Banks and hedge funds have traditionally looked at cryptocurrencies with a large amount of skepticism, but in the past few years, interest in the space has ratcheted up. With increased interest comes a lot of pressure on crypto exchanges to prove they meet institutional investors’ exacting requirements. 

Digital currency exchanges (DCEs) are where cryptocurrency trading happens, where the market data lies, and in some cases where the money lives, as is the case with traditional exchanges. And this wild new world is attracting prospectors. Institutional investors—hedge funds, traders from banks, and high-frequency firms—are interested in the possibilities crypto assets hold. But they are not without risks. 

DCEs don’t necessarily have the guaranteed latency and access to real-time market data that institutional investors want before they’re able to participate in the market. And with the crypto space heating up, these investors are more interested than ever in expanding into the market, so concerns over latency and execution might just scare them away. As the market grows, any exchange that wants to attract hedge funds and high-frequency traders, and scale up the market may need to look closely at their network infrastructure.

“If everyone is on the same ship, it’s fine for us. What I worry about is if I’m slower than my competitors,” says Ricky Li, founder of crypto-trading firm Altonomy. “Frankly all these new exchanges that come online, pretty much nobody has a physical location, so everyone’s on a cloud-based server and we’re fine as long as we know we’re not slower than other institutional trading firms.”

Volatility Protection

The cryptocurrency market is considered a highly volatile one with prices fluctuating wildly from day to day. Last year’s bitcoin surge, which saw bitcoin reach a high of $19,783 in December—at the time of writing it sat at around $6,000—is a prime example. In such a market, the protection of guaranteed latency at least ensures spreads are not too wide, and the executed price does not vary so traders are not vulnerable to being picked off through arbitrage.

The number of DCEs has also exploded in the past few years. Some estimates put the number around 500, although there is no official documentation on the number of current exchanges, many of which operate in an effectively unregulated fashion. Major players like Gemini, which was started by the Winklevoss twins; Coinbase; Houbi; Bitfinex; Binance; itBit; and Kraken offer the deepest markets and have the largest volume traded. 

Despite the inherent risk in the volatility, institutional investors have expressed a lot of interest in the market, according to Scott Freeman, co-founder and partner at crypto trading firm JST Systems.

“There actually are not a lot of institutional investors already in the market, they’re more just looking at it. If you have a $1 billion hedge fund it doesn’t make sense if you only do a small amount so you want the solutions that work so you can trade in amounts you want,” Freeman says. 

These investors understand that more must be done to ensure prices remain fair but some are willing to take chances now and get in while the market is still developing. Many agree, however, that the market will grow if DCEs offer services specific to institutional investors, like guaranteed latency and granular market data. 

Altonomy’s Li says institutional investors looking to enter the market are more comfortable if exchanges have better infrastructure, but for now it will do. That patience, however, has its limits.

“Right now, trading activity is not at the level of commodities or equities, so we’re still fine even with the infrastructure issues,” Li says. “They all know that soon they will need to host servers and need those infrastructures to be able to scale like the commodities and equities market.”

Crypto exchanges choose where to be hosted, either through cloud-based networks or in a datacenter, much like more traditional exchanges. Volatility in the crypto space, however, brings with it more challenges. In a more traditional setting, investors seek guaranteed latency—that is a set speed at which trades do not bounce around the many different servers set up—so they’re assured prices have not changed too much once the deal is done. High-frequency traders in particular value low-latency models as their algorithms are specifically written to take advantage of this speed. In a more stable market, a little slowdown normally does not affect prices but in a volatile market, a nanosecond can mean the difference between a $1,000 mistake and a $1 million one.

Scaling Up the Market

Institutional investors want to make sure the trades they execute are not subject to rapidly changing prices, and value this stability. Any DCE offering these services could have a strong competitive advantage in this segment of the market, which wields a lot influence. 

This has led many established exchanges to set up institutional investor-focused infrastructure. Coinbase—one of the most well-known DCEs—announced in May that it was setting up an electronic marketplace specifically for institutional investors. It will offer co-location in a datacenter and set up an office in Chicago. And Coinbase is not the only exchange making datacenter moves. Gemini and Bitfinex have also announced co-location strategies, either by physically co-locating customers next to their matching engines, or using an application programming interface (API) to connect to datacenters, in a bid to attract institutional investors.

Gemini, Coinbase and Bitfinex did not respond to multiple requests for comment. 

However, crypto trading platform Quione’s CTO, Ray Hennessy, says that as trade volumes increase, this lack of infrastructure could be an issue. 

“To ensure the ability to effectively service their clients, crypto trading firms demand ultra-low-latency and always-on connectivity,” he says. “With low latency comes high frequency, so infrastructure also needs to be scalable—and as volumes increase, capacity also becomes a major consideration. Instant failover, operations technology, bank-grade security, a unified FIX API, and liquidity are also essential must-haves.”

Network providers like BSO and BT have already received interest from a number of DCEs, executives at both firms say. Both offer cloud and hosted services and co-locate in datacenters so clients enjoy low-latency connectivity to exchanges such as Nasdaq and the New York Stock Exchange.

Gaspard Coudurier, pro­duct manager at BSO, says crypto exchanges and crypto traders have reached out to talk about enhancing connectivity for institutional investors. 

“Institutional investors, when it comes to choosing an exchange, use connectivity and latency as a parameter,” Coudurier says. “We’ve seen a lot of institutional investors thinking of moving into cryptos so we’ve seen a lot of consideration for latency.”

Yousaf Hafeez, BT Radianz’s head of business development, agrees, saying “good quality networks will help to overcome some of the challenges of liquidity fragmentation of cryptos, and consolidated market data feeds for cryptos,” and institutional investors will only be more interested once clearing and custodial services become more available.

Peeking into the Order Book

Other issues facing institutional investors in the crypto space are the lack of transparent execution information, including granular market data, and an inability to take a closer look at the order book. This market information lets traders find the depth in the market that provides a better picture of different trades—and enables analytics such as pre- and post-trade transaction-cost analysis, an increasingly important benchmark in the era of tightened best-execution rules.

Traditional exchanges offer three levels of market data where traders can see price quotes. The highest level, level three, provides the investor with the best bid and asks prices, supply and demand on the price levels, price ranges, and even the ability to enter bid and ask quotes. This requires access by the exchange to its own infrastructure.

“Some large crypto exchanges have their servers actually hosted on Amazon Web Services (AWS) so there’s no infrastructure like co-location or fiber networks. Not only that, the major concerns for institutional investors are to have execution feeds, on the level of market data that they can see,” says Altonomy’s Li. “[Most crypto exchanges] do not provide incremental changes of the order book, only a snapshot of it and you cannot always reconstruct the order book yourself.”

He says these crypto exchanges have to depend on their providers’ infrastructure to provide level three electronic data. He points out, however, that larger DCEs, including Coinbase, have begun offering similar services in a bid to appeal to more institutional traders. AWS did not respond to requests for comment.

Bringing more institutional investors to the crypto space could bring more liquidity and make the market more stable. Perhaps inevitably, there are crypto exchanges that have figured out institutional investors could be the perfect target market, so they begin life as an exchange catering specifically to them.

 While these exchanges are less well-known than the bigger exchanges like Coinbase, Gemini, and Bitfinex, they offer latency and execution guarantees.

One of these newer crypto exchanges looking to cash in on the entrance of institutional investors to the space is Archax, which announced the launch of its exchange in June.

“We looked around and saw exchanges that are not engineered to meet the needs of institutional investors,” says Archax CTO Andrew Flatt. “This is a maturing space so we felt it was important to offer something to institutional investors.”

Flatt says Archax decided to co-locate in a datacenter as it offers direct access without bouncing around on different servers, and wanted to provide a fixed connection either directly or through an API. 

Archax also partnered with trading technology firm Aquis to set up a suite of exchange operations tools including a matching engine, market surveillance platform, and post-trade services. 

Since the trading of spot cryptocurrencies is not formally regulated, Flatt says attracting regulated entities like banks had to be approached differently.

“It’s a brand new asset class; of course they want to play in it,” he says. “But it’s honestly hard to convince a regulated entity to participate in the market without having all features on market surveillance or connectivity that a regulated exchange might have.” 

Other Concerns 

But it is not the larger crypto exchanges or the institutional investor-focused newcomers that are problematic for institutional investors; it’s smaller crypto exchanges that were set up using white-labeled software and which connect to cloud providers. These exchanges don’t have the necessary infrastructure but still want to attract a larger customer base. The cloud offers a faster set-up time so a new crypto exchange can start providing trading services in popular pairs, such as bitcoin-dollar and ether-dollar, relatively quickly. Crypto exchanges turn to cloud providers’ managed services features since it is often expensive to build their own infrastructures. 

That is not to say, however, that crypto exchanges set up on AWS or Azure are not at all reliable. Craig Borysowich, digital platform strategist at consultancy Capco, says many believe cloud providers are more reliable than homegrown infrastructure.

 “Lots of ‘traditional’ exchanges are also on public clouds because it’s just a lot quicker to build things on it,” Borysowich says. “In fact, these cloud providers may even be more resilient than dedicated datacenters and can come back faster after downtime.”

He adds that latency and transparent execution may be issues
for institutional investors but there are far bigger issues in the space that need to be resolved, especially with concerns around custody, continued market volatility and of course the regulatory limbo of crypto exchange-traded funds and other crypto assets. 

Borysowich also notes crypto exchanges themselves have built credibility that overshadows any wariness around infrastructure particularly when the firms show they are secure and fair. But any potential market participant needs to understand the crypto world is different and cannot be made to imitate the world of more traditional assets. 

Institutional investors’ concerns have encouraged other firms to set up trading platforms or broker-dealer-like services that institutional investors can use with some degree of familiarity. 

JST’s Freeman thinks more broker-dealers will crop up as intermediaries in the market since institutional investors prefer not to have direct access to exchanges and that some crypto exchange will evolve to catering specifically to either institutional firms or retail traders. 

Whatever route crypto exchanges take, institutional investors are flocking to cryptocurrencies to see what the hype is all about. But getting them to stay and enrich the market may be a different matter altogether. 

“I have no doubt the market will mature and scale and institutional investors will want to get in, but before that happens, all this infrastructure has to be ready,” Altonomy’s Li says. “So we have to emphasize that institutional investors are so important, because the market is moving so fast that a lot of the important aspects of a traditional financial market are, by a large margin, ignored.”