June 2020

Trading Infrastructure

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The trading infrastructure surrounding digital assets is maturing. Trade volumes have risen dramatically over the last three years, helped to a large degree by the creation of derivative markets and over USD1 billion in investments allocated to institution-serving firms.

The trading infrastructure surrounding digital assets is maturing. Trade volumes have risen dramatically over the last three years, helped to a large degree by the creation of derivative markets and over USD1 billion in investments allocated to institution-serving firms. Three years ago, an institutional investor looking to participate in the digital asset space would have been hard pressed to find credible solutions to do so. Today, they would be hard pressed not to. With crypto exchanges becoming more professional and traditional avenues like the Chicago Mercantile Exchange (CME) now offering Bitcoin futures, there are a wealth of options for investors to choose from to gain exposure to the space. This month we will look into the evolution of trading infrastructure and why derivatives and in particular futures products have quickly eclipsed the volumes seen on spot markets.

When Bitcoin was first created in 2009, there were no exchanges or platforms that were capable of holding digital assets. Bitcoin could only be self-custodied and the philosophy behind the asset was that it was a reaction against the traditional financial system and against rent seeking middlemen. Early cryptocurrency exchanges were dangerous places. Losing assets from an exchange hacking was commonplace, the most famous example being the Mt Gox hacks of 2011 and 2014 with around USD500m being stolen (USD8 billion at today’s prices). On the back of hacks like this and under growing regulatory scrutiny, exchanges started improving their security and operational sophistication. Investment also flooded into new firms providing institutional infrastructure for digital assets.

Despite increasing professionalism, crypto exchanges are still largely incapable of accommodating institutional investors. The risk of holding assets with loosely regulated entities, lacking brand name custodians is too much risk for managers to subject themselves to. On top of that, institutional investors owning digital assets in crypto wallets remains challenging from a regulatory and operational perspective. Similar to commodity markets, the most desired exposure for institutional fund managers is through synthetic products rather than holding the actual product.

The result has been the creation of structured products that offer exposure to the spot price of Bitcoin in a way that is more familiar to the traditional investment world. Our Liberty Bitcoin Fund is one such example; structured as a mutual fund, where investors own shares in the fund and the fund holds bitcoin through OSL Custody, a Fidelity-backed custodian. Products like this are easier for fund managers to invest in and to account for. Another increasingly popular vehicle for gaining Bitcoin exposure is futures. Bitcoin futures markets originated with BitMex and have now spread to other crypto exchanges like Binance, Kraken and Huobi as well as to more traditional avenues like the CME. CME saw its open interest rocket from USD100m in April to over USD500m in late May.

Bitcoin’s market structure is similar to that of foreign exchange in that it is globally distributed and operates 24 hours a day. Unlike foreign exchange markets, most trading volume occurs on centralized exchanges rather than through an interbank market. Broadly speaking, there are three categories of market that trade bitcoin; spot markets of fiat to BTC, spot markets of stablecoin / other crypto to BTC and derivatives markets. Of these, the derivatives markets have arrived most recently and are now the largest by far.

Like other asset classes, derivatives markets in Bitcoin have become several times larger than spot markets. As a result of this, gaining exposure and trading in and out of crypto positions is becoming far more efficient through futures and derivate products as opposed to spot markets. The existence of these derivate products are evidence that Bitcoin has evolved from a fringe asset to one that mainstream investors can participate in. However, relative to traditional financial assets, Bitcoin’s trading volume remains tiny.

While the trading volume of Bitcoin and other digital assets may be small today, its growth rate is staggering. Bitcoin markets have grown from USD1m in 2013, to USD100m in 2017 and now to over USD19bn in 2020, growth of 190x in three years. If this growth rate were to persist, in under 4 years Bitcoin’s daily spot market volume would exceed the daily volume of all US equities. Whether or not that ends up happening, it is clear that trading markets for digital assets are growing rapidly and it is likely that the digital asset ecosystem will become a major asset class in the coming decade. The maturing of trading infrastructure is fuelling this growth, allowing institutional investors the ability to access a previously opaque market.

At CMCC, we are keeping a close eye on the evolution of trading infrastructure and its impact on digital asset markets. While derivate products make the space more accessible for larger institutions, it also opens the door to sophisticated traders who are utilizing a range of trading strategies. From an operational perspective, we are evaluating the use of newer trading instruments to improve risk management and our own efficiency in managing CMCC Global's portfolios.