The media narrative surrounding the entrance of institutional investors into cryptocurrency has long centered around waiting–waiting for the right platforms, the right regulations, and the right prices before a ‘wave’ of institutional cash will finally crash into crypto.
However, the real story is a bit more nuanced: the meaning of the word ‘institutional’ has become warped within the crypto space, and the impact of high-volume investment on the space has become somewhat muddled as a result.
At the same time, playing the waiting game for this institutional cash has caused the creation of platforms who can serve high-volume investors and institutional traders effectively, which is to say, serve them the way that they are accustomed to in traditional markets.
Recently, Finance Magnates spoke with Danny Kim, head of growth at San Francisco Open Exchange (SFOX) about how high-volume and institutional investors are impacting the cryptocurrency space, and what products and services they are actually using.
SFOX provides access to high liquidity and the ability to trade large volumes. As such, the platform is used by institutions, international businesses, and professional traders as a single point of access to more than 20 trading venues.
”This market is still very, very fragmented.”
Prior to his work at SFOX, Danny spent time as an Assistant Vice President at BNP Paribas, as a Director of Sales at Gemini, and as the Director of the Institutional Client Group at Paxos, formerly known as ‘itBit’. We tapped his perspective as someone who has experience with traditional finance as well as working with institutional clients in crypto.
We asked Danny what the biggest hurdles are for institutional investors in the space.
“This market is still very, very fragmented,” he said, “and what I mean by ‘fragmented’ is that there are so many different exchanges out there, and every single exchange (or brokerage) has a different price. For you to capture that price, you would literally need to have money in an account at ten or twenty different exchanges or liquidity providers and monitor every single one in real-time to see which one is the right one and capture that at that very moment.”
However, “because everyone is not this technically savvy, it’s nearly impossible–it costs a lot of money, costs a lot of resources to do that.”
SFOX’s solution to this problem was to “aggregate all of that information into one order book so that in one view, you can see all the best prices,” Danny explained. “We also have our own accounts on every platform, so that when a buyer or seller does want to execute on our platform, we are basically sweeping across every liquidity provider and exchange in order for you to get the best price.”
“This actually became very popular with high-net-worth individuals, family offices, and then day traders, because what we saw when we aggregated these liquidity providers was that there was natural [arbitration], meaning one exchange [would be] selling higher so that someone could actually buy very low and then immediately take that discrepancy.”
In case you were wondering, “SFOX” is an acronym that stands for ‘San Francisco Open Exchange’. 🌉
— SFOX (@SFox) February 25, 2020
“So, we had a lot of day traders come in and start making arbitrage trades,” he explained. “But as this platform grew, we had funds come in and say, ‘look, this buy and sell works great for us–but we actually need a little bit more, because we have different strategies–we don’t want to just by $1 million and then sweep it across the book; we want to do [things] in a better way so we can’t impact the market.’”
As a result, SFOX built algorithms that “really catered to different strategies,” Danny explained, adding that this improved prices. “When you buy or sell $1 million or $10 million, normally (if you do this on a single exchange) you move the market because there’s only so much an exchange can actually cover.”
“But then with these algorithms, we would then trickle out these trades piece-by-piece, and that ultimately ends up giving [the buyer] a better price.”
Regulation and compliance are still keeping institutional investors out of crypto
Indeed, different kinds of high-volume investors have different needs; however, the discourse around these investors and their needs has become somewhat muddled because of a lack of a common vocabulary and understand
“The word ‘institution’ has been so bastardized in this industry,” Danny said. “What does ‘institution’ even mean? People continue using that [term] so freely.”
“To me, institutions are the big markets–the large banks, the endowments, the pension funds; those are real institutions–and that, I don’t think we’re going to see [enter crypto markets] for a while, to be honest.”
This is because “frankly, there are a lot of compliance and regulatory hurdles that we need to go over,” he said. “The fact that governments don’t have full clarity on how they want to approach crypto–if the government itself doesn’t have that full clarity, then the banks themselves can’t do it, because they are reporting directly to that government and the regulators.”
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So, Danny believes that quite a lot of time will pass before these kinds of institutional investors stand a chance at entering into the space.
“When I was at banks, for any new product to come out–even something from the traditional side, something that they’ve already traded with, like a mortgage bond–that still required a lot of different hurdles, because there is a lot of hierarchy that you have to go through to understand the product, compliance, and first systems, and everything that needs to change.”
“Now, for the ones that are actually trading–the businesses or independent trading shops–there is a large slew of those guys [in crypto] because the big news is that since they are independent, the regulation is a little bit more light,” Danny said. “They’re always compliant, but because of what they’re provisioned to do, it gives them a little bit larger spectrum.”
“For instance, if you were a hedge fund, if you were going to raise money, you have an investment perspective,” he explained. “This really stakes out what you can and can’t invest in.”
Independent entities still have much more freedom than institutional investors
Therefore, hedge funds that might be interested in entering the crypto space “really can’t come in yet unless they raise a new fund. That new fund would then need to clarify that it is strictly for the purpose of getting into alternative assets that are maybe a little riskier, including crypto, and so forth.”
Once these kinds of pre-conditions have been met, “that’s the fund that can do it,” Danny explained. “So, that’s why I would say that you see a lot of family offices” and independent entities in crypto–”family offices [are in control] of their own money, so they can trade it however they like; if you are a trading prop shop, [you’re] a principal fund, so you can trade wherever you’d like, and there’s no stipulation for that.”
— Finance Magnates (@financemagnates) February 13, 2020
Danny explained that this kind of separation between what’s allowed for high-volume independent traders actually fueled the creation of more of these crypto-specific funds: in December, The Block reported that 804 of these funds were active.
“You saw a lot of these crypto funds come in because these crypto funds were specialized funds specifically for crypto, so as investors, you knew exactly what you were investing in,” Danny said, adding that many of these funds entered the space between 2017 and 2018.
“Now, traditional hedge funds are setting up these funds that are capturing and categorizing crypto specifically for those investors.”
Even if institutions aren’t going toward crypto., crypto is coming for them
While it may be a while before institutional traders to enter crypto markets, Danny said that he’s excited by the increasing number of examples of institutions using blockchain and cryptocurrency
Specifically, he pointed to Paxos, which recently launched a blockchain-based settlement platform that enables settlement of US-listed equity trades between broker-dealers Swiss financial services firm Credit Suisse and Nomura Group-backed Instinet.
“It’s so damn cool,” he said, referencing his previous experience working at BNP Paribas: “those transactions were so archaic and so painful; you would be marking things on spreadsheets and banks would actually be losing millions of dollars because somebody typed in the wrong digit or put a decimal point in the wrong place.”
Danny also pointed to the rise of decentralized finance, or ‘DeFi’, as one of the most exciting trends in the crypto space.
“What I loved about the ICO market…was the fact that it gave anyone anywhere the opportunity to invest in whatever they wanted. Having that sovereignty of power–no longer only allowing a [certain] group of investors to invest, but allowing the global market to invest–because this whole, entire big world became so much smaller just by being able to see who can invest.”
— Social Capital (@socialcapital) August 16, 2018
“There’s still a whole lot of development that needs to be done there,” he said. “But that whole idea–I still want that to grow, because that’s [so] powerful. Investing and earning have always been so siloed–but now you have all these new DeFi projects, were savings accounts allow people to earn outside of what they are traditionally only able to access through their local governments.”
“It still has a long way to go,” he acknowledged. But, for example, “if you are in a terrible economy, if you invest in crypto and put it into a [DeFi] savings account, you can earn a pretty healthy interest rate on it.”
Of course, “you’ve gotta be very careful because a lot of these platforms are still relatively new and there is still a lot of credit risk. So, if anyone’s looking into these, they should 100% look into and do their due diligence on knowing who the people are, and make sure they know what’s going on.”
Without due diligence, we run the risk of repeating the past: “what happened in crypto last time was that once everyone makes a lot of money, everyone gets very comfortable with everything…but then, when things go bad, they can go bad fast.”
Update: this interview was previously (incorrectly) transcribed to read “we don’t want to just by $1 million and then sweep it across the book; we want to do [things] in a better way so we can impact the market.” It has been updated and corrected to “we don’t want to just by $1 million and then sweep it across the book; we want to do [things] in a better way so we can’t impact the market.”