuiti in partnership with Bitstamp and CME Group on “Institutional Adoption of Digital Asset Trading” confirms that adoption is low among the 86 participants polled including buy side, sell side and proprietary trading groups specialised in traditional derivatives trading, clearing and execution firms.
It found that 26% of sell-side service providers embraced trading digital assets which was ahead of traditional trading firms where there was less than a third. However, CME or Bakkt were the favourites even though there out of the roughly 100 trading venues on the market. In addition, for those using digital derivatives, bitcoin and Ethereum still dominated the field with 57% of traditional firms trading the former and 29% the latter.
While high volatility, lack of internal expertise, limited client demand and fear of reputational damage are all cited in the Acuiti report as major stumbling blocks, the biggest concern among all institutions was security of exchange and fears of hacking. Custody was also high on the list for traditional trading firms especially in terms of margin requirements.
Equally as important was the lack of regulation, anti-money laundering and know your customer (KYC) structures. “One of the issues is that professionals from the classical financial services world, expect best practices from that space,” says Ilgar Alekperov, CEO, ZUBR, a digital asset derivatives exchange which targets proprietary trading firms and individuals that trade in a wide range of cryptocurrency markets, using arbitrage and other latency-sensitive strategies across multiple trading venues. The exchange received an in-principal approval for its DLT Provider licence in Gibraltar.
Currently, there is a patchwork of legislation across the geographical landscapes which makes it difficult to create a credible uniform digital market infrastructure for issuance, trading and settlement of digital securities. For example, the European Union recently passed the 5th Anti-Money Laundering Directive (5AMLD), which among other things marks the first time that digital asset service providers will fall under regulatory acumen. This means they will have to implement stringent KYC requirements.
UK regulated crypto asset businesses including exchanges and custodian wallet providers must also comply with AML rules and the Financial Conduct Authority recently banned the sale of crypto derivatives to retail investors.
Meanwhile in the US, the Cryptocurrency Act of 2020 has a three-part categorisation of digital assets by types and the regulatory bodies responsible for overseeing each type. For instance, crypto securities such as equity, debt, and derivative instruments that rest on a blockchain is governed by the Securities and Exchange Commission (SEC).
“There needs to be appropriate structures, standards, risk management and governance processes in place to support asset digitalisation,” says Jennifer Peve, Managing Director, Business Innovation at the Depository Trust & Clearing Corp (DTCC). However, she adds more work is also required on the technology side because too many inefficient processes and fragmented solutions which exacerbate operational challenges remain.
“It is a great opportunity to innovate and introduce new technology,” she says. “It is not about replacing current technology with emerging technology simply because it exists.”
She notes that DTCC is working on two proof of concepts, both of which look to leverage blockchain technology to improve the current business models. Project Whitney aims to validate an alternative, faster digital securities management service for asset tokenisation and digital infrastructure to support private market securities.
Alekperov echoes these sentiments. “If the crypto industry wants to attract institutional grade clients they need to more in terms of regulation as well as technology. They expect the infrastructure, systems, APIs and other protocols as traditional exchanges.”
A consistent approach
While the DTCC investigated the nuts and bolts of technology, ANNA set up a taskforce in 2019 to assess the role that International Securities Identification Numbers (ISINs) may play in the harmonisation of standards for identifying digital assets, including asset-backed stable coins, utility tokens, and hybrid tokens.
“It is important to use existing practices, such as ISINs, for digital assets and to have consistency and a uniform approach,” says Dreyer who adds that one of the key recommendations – endorsing the assignment of ISINs for debt securities that are tokenised has already been fulfilled. “It is a necessary step for trading that the security tokens can be bought and sold then feed into the existing post trade frameworks. “
Although the work of the taskforce has been wrapped up, there is a subgroup that will monitor how ISINs will interact with the forthcoming Digital Token Identifier (DTI) standard which is being developed to identify the technical information of a token such as where it sits on the blockchain, its genesis.
Classification is also the theme of the International Swaps and Derivatives Association (ISDA) Common Domain Model or ISDA CDM which is the first industry solution to tackle the lack of standard conventions in how derivatives trade events and processes are represented.
Although it covers the wide range of financial instruments, in the digital space, ISDA has been working with Digital Asset since 2018 to create a CDM reference model for its the open-source smart contract language DAML. Last autumn, they launched a pilot scheme that expands the capabilities of CDM for the clearing of OTC derivatives using DAML.
This covers the signing of state transitions, data ownership and privacy elements, which are necessary to put the CDM clearing model into production.
“Digital assets and tokenisation will become very important once technological advances around DLT come to the fruition,” says Ian Sloyan, director in market infrastructure and technology at ISDA. “The implementation of CDM in blockchain is an important application for the project and using CDM for clearing by leveraging languages like DAML will increase standardisation and operational efficiency across the entire clearing lifecycle.”
Beth Sendra, Director of Client Experience, Americas at Digital Asset, adds, the CDM creates a common blueprint for derivatives events processing that occur throughout the lifecycle, which leads to greater automation. She notes that “the goals are aligned with DAML and that the marrying of CDM and DAML provides greater standardisation and accelerates the use of the technology.”
Looking ahead, as the KPMG report points out, the staying power of crypto assets will be their ability to reduce friction and inefficiencies that currently exist in markets. In the institutional space, it will not only be those venues that can provide the requisite liquidity but also have robust governance and risk management structures in place that offer security and support.