As cryptoassets continue to endure a tough bear market, Profit & Loss hosted an event called OnTheBlock to discuss what impact this has had on liquidity conditions.
“Right now, we haven’t seen the wave of institutional money that everybody talked about in 2017,” said Martin Garcia, managing director at Genesis Trading. “The narrative then was very much that this is just the retail sector trading these assets and that when the institutional funds come in, it will grow to yet another scale.”
To be clear, Garcia still thinks that institutional-sized money and liquidity will enter the crypto space, but that it will do so at a much slower and steadier pace than many were previously predicting.
One reason cited by the panellists regarding why institutions have been slower than expected to enter the crypto markets is because of the dramatic collapse in the valuation of these assets over the past year. According to data from CoinDesk, in the one year period preceding December 4 – the date when the OnTheBlock event was held – the price of bitcoin dropped 65% from $11,350 to $3,888, with other cryptocurrencies enduring a similarly precipitous drop.
“In our experience as a CTA that trades bitcoin futures and targets institutional investors, I would say that a year ago when the prices were much higher, we had more interest from these investors,” said Peter Kambolin, CEO of Systematic Alpha Management, a well-established New York-based CTA that launched a fund specifically focused on trading bitcoin following the launch of the bitcoin futures contracts by the Cboe and CME exchanges in 2017.
It is worth noting, however, that the price action of cryptoassets can look very positive or negative, depending on the time horizon that is being viewed. Because while these assets might be significantly down from the previous year, bitcoin is still trading at double the price it was on December 4, 2015, for example.
But beyond the price drop of cryptoassets over the past year, some of the speakers at the event offered slightly different diagnoses regarding why the anticipated flow of institutional money into the crypto markets has been slower than previously anticipated.
Institutional infrastructure required
For Garcia, the main issue holding back these firms is the lack of institutional grade infrastructure in these markets.
“If you’re a pension, endowment or large hedge fund, holding cryptoassets on your own behalf is a very foreign feeling and right not it’s not really possible the way that most large institutions are structured,” he said. “Right now, there aren’t great options that meet the demands of these investors when they want to invest.”
The good news, according to Garcia, is that this infrastructure is being built. He pointed to the announcement that Fidelity plans to begin offering cryptocurrency custody and trade execution for institutional investors in 2019 and the fact that major exchanges have already launched derivatives on cryptoassets, with more planning to do so next year, as evidence of this.
“Our sibling company, Grayscale, has investment trusts that hold bitcoin and all the different cryptoassets that are out there, and the Bitcoin Investment Trust is publicly quoted on the OTCQX, so investors and institutions can actually go and buy these assets and get exposure through there. But as far as trading in the spot market, there’s not really a great way for institutional investors to get involved right now.”
In terms of infrastructure development, one audience member at the event asked about the digital currency lending business launched by Genesis Trading’s affiliate firm earlier this year, wanting to know if the firm has a custodial solution in place and whether users of the service get paid for allowing their coins to be rehypothecated.
“So when you trade with us, we’re non-custodial completely, we decided very early on that in the current state of the industry it was not something that we wanted to do. On the lending side it’s the same, we come to terms to borrow from you and then we’re turning around and lending that on the other side. So your counterpart is still always us, just like on the trading side,” he said.
Garcia said that he expects there to be significant developments in the custody space, pointing out that big, traditional financial services custodian banks such as State Street and BNY Mellon have all the necessary pieces in place to provide these services, minus the digital currency expertise and technology.
“There’s a lot of great targets out there for potential acquisition or partnership, and I think we’ll see some of that in 2019. And if that doesn’t happen, or we feel that is isn’t going to happen, I think that would be an area where we would absolutely look, given our position in the market,” he added.
Confusion over liquidity
In addition to that, Gabriel Burstein, head of cryptoasset strategy at KryptoIndex, argued that besides inadequate infrastructure, what’s holding back institutional investors is also the lack of available crypto-focused, diversified investment products.
“Everybody is trying to build trading execution for these institutional investors, as if they’re all going to come in and buy with crypto wallets and trade these assets directly; there’s this focus on the execution on individual cryptocurrencies. These firms are not going to trade outright crypto assets, not even bitcoin futures and, by the way, the bitcoin ETF is going to be another major disappointment because it’s a non-diversified investment vehicle. Institutions move into markets when they have funds and diversified investment solutions, and right now they don’t have that,” he said.
To prove his point, Burstein quoted the number of total open bitcoin futures contracts on CME (3,791 contracts at 5 bitcoins per contract) and Cboe (3,796 contracts at 1 bitcoin per contract), after one year of trading, as reported in the previous week of trading. He pointed out that at a valuation of $3,500 per bitcoin, this means that this is only approximately $80 million of notional value in total, adding that this proves numerically that institutions simply did not adopt bitcoin futures over the course of 2018.
Kambolin agreed that investors are looking for more diversified investment options, stating that, that this is why he is hopeful about the prospects of futures contracts based on other cryptocurrencies beyond bitcoin.
“We are eagerly awaiting the potential launch of ethereum futures and futures on other cryptocurrencies. One of the comments that we get from institutional investors is that we only trade bitcoin, we do this because we want to stay in the regulated futures markets and therefore that’s the only instrument available to us right now. If we had an opportunity to trade ethereum futures and others, both our returns and our chances of getting more institutional clients would definitely increase,” he said.
There was also some disagreement amongst the panellists about the relationship between liquidity in the OTC and listed markets.
“There’s a major confusion when we talk about liquidity,” said Burstein. “As we said, there’s close to $100 million in bitcoin futures (at these prices) right now, but this doesn’t mean that they’re illiquid. If tomorrow morning a big pension fund wanted $1 billion in bitcoin futures, there would be bitcoin future contracts opened to provide that, so it’s not that this market is illiquid, it’s that there’s no demand.”
According to Burstein, even when there was demand earlier this year as major prop trading houses entered cryptocurrencies, an important growing fraction of that has been executed OTC, meaning that the demand and the transactions were not being reflected in the exchange traded prices and could not contribute to a corresponding upward price move on the exchanges. This is just one factor among many, he said, that has contributed to the decline in the valuation of bitcoin and other cryptoassets.
A lowering tide
Garcia took issue with the claim that the OTC market is larger than the exchange traded market and offered a different explanation for the recent price collapse.
“This is an asset class where you have a finite supply of the asset. If a firm is doing a large order, they’re probably going to buy and hold and so, yes, they’re going to come to the OTC market because you can get it at a better price with less market impact. So, if a firm does a $10 million trade, while it won’t impact the price on the exchanges at the time, there’s still $10 million worth of bitcoin that’s now off the market. There’s now less supply,” he said.
Garcia said the firms he faces in the OTC market are not buying large positions and then selling off in the exchange markets, but instead contends that there’s just been an influx of sellers in the exchange markets this year, with the retail investors who rode the crypto wave up in 2017 now riding it back down in 2018.
“I think it’s just a young asset class and therefore it’s going to be susceptible to the general mood of the market. While I think that this will ultimately be an uncorrelated asset class, I definitely think that the general selloff is absolutely correlated to these being risk assets. So while the rising tide is going to lift all the boats, the lowering tide is going to lower all the boats,” he commented.
In trading terms, Kambolin revealed that he doesn’t care if the price of bitcoin is going up or down, as long it continues moving. He also said that, for a CTA like Systematic Alpha, which is deploying trend following strategies for trading bitcoin futures, the lack of institutional liquidity in the market isn’t necessarily such a bad thing.
“In futures you can go short without borrowing, so for traders like us volatility is good. When we speak to investors, we tell them that we’re not long crypto assets and that this asset class has many unusual properties. Number one, it is a lot more volatile compared to your typical commodities or financial market. And number two, about 90-95% of the liquidity is in the spot market and this is dominated by retail investors. What this means is that the people who are driving the prices up or down are mostly retail investors and we don’t mind competing against them compared to, let’s say, Goldman Sachs or other institutional investors. So for us, relatively low liquidity in futures is actually a positive, not a negative,” he said.
Towards the end of the discussion, the panellists were asked to pick out one development that they would like to see in the crypto space that they think would have a significantly positive impact on liquidity conditions in these markets. Perhaps unsurprisingly, given the different background and focus of each speaker, they all highlighted different developments that they would like to see happen.
Although Garcia expressed skepticism that the industry would get it, he cited regulatory clarity as a key factor that he thought could bring more liquidity into the crypto markets. “This is coming from something of a biased place because we are a regulated broker-dealer operating somewhat alone in this space right now, but if I could wave a magic wand, I’d have regulatory clarity regarding all the tokens and projects out there, or even just in general. I don’t think that we’re going to get that though,” he said.
This desire for regulatory clarity is linked to a recent initiative that Garcia highlighted, where Genesis Trading joined with 10 other firms to create new trade association for the digital asset markets, which is aiming to create and implement a Code of Conduct for this emerging asset class.
“I think that the industry needs to be more proactive in policing ourselves before the regulators will really take this seriously and this is the first step towards that,” he said.
Burstein, a former head of alternative portfolio strategy, claimed that what’s missing right now is education. For example, he said that he’s in regular contact with family offices, pension funds, endowments and foundations and is constantly having to explain the differences between on one side protocols,networks and stores of value (“coins”) and on the other side the new ICO/token-based companies (“tokens”) that are using these networks and protocols as infrastructure to build decentralised new blockchain businesses.
“Cryptos are just another alternative asset, so I think that what’s going to happen will be the same that happened in the alternatives space,” he said. “Alternatives were actually adopted at a very, very slow pace because few properly understood the difference between an alternative asset and an alternative strategy. For me, it’s like deja vu right now.”
Burstein continued: “Education is important, but what are the big banks doing? The first thing that they want to do when they start their crypto desks is trade bitcoin and custody bitcoin. When we did alternative investments, yes, we started with the possibility to buy and sell them (access), but we also created investment solutions, investment strategy, we had investment officers and research heads, all of which doesn’t generally exist in the crypto space right now. So more education at the institutional level would make a difference.”
Kambolin highlighted two factors that he thought could have a positive impact on liquidity in the bitcoin futures markets where his firm trades. Firstly, he said that more FCMs offering access to these markets could be beneficial in this regard.
“At the moment, Newedge, Societe Generale, Bank of America and ABN Amro, these major firms are not even offering trading on bitcoin futures. I think that this will change and if these major firms start offering trading, a lot of their customers that don’t have access to bitcoin futures at the moment will start trading these products and that could be very positive news to the industry overall,” said Kambolin.
And lastly, bringing the conversation back to where it started, he said that sentiment has to improve. Kambolin pointed out that in the current bear market there have been drawdowns in bitcoin and ethereum of close to 90% from peak to trough and that improved sentiment would help to bring back interest from various market participants, which would obviously be good for liquidity.