Crypto Long & Short: The Emergence of Prime Brokers Adds Resilience but Also Risk

There are many types of hockey-stick evolutions in new industries. Startups dream of the lying-on-its-back L shape for their sales growth. Entrepreneurs chase the “escape velocity” funding momentum. And a subsector can simmer along with a low hum of activity until boom, years of progress and feverish months of under-the-surface connecting explode in a series of announcements and launches that signal a new phase of development.

Ok, maybe hockey sticks are not the best metaphor as they are made of a solid piece of something (you’ll notice I don’t know much about hockey). And the crypto markets are far from a solid anything, with disjointed parts, confusing rules and fragmented information. But moving pieces can eventually come together.

You’re reading Crypto Long & Short, a newsletter that looks closely at the forces driving cryptocurrency markets. Authored by CoinDesk’s head of research, Noelle Acheson, it goes out every Sunday and offers a recap of the week – with insights and analysis – from a professional investor’s point of view. You can subscribe here.

I’m talking about the emergence of prime brokers for crypto markets. Over the past few days several “blue chip” names (by crypto market standards) have revealed plans to knit new connective systems for crypto trading and investment, with the experience and the backing to make a meaningful difference.

This week crypto exchange Coinbase announced the acquisition of crypto prime broker Tagomi in an all-share deal that boosts the exchange’s institutional offering and gives Tagomi access to a strong balance sheet. 

BitGo, one of the sector’s largest custodians, launched its prime broker services, adding lending and software to its existing suite of services. 

And last week, Genesis Capital* revealed the acquisition of crypto custodian Vo1t, which will enable it to add custody to its institutional lending and trading. 

Why now?

Several startups have been offering what they call “prime brokerage” services for institutional crypto investors, focusing on efficient order routing, but they generally lack the balance sheets and industry weight to be able to offer the crucial prime functions of lending, clearing and custody.

This lack of full service has been a barrier to institutional involvement in the industry. 

The crypto market is different from traditional markets in that its exchanges operate as siloed units, each with different order books, prices and onboarding requirements. Investors need to set up and fund accounts at each platform on which they want to operate, which is a cumbersome use of time and an inefficient use of capital. It also precludes “best price” execution as, even if a certain exchange offers a better price at a given moment, investors may not be able to trade on that exchange in time to take advantage of it.

Prime brokers that reroute orders can solve part of the fragmentation of crypto markets by giving investors access to several exchanges via one account. But institutional investors also expect greater capital efficiency through leverage, netted collateral, convenient custody and seamless access to a broad range of products.

Bigger is better?

Coinbase, BitGo and Genesis are three of the more well-known institutional names in crypto markets, with strong revenues, growth trajectories, balance sheets and networks. All have been in acquisition mode recently, strengthening teams and service offerings. And all have strong backers. 

This is significant, because any investor who lived through the painful fall of Bear Stearns and Lehman Brothers will stay well away from a prime broker that carries even the slightest risk of insolvency.   

It is also significant because only well-backed and strongly solvent companies can afford to offer lending along with routing and custody, without adding undue risk to the balance sheet. This service will unlock a significant capital inefficiency barrier, and perhaps encourage participation from a wider range of institutional investors.

Unfortunately, the limited range of infrastructure firms that can offer the full prime brokerage suite of services means we are likely to see growing concentration in this field. This introduces new risks to the sector.

One is the strong degree of centralization in a sector built on the premise of decentralization and resilience. By replicating market structures from traditional finance, we are introducing some of its weaknesses and vulnerabilities, such as concentration of power (with the possibility of censorship), dependence on a handful of suppliers (in which one firm’s crisis could ripple through the whole market) and the additional layers of cost.

On the other hand, asking “mainstream” institutional money to get its collective head around an entirely new type of asset and market structure is probably a non-starter, especially when the new technologies aim to disrupt the way of life on which institutional money depends. A familiar investment process will smooth the entrance for many.

Another risk is conflicts of interest. Will clients trust the Coinbase/Tagomi prime broker to route orders to the best price available, even if it’s not on Coinbase? Could competing exchanges be shut out in favor of Coinbase and allies? In traditional finance, the largest prime brokers (Goldman Sachs, Morgan Stanley, etc.) are also among the largest broker/dealers. But they operate in much more regulated sectors, where “best price” is a legal obligation for many orders. This is not the case in crypto markets.  

Rehypothecation could also start to rear its alarming head. One reliable source of income for traditional prime brokers is the lending out of clients’ collateral and assets in custody. This way, capital use becomes even more efficient, but the crypto collateral could end up in a convoluted web of ownership, undermining the very meaning of bearer assets and introducing a long trail of potentially incendiary flare-ups should anything go wrong with the original custodian or any of its clients.

What’s next?

While the new entrants to the crypto prime broker space will galvanize the sector as a whole in terms of a greater degree of professionalization of market infrastructure, which in turn is likely to attract a new type of market participant, the sector is still new and niche. Coinbase, BitGo and Genesis are big, but they’re not Goldman Sachs. They may be “blue chip” names to those of us in the sector, but the larger institutions will probably not have heard of them. 

The large, conservative institutions could decide to wait until their long-standing prime brokers start to offer crypto services. That will be the bigger game-changer.

(*Genesis Capital is owned by DCG, also CoinDesk’s parent.)

Goldman astonishes

Speaking of Goldman Sachs, it hosted a virtual presentation this week titled: “US Economic Outlook & Implications of Current Policies for Inflation, Gold and Bitcoin.” 

I didn’t sit in on the call, so this is mainly based on the slide deck. For the economic forecast section, they wheeled out the big guns. Jason Furman has an arm’s-length curriculum of top economic posts, including professor of economic policy at Harvard and adviser to President Obama. He gave an interview on NPR earlier this week insisting that we were not looking at an economic depression, more like a recession, with the following insight: “A very bad recession is a problem. I think we should be doing everything we can to avoid it.”

The other author, Jan Hatzius, is also no economic slouch – as well as chief economist for Goldman Sachs, he is the holder of several forecasting awards. He apparently shares Furman’s relatively rosy outlook on the economy (and remember, he’s a good forecaster), saying on CNBC earlier this month that the jobs slump has not been as bad as he feared and that he expects most of the unemployed to be redeployed. 

Their presentation forecasts GDP growth in 2021 of over 6%, with muted inflation. Yay.

All this must come as a huge relief to Goldman clients, to hear from two experts that things will be back to normal soon, so there’s no real need to change investment strategies. 

These renowned economists did not write the asset-focused part of the presentation – that was done by the Investment Strategy Group (ISG) within the Consumer and Investment Management Division at Goldman Sachs. A footer in the presentation notes that the ISG is not part of Goldman Sachs Global Investment Research nor Goldman Sachs Global Markets Division, and its views may differ. So, this isn’t a case of Goldman flip-flopping on its previous interest in bitcoin. It’s a case of differing views within the organization. Fair enough. 

The team concluded that neither gold nor bitcoin are good investments. Gold has underperformed both equities and bonds for extended periods of recent history. And bitcoin is not an asset class because it has no cash flow, earnings or portfolio hedge properties. And, this may come as a surprise to you: “a security whose appreciation is primarily dependent on whether someone else is willing to pay a higher price for it is not a suitable investment for our clients.” (My emphasis.) As Jill Carlson pointed out in her brilliant takedown of the report, “the fact someone else is willing to pay a higher price for a given instrument is probably the only criteria necessary to know something is a suitable investment.” 

The revealing explanation for the team’s stance on bitcoin lies in the last three words of the report’s previously mentioned conclusion: “for our clients.”

This says so much more about the team’s clients than it does about bitcoin. The division manages private and corporate money, and I imagine you don’t park your wealth at Goldman for it to undertake risky plays. You park it there to have your hand held. Goldman’s ISG clients obviously want to know that their blue-chip investments are safe, that no pesky depressions are going to get in the way and no irksome threats from edgy assets will disrupt their comfortable portfolio structures, which no doubt include a hefty dose of bond, equity and real estate funds that provide nice management fees to the firm. 

I’ll do you the favor of skipping a critique of the other five slides, with their escalating inanity. I will say that I’ve seen deeper insight on Fox News.

Let’s take a moment to appreciate, however, that they’re talking about bitcoin at all. We can conclude that their clients have been asking. 

We’ve seen this before, in the blind eye to growing risk in the financial system back in 2007-8, in the “it’s just the flu” chant of early 2020, and now in the “everything will be fine” mantra of private money managers. We’ve seen before how a lack of interest in real downside leaves portfolios vulnerable. We’ve seen before how top-level experts are usually reluctant to shake the tree that gives them fruit, and we all know that telling clients things they don’t want to hear is not always a good business strategy for money managers.

We also know that good money managers aren’t afraid to do so. Good money managers look at the whole spectrum of risk, not just the middle part. Good money managers don’t wear rose-tinted glasses with blinkers. And good money managers actually research an asset before giving a presentation on it.

Anyone know what's going on yet?

The re-opening of the NYSE infused the markets with a sense of optimism that even the crescendo of trade tensions and the escalation of social unrest could not dent, and the S&P continued its upward trend. 

The “back to work” narrative will have pushback, however, from the “new cold war” narrative emerging as I type, and from the relative absence of consumer demand – U.S. consumer spending plunged 13.6% in April, more than expected and almost double March’s slump.

It’s interesting to note that the Nasdaq underperformed the S&P 500 for the first time in weeks – its habitual outperformance that you can see in the YTD figures imply that the market rally has been concentrated in tech stocks. It seems that buying interest is now spreading to other sectors such as cyclicals and small-caps. 

Bitcoin reversed a couple of weeks of declines, although the price ranged 10% from its weekly low to its weekly high, so timing is everything. Corporate developments lent a constructive tone to the narrative, overriding any disappointment from the cursory treatment from Goldman Sachs’ private investment team (see above).

This brings up an interesting question: what is the prevailing narrative now that the halving is over? I think it’s the big steps forward in market infrastructure development as big prime brokers muscle in to entice institutional money. Yes, we’ve heard that mantra before – but this time, the infrastructure is getting in position. This may not be enough to make a meaningful difference in volume just yet. But it is a step towards standardization of the bitcoin market, which could enhance liquidity and lower volatility.

(Note: Nothing in this newsletter is investment advice. The author owns small amounts of bitcoin and ether.)

CHAIN LINKS

Crypto data provider Kaiko ran some numbers on bitcoin’s volatility compared to that of equities, gold and the U.S. dollar, and showed that the ratio between BTC and S&P 500 volatilities is increasing but still notably lower than in January. TAKEAWAY: This is not surprising given the general market turmoil at the end of Q1, where the volatilities of both shot up. Since then, however, the S&P 500 volatility has been settling down while BTC volatility has jumped in the month of May.

Bitcoin held on crypto exchanges hit an 18-month low, down 11% so far this year, while the amount of ether held on the same exchanges has increased by 7% over the same period. Glassnode showed, however, that bitcoin withdrawals from exchanges are not evenly distributed, with some balances remaining consistent or even increasing, while others such as those on Bitfinex have dropped over 60%. TAKEAWAY: So the conclusion that “people are holding more than before” does not hold up under closer scrutiny. The theory is that, if investors want to hold on to their bitcoin for a while, they remove them from exchanges to custody them in more secure solutions. Thus, declining exchange balances is a bullish signal. But if that trend is concentrated on just a handful of exchanges, then there could be something else going on. 

Last week I pointed out that bitcoin transaction fees were rising sharply. Well, now they’re falling, but are still well above pre-halving levels. TAKEAWAY: This could be a consequence of last week’s mining difficulty decrease, which should entice more miners back into production as it becomes more profitable. This marginally reduces the interval between blocks, which could ease pressure on fees.

Chris Burniske, partner at Placeholder Ventures, reminded us that, in the past, the CNY/USD exchange rate and the bitcoin price have been correlated. TAKEAWAY: That doesn’t mean they will be again, but the relationship could be worth watching, especially as trade tensions and geopolitical posturing continue to play out in the currency markets. The theory is that a depreciating yuan will send savers into bitcoin as a currency hedge. 

Crypto derivatives platform ErisX has launched an API for bitcoin, bitcoin cash, ether and litecoin block trading. TAKEAWAY: As well as facilitating liquidity in cryptocurrencies with smaller tokens (where large orders could move the price), this is yet another signpost in the evolving professionalization of the sector.

Digital asset manager CoinShares has launched the CoinShares Gold and Cryptoassets Index (CGCI), the first EU Benchmark Regulations-compliant index that combines digital assets and gold. TAKEAWAY: This brings bitcoin and traditional assets such as gold even closer together in the minds of portfolio managers by combining them into one index, designed to play on the relative lack of correlation between the two. The firm is looking into deploying the index as an investable benchmark, providing yet another example of how crypto assets are giving rise to innovative investment vehicles. 

An attempt to help blockchain companies based in Switzerland’s Crypto Valley via loans backed by a sovereign wealth fund has been blocked by the Swiss government. TAKEAWAY: Times sure have changed when what used to be a center for initial coin offerings is now relying on government bailouts for funding.

Podcasts worth listening to:

• Deglobalization and Other Narrative Violations, Feat. Geoff Lewis – The Breakdown, with Nathaniel Whittemore
• The ‘Brilliant Asshole’ Who Almost Blew Up Coinbase – Unconfirmed, with Laura Shin and Jeff John Roberts
• What explains the growth of Tether? – with Nic Carter and Dan Matuszewski
• How to Make Meetings Less Terrible – Freakonomics

Also worth reading:

• Pantera Blockchain Letter, May 2020
• The Regulatory State Is Failing Us – Conor Friedersdorf and Tyler Cowen, The Atlantic
• The Golden Rule Is Dying of Covid-19 – John Authers, Bloomberg

(Note: Nothing in this newsletter is investment advice. The author owns small amounts of bitcoin and ether.)