In a brief explainer article, DerivSource’s Lynn Strongin Dodds explores the how the industry infrastructure is evolving to support the trade lifecycle for digital assets. Read on for an overview of digital asset trading via exchanges, clearing and settlement, custody as it is now and the obstacles the industry faces now
Although there are distinct differences between digital and traditional exchanges, they both tend to focus on a narrow range of assets. In the former case, it is mainly the more established crypto currencies such as Bitcoin, Ethereum and Litecoin which have been on the scene for over ten years. It will be gradual, but hopes are running high that Non-Fungible Tokens (NFTs), Stablecoins, Central Bank Digital Currencies (CBDCs) and security assets or tokenised versions of stocks and bonds will feature more on digital trading venues.
Digital exchanges and trading venues
To date, there are almost 600 cryptocurrency exchanges worldwide although costs, quality and security vary widely. The volume of trading should also not be an indicator of calibre and in fact could be misleading because unlike their conventional counterparts, many are not regulated or approved. This has been the case with Binance and FTX, two of the largest exchanges that have attracted unwanted attention from regulators.
The UK’s Financial Conduct Authority recently cautioned against FTX in the latest clash between British authorities and offshore digital asset companies. The watchdog said the exchange appeared to be offering products and services in the UK without its authorisation.
The watchdog issued a similar warning over Binance, which offers complex and high-risk financial products. It said that the group is not currently permitted to undertake any regulated activities without its written consent.
On the flipside, the top ten most popular digital exchanges and compliant from a regulatory standpoint on the Forbes survey are Coinbase, Gemini, Kraken and FTX.US. They are followed by companies such as PayPal, Robinhood and Block where crypto trading is not their main business, but they still offer venues to trade.
There have been more entrants this year with the most recent addition being EDXM in September from Charles Schwab, Citadel Securities, Fidelity Digital Assets Paradigm, Sequoia Capital and Virtu Financial.
In terms of derivatives, research from EY, found that their digital versions will not be used much differently than their conventional equivalents. This means hedging positions, gaining synthetic exposure to price movements or creating structured/leveraged exposures in a capital efficient manner.
The EY article noted that currently digital asset-based derivative trading is dominated by listed futures and options on centralised exchanges. However, they only reference a subset of the population while crypto derivative volume as a percentage of spot is just a fraction in comparison to traditional markets.
Although the industry is expected to gain traction among institutional investors, the EY states there will be several hurdles along the way, most notably the lack of regulation. Unlike other asset classes that have well-defined contractual standards and definitions covering bilateral products, there are currently no standardised legal documentation or conventions for digital asset derivatives. Without conventions, “transparency and liquidity in the bilateral derivative market will suffer…,” EY added.
To address this gap, industry trade association, the International Securities and Derivatives (ISDA) is leading the way. ISDA is already working to establish contractual standards for crypto derivatives with definitions due out soon. (See DerivSource’s Q&A with ISDA’s Mark New on how the trade association is readying OTC contractual standards)
Overall, in terms of regulation, the European Union is ahead with its Markets in Crypto-Assets (MiCA) legislation, which is part of the European Commission’s EC’s Digital Finance Package, published in September 2020. It is expected to come into force next year and aims to create a legal blueprint for crypto assets; support innovation and competition; protect consumers and investors; and bolster financial stability.
By contrast the US is lagging behind with President Biden only recently issuing an executive order calling for a coordinated strategy on digital assets. This means that Federal financial regulatory and administrative agencies have to study aspects of the digital assets industry, report on their findings, and make recommendations for policy development (See DerivSource’s market update on U.S. Digital Asset Legislation and Regulation Addressing Illicit Finance).
Unsurprisingly, the dearth of rules has made banks wary of becoming involved in either selling digital assets or joining consortium to build trading platforms. An article from Fitch Ratings noted they will “tread cautiously until there is a comprehensive and ideally globally-coordinated regulatory framework given heightened fraud risk, cybersecurity concerns, and operational risks…” Market, regulatory, liquidity and counterparty threats are also flagged as main problems while the relative nascence of the asset class creates additional uncertainties that are difficult to assess under a more mainstream risk framework.
Clearing and settlement
To date, there have several initiatives in the clearing and settlement space for digital assets. However, as Eurex points out in its “5 key takeaways from Focus Day: Digital Assets & Crypto Derivatives”, that “Distributed ledger technology (DLT,) or the blockchain, is set to fundamentally change the workings of capital markets but progress will be slow. DLT is not a panacea but does bring major improvements in efficiency to settlement and the transfer of ownership of assets and securities.”
In September 2021, the German exchange group debuted a derivatives product that offers Bitcoin exposure within the fully regulated and traditional financial infrastructure fold. It used an exchange-traded note (ETN) as an underlying instrument while Clearstream Banking, the custodians of Deutsche Börse for paper assets, provided the custody and settlement. This product launch follows the debut of the first centrally cleared Bitcoin ETN, launched back in June 2020 by Deutsche Borse. Other exchange groups including, CME, Intercontinental Exchange and Eris X (now part of CBOE) all offer various crypto derivatives products.
The summer also saw Fidelity Digital Assets and TP ICAP, along with Zodia Custody and Flow Traders unveil a wholesale electronic marketplace for spot crypto asset trading, including Bitcoin and Ethereum, as well as providing connectivity and settlement services to a network of digital assets custodians. (https://www.fidelitydigitalassets.com/research-and-insights/enhancing-institutional-digital-asset-trading-clearing-and-settlement).
Meanwhile, earlier in the year, decentralised financial market infrastructure Bosonic launched Bosonic Enterprise Solutions, a clearing and settlement capability for digital assets. The company said the goal is to support payment versus payment (PvP) instant clearing and settlement of digital assets and fiat currencies. Its target audience is regulated financial market infrastructure organisations and banks as well as newly formed digital asset exchanges that need a post-trade clearing and settlement solution.
Digital custody – all types
Although many of the clearing and settlement projects involve a custodian, many of the players are formulating their own gameplan. Northern Trust was one of the first out of the gate in the UK. It joined forces with SC Ventures, the ventures and innovation arm of Standard Chartered, to form Zodia Custody two years ago, to offer institutional grade crypto asset custody solutions.
This year witnessed State Street Digital enter a partnership with Copper.co, a London-based provider of institutional digital asset custody and trading infrastructure while BNY Mellon introduced its Digital Asset Custody platform in the U.S.
Their entry is seen as key to the development of the industry for the buy side. In an article in the Wall Street Journal by Anastasia Traylor, partner, and Seth Connors, senior manager, both with Deloitte Risk & Financial Advisory, said, “increasing institutional adoption of cryptocurrencies will likely require instilling a higher level of confidence in the assets, and custodial services can play an important role.”
They argued this is because third-party custodial services are used by many financial institutions to mitigate security risks associated with holding assets. Custodians are generally responsible for the safekeeping of assets that belong to an institution’s clients as well as processing related transactions. However, in the fledgling digital asset market, there are emerging custodial risks that leaders at financial institutions should consider, and those risks tend to cluster around three areas: the custodial relationship, controls, and reporting.
Responsibilities will differ in many ways because unlike equities and bonds, custodians do not store the assets but, instead, the cryptographic keys which verify proof of ownership on the blockchain. It is extremely difficult to recover a private key if it is lost or stolen, due to the decentralised nature of the entire crypto ecosystem.
Currently, there are three main storage mechanisms https://www.aima.org/sound-practices/industry-guides/digital-asset-custody-guide.html (The safest and most popular option is cold storage because it uses offline digital vaults, where private keys and seed phrases to re-generate keys are physically stored in designated locations. It also incorporates security measures such as two-factor authentication, whitelisting of wallet addresses, multi-signature wallets, geographical distribution, time locks and multi-party computation.
By contrast, hot storage requires internet connectivity which allows ease of access to move digital assets quickly, but it can also cause significant security vulnerabilities. Finally, is warm storage – a combination of hot and cold. Internet connectivity is required but most of the keys are kept in cold storage.
Looking ahead, digital assets are likely to be a firm fixture on the investment landscape, but it will take time for the post trade infrastructure and regulatory concepts to develop to make institutional investors completely comfortable with these investments. There is likely to be collaborative efforts especially on the trading platform front as well as individual projects to ensure that robust systems, frameworks and processes are in place.