Cryptocurrency – Major Financial Institutions Are Moving Forward Cautiously, But Steadily

Investing, Regulation | August 24, 2018 By:

In the midst of a cryptocurrency boom, prominent skeptics continue to influence the growth of the market. Titans of finance, from Chase CEO Jamie Dimon to legendary investor Warren Buffet, have offered scathing comments, but that hasn’t stopped major financial institutions from taking tentative steps into the market. And as in Dimon’s case, there’s evidence that attitudes are changing and acceptance is growing.

Despite regulatory uncertainty and persistent questions about clarity and transparency, recent moves suggest many of banking’s biggest names are in no way deterred from cashing in on the crypto craze. Goldman, Barclays, and even major asset managers such as Fidelity are all making forays into the uncharted waters of cryptocurrency, despite a hazy regulatory outlook and fundamental trepidation about entering an evolving market.

Initially, most of the big names are simply allowing their clients to trade a crypto forward or futures contract based on what the price of bitcoin will be at a specific date. And since bitcoin remains highly volatile as the market evolves, there is clearly ample opportunity for trading just the underlying asset. But institutional level profits won’t be made overnight. The evolution of the institutional crypto market will progress, and volumes will grow – and will require significant investment in trading network technology as they do – but it’s important to remember this phenomenon is in its early stage.

It’s understandable that regulatory agencies will take some time to understand cryptocurrencies, classify them and devise appropriate safeguards for market participants. Right now, the SEC considers cryptocurrencies to be securities, while other authorities view bitcoin/Litecoin in the same way as the traditional currency pairs like dollar/euro. Some others question whether crypto is even a legitimate investment asset at all. Beyond these fundamental compliance issues, there are more questions: how does a firm go about declaring taxes on any gains from crypto trading? These are grey areas that will need to be clarified before larger players get fully involved in the market.

Given this lack of regulatory certainty, applying traditional trading practices to crypto remains problematic, but the need for secure trading infrastructure still exists. Major electronic trading houses rely on two key forms of trading: the first involves simultaneously buying and selling assets to make money on price differences, a form of arbitrage. The second centers around entering lots of small orders into a computer to weight the order book favorably, or order book scalping. Both approaches rely on highly liquid markets. If volumes are flat, then the opportunities for profit are limited, regardless of the size of the institution doing the trading. Even in a period of rapid initial growth, crypto trading volumes are a fraction of the volume of stocks traded on global exchanges.

This is the main challenge for any institution entering the crypto world. Using arbitrage and order book scalping strategies requires guaranteed connectivity to the exchange, and yet exchanges haven’t made the necessary investments to ensure this, because trading volumes still aren’t large enough to justify the expense. But if a connection to an exchange cuts off for just a few seconds, a market maker’s profits could suddenly turn to loss. No institution wants to have their algos trading crypto if they can’t guarantee connectivity to the venues.

On the other side of the coin, financial institutions will not dive head first into trading cryptos without the requisite underlying infrastructure support. Those that do will have to go through the specialist venues that do not fear lightly regulated markets as much as the larger exchanges.

It’s a classic chicken and egg conundrum. Who will blink first? Eventually, regulators will agree on how to define crypto. There’s still more uncertainty than clarity on this issue. But once it’s resolved, national exchanges will start making their moves.

Financial institutions that have laid out their crypto trading cards early remain a bit ahead of the curve. They are adapting strategies that succeed with lower volumes and aren’t as dependent on infrastructure and taking regulatory and exchange connectivity issues into account. As larger institutions move further into crytpo, they can learn from the earliest market participants, who may not be making institutional scale returns, but are nevertheless proving that this is a viable market.