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Charles Bennett
Charles Bennett

2020 Will Bring The Rise Of Prime Brokerage In Crypto Custody __HOT__

At the same time, in another place and another market, a much newer financial services company reaffirmed its commitment to enter the prime brokerage business. Coinbase launched a prime brokerage offering in crypto for its institutional clients midway through the third quarter. On its earnings call, the company\u2019s CEO highlighted it as a key area of investment.

2020 Will Bring the Rise of Prime Brokerage in Crypto Custody

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This week, we take a closer look at the prime brokerage business model and its application in crypto. Earlier this week, the aggregate value of the world\u2019s crypto assets flew through $3 trillion for the very first time. Institutional interest is rising and an effective prime brokerage solution could be the way to unlock it.

Most retail investors have a single brokerage account through which they manage their investments. Their broker will usually look after custody for them and offer additional services such as margin lending. If they have more than one account, they are likely to be distinct: funds in one account can\u2019t usually be drawn to cover positions in another.

Prime brokers make most of their money on the financing side. They lend explicitly through cash margin loans (for long positions) and stock loans (for short positions), or implicitly through equity derivatives (which can be long or short). Like any form of lending, prime brokerage is a spread business: money is made on the spread between what hedge funds pay for financing and what prime brokers pay as the cost of their funding. In 2020, Goldman\u2019s equities financing revenues were down, not because of a lack of hedge fund activity, but because the firm suffered \u201Chigher net funding costs\u201D.

Seven months after disclosing its prime brokerage losses, Credit Suisse decided that it doesn\u2019t have \u201Cthe competitive advantage required to deliver sustainable returns above our cost of capital in this business.\u201D It is shutting the business to free up $3 billion of capital. Revenues were around $800 million in 2020, so not too bad, but costs were high.

In order to service these institutional clients, Coinbase rolled out a prime services product that combines trading, custody, analytics and financing in a single solution \u2013 the kind of thing Goldman and Furman Selz did in equities many years ago. The demand is potentially greater in crypto because custody is a harder problem to solve.

Others in the industry are also developing their prime brokerage activities. We discussed Galaxy here in Net Interest a few months ago. Founded by ex-Goldman partner Mike Novogratz, it is set up as a \u2018merchant bank\u2019 for crypto, focussed on the institutional market. It began offering prime services to select clients during the second quarter, taking in $150 million of customer funds onto its balance sheet by quarter end. Other providers include Copper, which provides some core prime services, notably custody. FTX is a leading crypto exchange that began by targeting large, active traders and is making inroads on the institutional side.

Deep diving into an institutional strategy, there are two distinct uses of crypto-currency investment: 1/ a willingness to be exposed to a new asset (trading firms, asset managers, Family offices) 2/ a cash investment to seek a minimum return (especially in a low or negative interest rate environment) while safeguarding the capital (corporate strategy). In both strategies, risk tolerance is absolutely opposite but the maturity of the actual crypto-world allows them to find architectures, custodians, prime-brokers, that offer solutions which suit them all. Also risk tolerance may be adjusted in setting up a wide range of cryptos in their portfolio (more stablecoins vs exotic coins).

Now that institutional custody is a more mature market, prime brokers are emerging to provide hedge funds and institutional investors more complete services regarding their will of investments. SheeldMarket, Tagomi (exited ; Coinbase 2020) or FalconX could be referred to as pioneers when it comes to prime brokerage for cryptocurrency.

Some custodian companies are following the trend of prime brokers. Coinbase, one of the pioneers when it comes to trading crypto, recently announced the launch of their prime crypto brokerage solution for all institutional investors, after a beta launched in May 2021.

We could also thank the ADAN initiative which wants to shake things and is pushing new tax rules to the french National Assembly for the next Loi de finance 2022 (French finance act 2022), with proposals like the tax neutralization for crypto exchanges in an enterprise financing purpose, the carring-forward crypto and token losses for 10 years, or a better split between professional and non professional trading (same treatment as in financial markets). Overall, bills are currently being discussed with the will to equate crypto taxation with stock market transactions and thus bury the final entry of cryptos into the financial world.

PALO ALTO, CA, June 23, 2022 - BitGo, the leader in digital asset financial services, today announced the appointment of Adam Sporn as Head of US Institutional Sales. Mr. Sporn joins from State Street, where he served as Managing Director. In his new role, Mr. Sporn will lead a US institutional sales team that provides clients with regulated, insured, and qualified custody, as well as financing and execution services through a single platform. Since 2020 BitGo offers market leading trading, lending, and borrowing services through its prime brokerage services.

BitGo is the first digital asset company that has been focused exclusively on serving institutional clients since 2013. BitGo provides institutional investors with custody, liquidity, and security solutions. Active in both centralized and decentralized finance, BitGo offers market leading trading, lending, and borrowing services through its prime brokerage services and acts as the custodian for WBTC, the leading global stablecoin for Bitcoin.

Cryptomarkets have opened the door for the democratization of finance, allowing the general public to access trading venues with small entry-ticket sizes. An important indicator of the exponential adoption of digital assets is the number of digital custody wallet users currently existing. With increasing capital being traded through digital assets, securely managing custody has become critical to users. To date, there are more than 70 million wallet users and more than 100 million identity-verified crypto-asset users in 2021. According to user data from exchanges/trading platforms and wallets, the global user base increased by 190% from 2018 to 2020, and the number of accounts by 37% (Statista, 2021a).

BaFin. Guidelines on applications for authorisation for crypto custody business. 2020. Retrieved from _Hinweise_zum_Erlaubnisantrag_fuer_das_Kryptoverwahrgeschaeft_en.html;jsessionid=9C415FE8DB19BB5C4681AA27F725B2D2.2_cid501?nn=9451720#doc13886752bodyText1. Last Accessed 07.09.2021.

So far, those who have labelled themselves as crypto prime brokers usually approach the business from one or two of three angles; focus on 1) efficient order routing, 2) secure custody, or 3) lending.

Each of these services has its place in the ecosystem, one serving some clients better than another. Prime brokers in crypto still differ considerably from prime brokers in TradFi, and these are the closest we get in crypto today. I believe we are currently at the intermittent stage of development where non-complete services have to be offered to bootstrap the balance sheets & operations to support the development of full-fledged prime brokerage services.

Service providers will spend the following 3-5 years bridging the gaps between digital asset prime brokerage and the services we are used to in traditional finance. The list of requirements for a true digital asset prime broker is long and by no means easy to execute due to the reasons discussed above. However, some of the most important things the industry needs to focus on in the coming years are a solid financial condition & regulatory approach, availability of capital, standardisation of investment products, seamless access to a broad range of products, strong & creditworthy status, secure & audited custody solutions, operational excellence, manageable fees, excellent technological connectivity (e.g., via APIs), high liquidity, reasonable pricing, white-glove service, and robust AML/KYC processes.

Amidst the severe contraction in cryptocurrencies and the near or actual insolvency of prominent crypto companies and Stablecoins (BlockFi, Celsius, Voyager, Terra Luna, among others), there is legitimate concern about the structural integrity of this sector and whether institutional investors should take this asset class seriously. Our analysis of the market, discussions with a cross-section of market participants, and announcements from several high-quality institutions paints a different picture. The real takeaway is that institutional and corporate interest in digital assets is growing despite crypto prices declining this year. A greater number and a wider variety of service providers are expanding access to digital assets, including exchanges, custodians, institutional prime brokers, retail brokerage platforms, asset managers, payment providers, and retailers. Separately, a large number of non-financial S&P500 corporates are marching into adjacent but related spaces like issuing non-fungible tokens (NFTs). Huge brands like Adidas, Budweiser, Dolce & Gabbana, Gucci, Nike, and Tiffany. By some accounts, Nike has already generated a whopping $184Mill from NFT-based projects and investments, which is attracting the interest of a lot of other retailers.

One of the big reasons for the slow pace of adoption among institutions of Crypto and Digital Assets has been the lack of institutional-grade infrastructure providers that perform critical functions like custody, prime broking, lending, etc. While many of these functions were being offered by several crypto-native firms, even established firms like the publicly-listed Coinbase, large institutional participants were more hesistant to trade unless traditional service providers like BNY Mellon or State Street started offering services supporting Crypto. Large institutions also need strong clearing, margining (including cross-margining capability), and collateral management from their prime brokers and custodians.


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