Institutional Crypto Needs Greater Trust. Prime Brokers Can Help

Bitcoin price may have recovered from the collapse of the FTX crisis, but its fallout continues to reverberate across the crypto industry. As participants seek ways to regain the institutional trust that the current crisis has created, and avoid the next one, one of the theories being advanced is the potential for prime brokers to develop and maintain credit relationships.

For institutions, a major barrier to entry is the operational risk of crypto. Many spot exchanges are heavily retail-focused and place a lot of risk on the client, which is unsettling for institutional players. Dealers and prime brokers understand and manage that risk for clients.

According to Luke Hoersten, the Founder and CEO at Bitnomial, this is where crypto-native prime brokers can really step up. "At-scale crypto operations are much more involved and nuanced, and so there is a choice institutional investors must make between actual crypto exposure and synthetic exposure that can break down during market unrest," he stated.

"I think we are already seeing such an FX/OTC style market emerge from crypto-native prime brokers and dealers who are quietly building and expanding their service offerings."

Compliance Concerns

Traditional structures such as inter-dealers should boost institutional investor appetite as they already understand the offering and mechanisms of these market facilitators from other asset classes. Having these players active would demonstrate the evolution and maturity growth of the industry.

"Investors take confidence from familiarity when investing in new asset classes," noted Danny Bailey, a Senior Institutional Sales Lead at Bitstamp. "However, this of course needs to be coupled with risk mitigation and regulatory oversight."

The current wave of institutional crypto adoption includes more conservative institutions, with compliance departments concerned about counterparty risk, who cannot easily change their existing workflows.

As a relatively new asset class, it is necessary to have the right market participants to raise investor confidence and widen adoption, reckoned Ayal Jedeikin, Founder and CEO at Cypator. "Interbank dealers and prime brokers bring a natural market structure to the digital asset ecosystem, facilitating institutional participation through an understood workflow," he observed.

"Prime brokers bring efficiencies in a risk-managed fashion by reducing counterparty risk. Meanwhile, inter-dealers introduce a setup conducive for large participants to face each other frictionlessly.

"We have seen leading crypto-native participants shift to this model, wherein counterparty risk is significantly reduced, and efficiencies are gained in collateral management."

All About Trust

Deribit has multiple prime brokers active on its platform, and Chief Commercial Officer Luuk Strijers referred to trust as one of the main benefits.

“Instead of opening accounts with 10 exchanges, a firm can open an account with one prime broker and get access to all 10 markets almost instantaneously at competitive rates,” he said.

“The presence of reputable or large prime brokers would also ensure stricter adherence to compliance and regulatory standards, leading to increased transparency and trust in the market.”

Like mature markets, interdealers and prime brokers allow institutions to keep their funds at a non-exchange custodian. They also enable capital-efficient order routing to various venues and provide a suite of services such as OTC trades, hedging, derivatives, and potentially margin/leverage. David Wells, the CEO at Enclave Markets, explained: “An interdealer settlement network would allow net settlement across custodians, brokers and trading venues.”

The FX and Crypto Synergy

Despite banking and regulatory uncertainty in the digital asset space, crypto companies and traditional financial institutions have a lot to gain from establishing common ground. That is the view of Rich Evans, the Managing Director for Institutional Sales of Prime Liquidity at CEX.IO, who said bridging the gap will continue to present opportunities as these spaces are further defined and strengthened. “In short, I think the obvious answer to the question of whether bringing interdealers and prime brokers into the crypto market would boost investor confidence is yes,” he said.

“In addition to broadening the potential and reach of each industry, welcoming larger asset managers into the space would help demystify the ecosystem for other high-volume clients. As well as providing deeper wells of available liquidity, their presence would help correct some of the misunderstandings around the legitimacy of the digital asset space.”

Interdealer infrastructure, such as voice brokers and mid-books for digital assets, is missing in some respects, but it is only a question of time before it emerges. For now, the large number of existing exchanges (even though they mostly service retail clients) are bridging that gap.

That is the view of Thomas Restout, the CEO of EMEA at B2C2, who suggested that as long as most of the volume remains retail-driven, and the exchanges are the conduit for those real volumes, the pressure on interdealer infrastructure remains low.

He added that prime brokers would be a massive and welcome addition as credit is a key inhibitor to industry development. “All the major market participants interact with us,” Restout pointed out.

“Yet for them to deploy enough capital to the crypto market, they will need the help of players with much larger balance sheets or alternative solutions to reduce their credit risk with players such as B2C2. Considering recent turmoil, the credit risk of any exchange or player is deemed high so any mitigating method is welcome.”

“The Opposite of What We Stand For”

With more interdealers and prime brokers, fluidity in the market should compress margins and it may increase adoption and give confidence to large institutional money players. “We are supportive of the latter and provide all the support we possibly can to those institutions and banks to develop the ecosystem,” adds Restout.

Patrick Bärtschi, the Head of Business Development at Bittrex Global agreed that the benefit of interdealer and prime broker involvement in the crypto market is a hot topic across the cryptosphere right now, especially in the post-FTX climate. Interdealers and prime brokers are typically highly regulated and well-established institutions with proper risk management and expertise. Embedding this type of infrastructure into crypto trading would definitely reduce counterparty risk and add more credibility and legitimacy to the market. “I have no doubt that this would increase investor confidence, particularly with institutional traders,” said Bärtschi.

“However, as crypto is still dominated by retail investors, the prime broker model may not be the best solution for a variety of reasons such as the higher costs involved, and the increased complexity for retail investors in dealing with prime brokers as well as the reduction in control and oversight of associated trades.”

Another dissenting voice in this debate is Andre Cronje, the Co-Founder at Fantom, who suggested that crypto-native investors understand that the true value of crypto is self-custody, self-sovereign control.

“To them, brokers are the exact opposite of what we stand for,” he said. “So brokers would boost investor confidence in terms of traditional finance, but would lower confidence in terms of decentralised finance."