Current cryptocurrency systems have not reached the level of trust associated with traditional trading standards. We’ve found out what cryptocurrency markets can learn from traditional finance.
Cryptocurrency exchanges have to adapt a more traditional market structureMarket Structure — Cryptocurrency marketMost cryptocurrency exchanges have adopted business models where their platforms are essentially built in the following manner:
- One large bank account
- One large cryptocurrency wallet
BOTH of which are controlled by the exchange. There are no third party custodians involved: clients send funds to the platform and basically hope for the best.
In the industry’s current infrastructure, a cryptocurrency exchange acts as an exchange, a clearinghouse, and a custodian. This creates a very high level of risk to investors. There is no responsibility and risk sharing between different entities that interact together, which is standard in the traditional markets.
Market Structure — Traditional markets
In traditional financial markets, the exchange’s primary responsibilities are receiving and matching orders, and maintaining a fair and orderly market. Exchanges are processing information transfers, rather than financial flows. In other words, traditional exchanges do not control the funds of their clients. Funds and assets are stored by custodians in dedicated brokerage accounts and trades are cleared and settled by clearing firms.
The result is that in a traditional market, risk is split between different regulated entities: the exchange, the bank, the custodian and the clearing firms. Clients funds are always stored in their own accounts, and are never handled by the exchange itself.
In order to fit institutional clients needs, cryptocurrency exchanges should adapt their trade process and risk controlsThe market infrastructure of cryptocurrency markets is very different, which results in a radically divergent trade process and risk controls. In the traditional markets, the trade process consists of three different steps:
- Execution: Orders are matched on the exchange
- Clearing: Clearing firms act as a counterparty to the buyer and the seller, using and reconciling the trade data from the exchange
- Settlement: Clearing firms proceed to the financial settlement of the trades, moving funds and assets in and out of the traders’ accounts held by third party custodians
At each step, one entity oversees what one of the other market participants has produced in order to make sure that there are no flaws in the whole process. Each entity reconciles with one another, avoiding single points of failure. Interestingly, data is double checked at every stage of the process by various different sources of truth — ensuring that trades booked settle properly.
The same goes for clients’ internal teams and risk controls. A financial institution, like an investment bank, often has three teams interacting with each other:
- Front Office: places orders and trades on the market. Directly interacts with the exchange.
- Middle Office: ensures that trades ordered by the front office are recorded, processed and paid. Interacts with the clearing firm.
- Back Office: oversees the settlement of trades. Interacts with the custodians in order to check that balances reflect the amount traded by the front office.
The three teams interact together, and provide checks and balances for one another. For example, the middle office may establish trading limits for the front office.
In the cryptocurrency world, there are no such distinctions. The exchange is the only source of truth and the only point of contact for institutions. It becomes impossible for clients to set up their internal risk controls. This makes the adoption of current cryptocurrency exchanges incredibly difficult from a risk and compliance standpoint.
We’re touching on the key difference between the cryptocurrency market and the traditional market. Cryptocurrency companies have been created with a Silicon Valley ambition: become a one stop shop for all things crypto and capture the whole value chain of a cryptocurrency trade. This cannot work in a financial environment. The financial market value chain is fragmented for a very specific reason: to mitigate the risk that market participants bear with one another. The way cryptocurrency startups are structured today is completely incompatible with the risk limits that traditional institutions can support.
Cryptocurrency exchanges should be regulated like traditional exchangesBecause of these fundamental differences, cryptocurrency exchanges are not regulated like traditional financial ones.
- Traditional market: Exchanges are processing orders and matching them. Depending on the underlying assets, they can be either regulated by the Securities and Exchange Commission (SEC) or by the Commodity Futures Trading Commission (CFTC). Clearing firms and custodians are also regulated.
- Cryptocurrency market: As cryptocurrency exchanges hold and transmit funds on behalf of their clients, they have to be regulated accordingly. Money Transmitter and Trust Company licenses allow cryptocurrency exchanges to operate in compliance with how they handle funds in the United States. This does not solve the counterparty risk that these companies are creating for traders. Very few take into account the very nature of the assets which are listed. In particular, the SEC has recently fined a cryptocurrency platform for operating as an unregulated securities exchange. This is a first, but certainly not a last in the industry.
While NASDAQ, NYSE, BATS and Instinet are regulated by the SEC as National Exchanges or Alternative Trading Systems — with all the procedures and investments this requires — cryptocurrency exchanges are essentially regulated like PayPal or Venmo. While this may bring bring a level of comfort on their processes, it is irrelevant of the core business of what a cryptocurrency exchange should be.
The cryptocurrency market has a lot to learn from traditional markets. More than two hundred years of booms and busts have forged the financial markets as they are today: a structure that minimizes counterparty and systemic risk. Darwinism also applies to business, and looking at the capital markets, one can easily see how leaders of the digital asset and cryptocurrency market will operate. Counterparty risk is a deal breaker for the vast majority of financial institutions, as it goes against the fiduciary duty they have with their clients. It is LGO Markets’ mission to build the bridge that institutions will use for trading digital assets.