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

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Please consider using a different web browser for better experience. Please enable JavaScript in your browser for a better site experience. Crypto Long & Short: The Emergence of Prime Brokers Adds Resilience but Also Risk Jun 1, 2020 at 00:21 UTC opinion Noelle Acheson 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 lay...