In the Chinese Zodiac, 2021 was the year of the Ox. But as far as the Collins Dictionary was concerned, 2021 was the year of non-fungible tokens (NFTs)—it named the digital asset its word of the year. Interest in digital assets is on the rise overall, while work is underway to bring security tokens to the fore. Yet many institutions are still grappling with whether or not to get more involved in the original and still most controversial digital asset: cryptocurrencies.

Making the investment decision to trade in crypto is one thing—and it’s no secret some still believe the fundamentals aren’t there. But once they do decide to invest, how they go about it is another question altogether.

Similar look, different experience

“Even if someone made the investment decision that they wanted to buy digital assets broadly, then they had yet another hurdle of how do they actually get exposure? ‘How do I buy this? How do I store this?’ Because historically, it’s been very different to trade—there are disparate exchanges, fractured liquidity. You don’t really know what to do, right?” says a product manager at a large US-based asset manager, contrasting digital assets with the equities markets, where trading in a stock is generally centralized on a single exchange.

This, and custody, were previously considered the major barriers to institutional participation. But not so anymore, as traditional custodians get more skin in the game. For example, BNY Mellon launched its Digital Assets unit one year ago in February 2021 and is developing a prototype for a multi-asset digital custody and administration platform for traditional and digital assets. Then there’s Zodia Custody, a UK Financial Conduct Authority (FCA)-registered crypto asset custodian co-developed by Northern Trust and SC Ventures, the ventures and innovation arm of Standard Chartered.

But institutional firms need more than just custody. They want something that looks and feels like the order, execution, and portfolio management processes they already use to trade in traditional asset classes, such as equities, fixed income, and FX. And as institutions continue to weigh that investment decision, now at least there is better tooling available so they don’t have another hurdle, and sources say the development of institutional tools—by providers such as Talos and TradAir—has certainly helped

New York-based Talos, founded in 2018 by CEO Anton Katz and CTO Ethan Feldman, provides institutional-grade technology infrastructure that supports the full lifecycle of digital assets trading, from price discovery to execution and settlement.

Before founding Talos, Katz was head of trading technology for AQR Capital Management for about three years. Before that, he and Feldman worked together at Broadway Technology.

The company’s key differentiator—and what sets it apart from other platforms catering to broader retail markets, as a platform targeting institutional clients—is its team of about 40 people, many of whom come from a capital markets background, Katz says.

“Our team comes from years and years of experience of building exactly these kinds of systems in capital markets. … We built these systems in every single asset class, and we power a lot of the execution that exists right now, in capital markets, both in FX and in fixed income, in treasuries, and in futures. The experience that you have there, and really that notion of not just building the feature set, but actually building a safe environment, building a performant environment, building a compliant and secure environment that institutions need—that’s where a lot of our experience actually comes from,” he says.

At its core, Talos provides clients with trading capabilities—including algorithmic execution tools, direct market access (DMA) services, and multi-dealer request-for-quote (RFQ)—and connects to about 40 different liquidity providers, including exchanges and OTC desks.

“Our job is really to make sure that we can make it easy and familiar for institutions to trade digital assets. So, really, kind of like softening that transition from traditional markets and giving them the ability to add digital assets,” he says.

These include tools that Katz says were not as available previously in digital assets, such as transaction cost analysis (TCA), as well as other pre- and post-trade tools. While these are widely used in capital markets, they are still lacking in digital assets.

Katz says Talos spent “a lot of time” building those tools. Talos also plugs into tools like Fireblocks, and Silvergate, both of which operate in the digital custody and settlement space.

One thing he stresses is that Talos is not involved in the trade. “We are not a broker. Our clients do not trade with us; they use our technology, our platform, to interact with the underlying providers,” he says.

Cryptocurrencies aren’t like other currencies

Vibhanshu Bahuguna, regional manager for Asia-Pacific at TradAir, agrees that tools need to be further developed for institutions to start trading crypto on a more widespread basis. Though often compared to FX as an asset class, where plenty of tools exist, crypto is quite different. For example, he says, a $5 million order barely makes a dent in the world of FX as the market is very deep, with anywhere between $3 trillion to $5 trillion traded every day. It’s not the same for crypto markets.

TradAir, which was acquired by Ion Group in January 2021, is an end-to-end front-office trading technology provider for banks and brokers in the global FX, contract-for-difference, and crypto markets. TradAir was previously owned by Long Ridge Equity Partners, an investment firm that still has an active investment in Broadway Technology, another firm bought by Ion (but later spun off again).

TradAir spent $10 million building its liquidity aggregator—which shows traders the top-of-book in real time—over about six months, and despite “borrowing” technology that it has used to support its FX business for more than 10 years, configuring the platform for crypto use was a “heavy lift,” Bahuguna says.

For example, he says that for FX, institutions usually trade a minimum of $250,000, whereas that’s not the case in the crypto markets. “I could trade in 0.01 BTC (bitcoin). These were the kind of configuration changes that we had to do, because you can ask for the price of 1 million BTC, but institutions won’t trade 1 million because that’s too big of a ticket size,” Bahuguna says, as a trade of that size would cause a market impact.

Right now, we’re like racing to parity. We’re racing to bring the clients into this familiar environment, making sure that they know exactly what they’re doing.

Anton Katz, Talos

So, in 2017, TradAir made changes designed to support smaller trade sizes and higher numbers of trades. “Imagine institutions trade 0.01 BTC all day long and that’s the nature of the market, so decimals were a large part of [the configuration]. Also, the number of tickets in the database from a trading and market data perspective—we had to ramp up our database to collect thousands of tickets every day,” Bahuguna says.

While working on configurations like adding decimals to trade sizes may seem an easy task, he says it took TradAir six months to complete. “It was a huge project for us, especially on the API level. There were a lot of changes that had to be configured, developed, tested, and then rolled out,” he says. “And it’s not just the price that I’m showing in four decimals, but also the quantity had to be accommodated for four decimals. It was a heavy lift for us.”

And there’s more heavy lifting to be done, to accommodate the nuances of the crypto markets: For example, the vendor is currently building the equivalent of a portfolio management system (PMS) for crypto assets, which it plans to roll out before the end of March.

“We essentially thought that we could just be the execution platform, which is the case in the more traditional assets, where you have very clear, defined areas, like someone is an expert in OMS, and another is an expert in EMS or back office. But in the crypto space, it’s all sort of merged in one single platform,” he says.

As for Talos, it uses past experiences in dealing with capital markets as a crystal ball to predict what’s needed to provide that familiar environment for institutional investors.

“We know what the clients are usually looking for, what kind of services they need, what they use in every other asset class. But that’s half of the story. Right now, we’re like racing to parity. We’re racing to bring the clients into this familiar environment, making sure that they know exactly what they’re doing,” Katz says.  

However, servicing the digital asset space also presents an opportunity to be more innovative, as many of these platforms are built from the ground up.

“In your career, you don’t get many opportunities like this to rewrite some of the stuff and to start anew. Usually, when you’re working on an existing system, you’re working on enormous technical debt, and so moving that system forward and revising some of these kinds of challenges of the past is really difficult. We have the opportunity to actually do something about that. A lot of the choices—whether it’s design choices, or monitoring, or even deployment choices—that we’ve made, are because of lessons of the past,” he says.

Crypto caution has more ‘fundamental’ issues

But not everyone shares Katz’s optimism and excitement around the “opportunity” to shape a new market. Despite the increasing institutional interest, there are still doubts about the fundamentals of crypto as an asset class. According to research by Hong Kong-based strategic consulting firm Quinlan & Associates, current institutional investor activity in the digital asset space remains “somewhat muted,” especially due to the lack of “clearly visible fundamentals” in many digital asset classes. But reaching beyond that, the report highlights that regulatory clarity is key. Investment mandates won’t allow institutional asset managers to invest in unregulated products, and the lack of fundamentals in many digital asset classes makes it more difficult.

However, Steve Sanders, executive vice president of marketing and product development at Interactive Brokers, which now also has a crypto trading platform for institutional investors, disagrees. He says the biggest factor holding crypto back from institutional trading is still a lack of regulatory clarity around digital assets.

I don’t really see lack of tools or fundamentals as a showstopper for institutional participation in crypto, given that institutions buy gold/crude and that doesn’t have fundamentals.

Steve Sanders, Interactive Brokers

“Governments will eventually want to regulate crypto in some way because of the potential illicit activity that could occur. We offer crypto, and if the demand for tools is there, we’ll build it. I don’t really see lack of tools or fundamentals as a showstopper for institutional participation in crypto, given that institutions buy gold/crude and that doesn’t have fundamentals,” Sanders says.

However, it’s difficult to generalize all institutions in one way—whether they’re adopting crypto, or not. The product manager at the asset manager—who asked for anonymity as they are not authorized to speak publically for their firm—says there is a clear shift toward institutional firms seeking more exposure to digital assets—it’s just that not every institutional investor is on the same page yet.

And while some big names have gotten involved, attitudes still vary wildly. For example, while BlackRock CEO Larry Fink has publicly said while he sees “huge opportunities” for cryptos, he also—much like JP Morgan CEO Jamie Dimon—thinks bitcoin is “worthless.” Despite this, in January, BlackRock, which has about $9.5 trillion in assets under management, authorized two of its funds to engage in trading bitcoin derivatives.

Others prepping crypto-related products include Fidelity Investments, which has $7 trillion in assets under management, plans to launch a crypto exchange-traded fund (ETF), while its digital asset arm, Fidelity Digital Assets, which launched in October 2018, provides custody and execution services for crypto assets to institutional investors.

For its 2021 edition of The Institutional Investor Digital Assets Study, Fidelity Digital Assets surveyed 1,100 professionals ranging from high-net-worth individuals, financial advisors and family offices to specialist crypto hedge and venture funds, traditional hedge funds, as well as pension funds and defined-benefit plans. The survey concluded that nearly 90% of investors surveyed found digital assets appealing due to the high potential upside, but still had major concerns: 44% of investors cited the lack of fundamentals to gauge appropriate value as a barrier to investment, while 54% highlighted price volatility.  

The product manager agrees that “plenty” of institutions are still looking at the fundamentals and trying to understand how to value the asset.

“Some are just going in because maybe they figured out a way that they could value it. Or, they’re saying it is digital gold, and that’s why they’re going to add exposure to bitcoin. So, it really depends where on the spectrum that institution falls and how much risk they’re willing to take,” they say. Once a firm has made that decision, that’s where the types of tools discussed earlier become helpful in determining how they can best get exposure.

Different strokes

There are different ways some of these institutions are adding crypto assets to their portfolios. Some might decide to label bitcoin “digital gold,” and treat it similarly to commodities. Others might classify it as an asset they can add to their venture portfolio. “Some are just saying, ‘I have a 60:40 portfolio, and 10% of that is alternatives, so I’ll just put bitcoin or other digital assets in my alts sleeve,’” the product manager says.

So, that’s how firms are allocating it. But then, how do they actually trade it? Should they buy the spot market directly, or trade futures or ETFs?

The product manager says futures and ETFs that provide a familiar “wrapper” around underlying crypto products will prove much easier for investment advisors and some other institutions, since their existing systems are already set up to handle those assets, and since these provide continued liquidity and pricing because there is a wider range of products and market makers. Portfolio managers and traders, however, may see the spot market as more efficient in terms of fees and liquidity.

“We see a lot of folks tend to go that way [using futures or ETFs], unless for whatever reason they must hold a security; in that way, they’re doing it through a wrapper that is a future or some other type of investment product,” the product manager says. “I think what those larger institutions struggle with then is the liquidity in those tokens, and their ability to actually access that in a secure fashion.”

STORY CONTINUES AFTER THE BOX

Asia and experience leads the way

Fidelity Digital Assets’ research shows that investors in Asia are more open to digital assets. Of those surveyed, 71% of institutional investors already have allocations to digital assets, compared to just 27% of US and 56% of European institutional investors. Fidelity Digital Assets found adoption was driven by financial advisors (100%), high-net-worth investors (86%) and crypto hedge funds and venture capital firms (53%).

Michael Wong, co-founder, managing partner and COO at MaiCapital, a Hong Kong-based crypto fund manager, says most of its investors are currently family offices and high-net-worth individuals, but that the firm is also seeing more interest from institutional investors.

There are two reasons for this, Wong says. “One, the market believes it’s here to stay and there’s a future there. Two, the threshold of consideration is higher, meaning they want to see longer track records. Usually, they maybe need to see 6 or 12 months of track record, but for traditional hedge funds, a lot of them now want at least two years of track record, which is where we are,” he says.

MaiCapital is regulated by the Hong Kong Securities and Futures Commission (SFC) and currently has two fund offerings—a blockchain opportunity fund and a bitcoin+ investment fund.

The former is a long/short hedge fund investing in blockchain equities, crypto and related-assets, that trades in and out of the top 30 crypto and crypto-related assets, including futures and derivatives, while the latter is a blockchain-related asset quant fund aiming to track and potentially outperform bitcoin’s performance in various market conditions.

Wong says from the onset, MaiCapital designed its products and operation to suit typical institutional flavors. “That’s why we went ahead and got a license in Hong Kong, and that’s why we structure our current product in a way that is very similar to what traditional hedge funds look like in terms of having fund administrators, licensed managers, fund auditors—all the bells and whistles that you will typically see in the traditional hedge fund space,” he says.

That approach of appealing to traditional financial sensibilities should go some way to reassuring those still hesitant about crypto. Also reassuring is that these aren’t fly-by-night college dropouts with a patent and a Powerpoint deck. Wong has engineering background and spent more than 15 years at semiconductor manufacturing company Qualcomm. He co-founded MaiCapital with CEO Benedict Ho, who has more than 15 years of experience in trading and asset management. Also on the team is ex-Goldman Sachs executive director Marco Lim, who joined in 2019 as managing partner.

Wong says his technical background, combined with Ho’s asset management experience, is a good mix. “I think what we’re doing today, it’s a fintech mixture. Even though a lot of the operational stuff and the product itself is quite financial in nature, it requires quite a lot of technical know-how and expertise in understanding what we’re investing in—what the underlying asset is and what it means—as well as the operational aspect,” he says.

Similarly, when crypto trading-tools vendor Talos was deciding who would spearhead its expansion in the region, it chose Samar Sen—who has over 20 years of capital markets experience working in various product, strategy, and technology leadership roles at Deutsche Bank, BNP Paribas Wealth Management, Barclays Wealth and Investment Management, Goldman Sachs and KPMG—as its head of Asia-Pacific.

Sen says another key issue is not trying to appeal to firms with a purely crypto-based product pitch, but rather offering flexibility. Although Talos started with clients in the hedge fund and family office space, Sen says the firm is in “deep conversations” with well-known bulge-bracket financial institutions.

“We’ve seen Asia almost leading the pack in some of these areas. We see many more segments coming to the fore, whether they are typical FX brokers that are now offering an additional asset class, or more traditional buy-side funds, which are now allocating to this asset class that were not natively crypto,” he says.

What’s still missing?

While more institutional-grade tools are available, they still aren’t comparable to the most basic existing offerings in the prime brokerage space in other asset classes, says Samar Sen, head of Asia-Pacific for Talos.

“Few of these types of offerings can fully service the crypto market, which is open 24/7; it’s open every minute of the day,” he says. That’s one challenge; another is building tools that are not only tailored to this new asset class, but to specific strategies that firms want to execute in it.

There’s the buy-and-hold strategy, which is the most volatile in terms of market risk, but is an easier strategy from an operational risk standpoint as more custodians, exchanges, and brokers with licenses can serve institutional investors, says Michael Wong, co-founder, managing partner and COO at MaiCapital.

As part of its mission to adapt tools for crypto markets, TradAir has also tackled the issue of making well-known strategies to the distinct nuances of crypto. At a basic level, in a consolidated mode, a trader would see a mirror of liquidity providers’ order books. Applying algos like a volume-weighted average price (VWap) or a time-weighted average price (TWap) cleans up the liquidity view and presents prices in a way that makes sense to a trader, Bahuguna says. TradAir also offers time-slicer and iceberg algorithms specifically for crypto trading.

As for more “exotic strategies”—such as those employed by MaiCapital’s funds, Wong says—the level of difficulty increases as there are not yet enough exchanges and brokerages that are licensed and have risk mitigation mechanisms to handle these for crypto.

“That makes it a little bit harder if you want to trade across different brokerages, and then the other part is the safekeeping of it. For example, for super high-frequency trading strategies, it requires you to basically leave the assets on the exchange, because you need to make trades all the time,” he says.

This could be a problem as crypto exchanges are susceptible to hacks. If an exchange is compromised, the assets left there could be compromised too.

Ideally, after buying some bitcoin, firms would move the asset to a safe place—a custodian that’s insured—Wong says. But if they want to trade on a high-frequency basis they can’t be constantly moving holdings back and forth. “So, there are some logistical things you need to figure out. That’s where the prime brokerage value comes in. Today, when you trade equities, you don’t have to worry about that; you open a prime brokerage account, and they just take care of all the background stuff,” he says. “In the crypto space, all these service providers are still coming together, they’re building the tools and stuff like that, but it’s still not in one piece. And even if it is, it’s still not comprehensive enough, for example, to deal with the 24/7 problem.”

MaiCapital uses TradAir to help with its execution. “Because we trade futures, derivatives, as well as spot, it just makes it easier from a trader’s perspective, that they provide execution to have kind of a centralized place where I could see my orders, [and where] I can place orders under one interface,” Wong says.

Don’t ‘settle’ for sub-standard

As for the exec at the asset manager, settlement is one of the main challenges hindering more institutional involvement in this asset class.

“Settlement is still disparate and fractured, and the institutions have two options: they can pre-fund exchanges—so they get transparent order books, but they lose capital efficiency, meaning they have to pre-fund and put assets at various exchanges to get that best ex view—or they may transact over the counter through a market maker,” they say.

“That pricing is a bit more opaque. You don’t really know how deep the book is, and you don’t know what the impact is going to be on exchanges, but you could settle on a post-trade basis. You’re still taking some counterparty risks and some credit risk there … both parties are. There isn’t the equivalent of a Depository Trust and Clearing Corporation (DTCC) that helps facilitate equities settlement, or continuous linked settlement (CLS) for FX—that doesn’t yet exist in digital assets.”

And beyond settlement, standardization—or rather, the lack thereof—is a much broader issue: the product manager says the key challenge isn’t so much a technology problem as it is a network and a non-technology problem.

“It’s getting people to agree to best practices. Every custodian and every exchange is different. If you want to trade on exchanges, they’re going to view that as their own pool of users and pool of liquidity. They may not want to share that pool with one of their competitors. There are plenty of technology solutions, but really, it’s how do we build standards and best practices for what settlement should look like in digital assets?”

How should that look in practice? According to the product manager, it should be when traders can transact all day, and then the netted positions get settled at the end of the day between custodians and exchanges, wherever the assets are held.

That’s when the “24/7 problem” comes up again, and the industry needs to solve issues as seemingly simple as deciding when the “day” ends. “In a market that trades 24/7/365, the closest thing to it is FX,” they say. “So, you kind of look to the FX model and market and decide when does the day end? When do we do rolls? That’s where a number of the participants are struggling.”

Although some of these issues will continue to hinder institutional participation in crypto, the space is evolving fast. As traditional banks and custodians, as well as newer service providers, continue developing their platforms and tooling for institutional investors, it is surely just a matter of time before more institutional participation becomes widespread, says MaiCapital’s Wong.  

“At the end of the day, everyone can make money—it’s just the amount of risk that you’re willing to put into making that money. And for institutional investors, managing the risk is the more important part,” he says. “Investing into the crypto space comes with not only market risks, but also a lot of operational risk. Figuring out an operation that can fit the investment strategy that you want, and at the same time, has enough of the operational process and counterparties that can help you manage the risk that fits your strategy—I think that’s the most difficult part, frankly.”