As acceptance of digital assets grows among buy and sell-side firms, our CEO and co-founder Matt Barrett spoke with Mike O’Hara at TradingTech Insight about the complexities of building an institutional-grade market infrastructure for trading these assets. The article examines the issues faced by institutions approaching technology and infrastructure for both primary market issuance and secondary market digital asset trading and how to overcome them. While integrating innovative solutions on top of existing legacy systems can prove particularly challenging – Adaptive has proven experience in helping firms leverage existing trading infrastructures to deliver truly differentiated solutions incorporating this exciting new asset class.
Beyond Cryptocurrencies – Building a Market Infrastructure for Digital Assets
This article by Mike O’Hara was originally published on the A-Team Insight blog on 7 October 2021 here.
Mention digital assets, and most people will immediately think of cryptocurrencies. This is perhaps not surprising, as ownership of digital assets is currently dominated by the two leading cryptocurrencies, Bitcoin and Ethereum.
The fast-evolving world of digital assets now goes way beyond the realm of cryptocurrencies, however, and has the potential to open up a wide range of new opportunities for institutional investors. The vast majority of trading in digital assets may still be in cryptocurrency. But as Mike Powell, CEO of trading technology vendor Rapid Addition, puts it: “The tokenization of physical assets is much more interesting and exciting for the institutional market going forward.”
In a recent wide-ranging survey of institutional investors conducted by Fidelity Digital Asset, 52% of firms surveyed globally confirmed that they are currently invested in digital assets, either directly or through alternative investment products. With 90% of respondents saying that they found digital assets appealing, there is clearly a strong – and growing – institutional appetite.
“What is amazing about the digital space, is that both individuals and institutional players can work side by side, by adding creative ideas and time-tested approaches from both worlds,” says Serg Gulko, Co-chair of the FIX Digital Asset Working Group and Chief Technology Officer at XTRD, an institutional-grade OEMS for digital asset trading.
Investment banks, exchanges and technology providers are now looking at how they can best serve this burgeoning marketplace. But creating and building an institutional-grade market infrastructure for the primary issuance and secondary trading of digital assets is a challenging proposition. So what are the challenges, and how are they being addressed?
This will be the subject of discussion at a forthcoming A-Team webinar, “The Emerging Market Structure for Institutional Trading of Digital Assets.” on 17th November 2021.
Types of Digital Asset
The common denominator across all types of digital asset is that they are created and maintained on a distributed ledger, or blockchain. Various types exist, including:
- assets that cannot exist without the underlying distributed ledger that created them, e.g cryptocurrencies
- digital representations of physical (real-world) assets such as gold, real estate or real-world art (e.g. paintings)
- digital representations of intangible (non-physical) assets such as equity and debt
- initial coin offerings (ICOs) and security token offerings (STOs)
- non-fungible tokens (NFTs), which are assets created digitally (such as digital art) containing a unique digital signature
Across these asset types, demand is growing amongst institutional investors, for a number of reasons. Cryptocurrencies, for example, are generally uncorrelated to other assets, thus providing alternative sources of alpha and high potential upside for firms looking to diversify their portfolios (also potential downside, as these are highly volatile instruments, which in itself creates trading opportunities).
ICOs and STOs provide early stage companies with an easier means of raising capital, and enable investors to participate in their growth. Another benefit of digital assets is the ability to obtain fractional ownership of both physical and intangible assets, with lower investment minimums.
“What’s really interesting about digital assets is that you can list and fractionalise assets that were not trading that way before,” says Ian Salmon, Director of Ignite G2M, a consultancy firm specialising in the digital asset space.
“So there’s a lot happening around real estate and big infrastructure projects for example, where previously, firms would have to take these on the balance sheet as big, chunky investments. Now, because it’s fractionalised, they can buy a basket of infrastructure projects that are wholly complimentary with their investment portfolios, which lessens their risk. Assets they couldn’t trade before now become legitimately traded instruments, providing new sources of alpha.”
Despite their potential benefits however, digital assets operate in a nascent and still mostly unregulated market, which means that many investment firms, though interested, remain wary.
“There are so many great developments around digital assets like NFTs, but the traditional buy side can’t take the leap yet, because they’re fiduciaries,” says Travis Schwab, CEO of Eventus, a trade surveillance and risk solutions vendor. “The last thing they’re going to do is put pensioners’ money into something that is unproven. They don’t know if it’s secure. They don’t know the regulatory issues yet.”
Servicing the institutional market
Notwithstanding the uncertainty around regulation and security, buy-side firms are increasingly looking for ways to include digital assets in their investment portfolios, and sell-side banks have started to make the necessary moves to accommodate them.
“Knowledge and awareness of the digital asset space by investment banks and institutional investors is growing rapidly,” says Ludovic Blanquet, Chief Product Officer at electronic trading solutions provider smartTrade Technologies. “Institutions and their service providers have an ever-increasing understanding of both digital assets themselves and the operations and processes involved in trading them. Custodian banks are entering the digital asset arena, as improved, secure custody services for digital assets have gone some way to alleviating risk concerns for regulated institutions. Other banks are looking at providing market access for customers.”
As with asset classes such as equities and fixed income, digital assets require the appropriate technology infrastructure for both primary market issuance and secondary market trading. And while there has been much activity – and a certain amount of success – around the former, the latter is proving a tougher nut to crack.
“Primary issuance is where institutions see real value, in making it easier to raise capital. Not necessarily ICOs, but more securitisation of existing assets, for example to securitise commercial real estate,” says Matt Barrett, Co-founder and CEO of trading technology specialists Adaptive Financial Consulting. “But for primary issuance to be successful, it needs to integrate with the secondary market very easily – without that bridge, it’s not going to work. So there’s been a big push to create these secondary trading platforms.”
From a market infrastructure perspective, one particularly challenging aspect of digital asset trading is the need for pre-funding. Unlike more traditional asset classes, which are generally traded on margin and settled on a T+x basis, digital assets – because they reside on a blockchain – are generally traded and settled at the same time, with instantaneous movement of asset and funds between the counterparties of the trade. Not only does this tie up capital, particularly if firms are trading across multiple venues, it also presents a headache for banks, custody providers and their technology partners.
“You can’t trade on any of these exchanges without pre-funding on the exchange first,” says Gordon Russell, Head of Asia and Digital Assets Strategy at Torstone, a post-trade technology provider. “That creates a massive logistical challenge for organisations because they’re not used to moving money in a real time T+0 environment prior to trading. And it’s not only intraday pre-funding, it’s also a case of intraday allocations across your clients.”
Another issue that institutions face is that of permissioning: who has access to the distributed ledger on which the assets reside. Cryptocurrencies such as Bitcoin, Ethereum, Litecoin and Dash all exist on permissionless blockchains, which means that anyone has access. However, as regulated entities, banks and other financial institutions need to have clearly defined governance structures around who can transact, particularly for digital assets based on intangible assets such as equity and debt.
“The fixed income world is all about permissioning. It is about knowing exactly who you’re dealing with,” says Charlie Berman, Co-Founder and CEO of Agora DCM, a technology provider specialising in digital assets for fixed income. “For institutions, peer-to-peer networks without somebody managing the system just don’t work. You don’t necessarily need a central authority saying who can be part of the system, but you do need the people within the system to decide who is permissioned to join.”
Exchanges and technology providers
There is a plethora of exchanges that now exist for trading cryptocurrencies. Binance and Coinbase are two of the more successful examples. However, the majority of these exchanges, and their trading platforms, are targeted more at the retail, not the institutional market.
“A lot of the platforms are being built with retail in mind,” says Russell. “But they’re not going to solve the institutional problem of having consolidated books or records, or presenting reports to regulators. And many of the legacy systems just don’t have the flexibility for digital assets.”
A number of regulated exchanges, such as CME, CBOE, Nasdaq, Deutsche Boerse, ICE and SIX, have launched exchange-traded products in the digital asset space within the last few years. However, most of the listed products are based around cryptocurrencies – there are still relatively few traditional, regulated, institutional-focused exchanges that list other digital asset types.
One such is SIX Swiss Exchange, whose subsidiary SIX Digital Exchange (SDX) received formal approval to operate from FINMA, the Swiss Financial Market Supervisory Authority, in September 2021 [here]. SDX initially set out to build an integrated trading, settlement, and custody infrastructure for digital assets three years ago. Following SDX’s regulatory approval, the exchange now intends to work with banks, issuers, insurance firms and institutional investors to create a global exchange network for digital assets.
Can leveraging existing market infrastructure, for example established OMS and EMS platforms, help them to achieve that goal?
“From a trading execution standpoint, liquidity access does not necessarily change much, as trading institutions need connectivity to those exchanges offering digital assets/securities in the same way they do today for traditional stocks, for example,” says Michele Curtoni, Head of Strategy at SDX. “OMSs & EMSs are likely not to change much beyond offering views, charts and data on these new asset classes. What changes is downstream at the exchange/broker level, which needs liquidity creation and order books offering digital assets.”
Other new players directly targeting the institutional market include Archax, the first digital securities exchange to be regulated by the UK’s Financial Conduct Authority (FCA). “We’ve built Archax as an exchange and a custodian, all rolled into one with its own OMS/EMS front end,” says Simon Barnby, Chief Marketing Officer. “So the idea is a one stop shop, to help kickstart digital assets trading. We also have a FIX interface and our own API, so that it can be integrated into other systems.”
Having the ability to integrate the trading of digital assets with more traditional asset classes is likely to be a key requirement for institutions, but that can be a challenging proposition. “Established companies will stay with their existing OMS & EMS systems, at least until blockchain-native solutions start to show similar performance,” says Gulko. “The practical challenge is how to integrate new asset classes and workflows into the existing ecosystem.”
“Firms are going to have to work with their OMS providers, but they’re going to have to be very clear which venues they want to go to and why,” says Salmon. “And one of the big gaps at the moment is around order & execution management, and institutional connectivity to new crypto and digital asset markets. This is where there’s opportunity in the market for the existing trading tech companies, to step up and be the first movers in this space, creating platforms that institutions can actually trade digital assets on.”
Blanquet of smartTrade agrees that the opportunities are there for technology vendors who can rise to the challenge. “Development of the digital asset infrastructure is, in many ways, evolving in the same way that traditional capital markets infrastructure grew and developed. There is a huge opportunity for technology providers who already supply electronic trading tools for banks to expand into the digital asset space and to grow with the market.”
Incumbent OMS and EMS vendors may have a head start because they are already well-established in the institutional market, but adapting their technology solutions to service the digital asset space could present problems if their architecture is dated.
“The key to driving institutional engagement is to make the barriers to entry as low as possible by leveraging existing infrastructure and protocols,” says Rapid Addition’s Powell. “For digital assets to succeed, they need to be able to leverage existing market connectivity, trading infrastructure, risk management and middle office systems, and so on, while also adopting protocols such as FIX. The challenge however, is that some of the platforms in the trading technology space are now legacy. The technology was very good when it was created, but it’s perhaps not as open and interoperable as more modern solutions, and therefore may struggle to onboard new types of digital assets.”
Price formation, market data & liquidity
In the Fidelity survey, 44% of respondents saw the lack of fundamentals to determine the value of digital assets as one of the main barriers to adoption. So why is pricing digital assets so challenging?
“Depending on where you’re executing, there could potentially be different prices for the asset,” says Torstone’s Russell. “So how do you make sure that you are executing at the best possible price for the client and proving best execution?”
Part of the answer might lie in smart contracts, self-executing agreements between buyer and seller, directly written into lines of code that exist on the blockchain alongside the digital asset itself.
“It’s very difficult to come up with a fair market value for a tokenized asset,” says Russell. “However, the underlying framework allows smart contracts to contain variables around how you can potentially price and value the asset. So technology companies need to have the flexibility to capture the details of the smart contract, in order to create a theoretical mark to market for the asset until secondary trading starts.”
Benchmarks can also help, says Powell. “If you take property investment for example, obviously you’ll have a much clearer understanding of the underlying value, because it’s a tangible asset, so you can benchmark that asset and compare it with other property assets. And because of that, the price volatility is not going to be as extreme, given you have a relative benchmark to compare against.”
Use of smart contracts and benchmarks might go some way to address the problem of pricing digital assets, but lack of transparency around how instruments are priced is still a concern, says Powell. “The two big industry aggregators have done a fantastic job for decades in terms of sourcing and aggregating data for traditional asset classes. But with digital assets, there is a big issue around the underlying data quality,” he says. “There’s a lot of noise in the data, which can make it very difficult to create an accurate view of the broader market. If you can’t offer clean and transparent data for price discovery, then good luck gaining traction with institutional customers.”
The problem is exacerbated by the fragmented nature of the market, says smartTrade’s Blanquet. “If digital assets are to take their place as institutional-grade instruments, concerns about market transparency must be addressed – specifically around market manipulation, price formation and real-time data. Market fragmentation means that new marketplaces are constantly appearing, all of which support different assets, standards and processes across multiple jurisdictions.”
The lack of reliable market data for digital assets remains a concern to both institutions and regulators, particularly when it comes to market surveillance. “You’re going to have to have proof of where you’ve executed, and you’re also going to have to surveil the trading,” says Ignite G2M’s Salmon. “But market surveillance is going to be tough, because you can’t market surveil without market data.”
Eventus’s Schwab highlights the scale of the problem. “If you think about all of the ways to trade equities, futures and options, and then ETF products on top of that, surveilling that market in a meaningful and reasoned way is not trivial. When you tokenize every single one of those asset classes, that problem becomes exponentially harder,” he says.
Another potential barrier to more widespread adoption of digital assets, particularly in the secondary market, is how to source liquidity.
“In terms of liquidity, the major issue is a cold start problem, i.e. the creation of a new market with nascent or little liquidity, and a new infrastructure to underpin it,” says Michele Curtoni of SDX.
Adaptive’s Matt Barrett however, believes there are bigger issues at play. “People are more concerned about risk than they are about liquidity not being available. They only worry about liquidity when they’re confident their assets aren’t going to disappear overnight,” he says.
In traditional asset classes such as equities, exchange-traded derivatives, FX and fixed income, much progress has been made in recent years around workflow automation, particularly for electronically traded instruments. However, a number of inefficiencies do still exist, particularly in the post-trade space. Can digitising these assets remove some of the inefficiencies, by bringing about greater automation through smart contracts, for example?
Torstone’s Russell thinks so. “The fundamentals of smart contracts, which can sit behind the tokenisation of any asset, are that they can have very specific events in them. Unlike a bond, where you’ve got a coupon or an expiry, these new smart contracts can have many other events in them, such as pay events, or what happens when the underlying asset is sold, for example.”
Ignite G2M’s Salmon also highlights the advantages that smart contracts can bring to workflow automation. “Swaps contracts, for example, are bespoke to a particular arrangement between two parties,” he says. “Smart contracts allow you to lock in the terms of those at the point they’re traded, including being able to automate the workflow of the payments or other terms over the lifecycle of the swap, such as rebasing a rate for example. By automating those events through the smart contract, it lowers risk, because the terms agreed between the parties are immediately locked into this golden record.”
This approach could be especially beneficial in the fixed income market, believes Agora’s Berman. He gives an example of how it can work in practice.
“At the end of a pricing call, users apply their individual digital signatures, so you know exactly who’s done what and when. The commercial terms are agreed and recorded on ledger, only seen by those who are permissioned. That contract is then ready to go to the lawyers to complete the Final Terms, which are then signed off by the issuer. That document then feeds the downstream world, including custodians, the CSDs, the IPAs, and it all happens within minutes as opposed to hours. Moreover, you know that the provenance of the information you’re receiving is absolutely correct."
For Archax, instantaneous settlement and custody is a key characteristic of the exchange. Says Barnby: “At the start, everything’s fully funded, and we act as custodian. So if someone wants to trade, we hold the tokens from the seller in our custody service and we can see the buyer has money in their account. And it’s an instantaneous settlement, it happens straightaway, so there’s no clearing and settlement process afterwards. Regulations dictate that regulated instruments like digital securities have to be recorded into Crest as the CSD. So within Crest, it shows Archax as the legal title holder for the assets, but the actual beneficial holders are all within our custody service, where the trading is taking place.”
Standards & regulation
Two of the more significant challenges that still exist in the world of digital assets are the lack of standardisation of data, and the current regulatory uncertainty that institutions face. “Standardisation and regulation are crucial for the real inflow of institutional money,” says Russell.
Organisations such as ANNA, ISO and FIX are working to address the issue of data standardisation. Last year, ANNA (Association of National Numbering Agencies) laid out a plan to use International Securities Identification Numbers (ISINs) to identify digital assets, and exchanges such as Archax are adopting this methodology. “On Archax, every regulated instrument has an ISIN code and a ticker symbol, the latter being unique to the exchange. So it very much follows a standard exchange model,” says Barnby.
Earlier this year, ISO (the International Organization for Standardization) published a paper – ISO 24165-1:2021 – outlining its approach to establishing the Digital Token Identifier (DTI). And FIX, through its Digital Asset Working Group, focuses on the use of FIX for the electronic trading of digital assets, and works closely with ISO to help its members adopt the necessary standards.
“With electronic trading, if you’re trading Amazon, it’s got CUSIPs, ISINs, and so on, so that when you create an electronic message, the exchanges know exactly what it refers to,” says Lee Saba, Co-Chair of the FIX Global Steering Committee & Head of Market Structure at Rialto Markets, a US broker-dealer. “The DTI has come from the industry standards organisations globally working together to create a naming system that’s universally understood, across all these digital assets. It doesn’t solve everything, but at least you can reference the digital asset back to an industry standards organisation like FIX or ISO.”
From a regulatory standpoint, there is much work still to be done. In Europe, the EU’s new MiCA (Markets in Crypto Assets) proposals aim to provide harmonised regulation for digital assets (particularly cryptocurrencies) across the EU. In the US, things are less clear, although the SEC has released various papers on the topic.
It is clear that digital assets have the potential to grow exponentially in the coming years, and that institutional interest will fuel that growth. However, many challenges still exist and will need to be addressed as the market evolves, not least of which is the lack of regulatory clarity preventing widespread adoption among financial institutions.
Despite these challenges, however, the market infrastructure is steadily building and forward-looking firms are taking the necessary steps to capitalise on this nascent, but fast-growing market. So how might things play out?
“There will be increased demand for cross-asset solutions which have already proven their worth in traditional asset classes as more institutions enter the digital asset arena,” says smartTrade’s Blanquet. “Many investor concerns, particularly around regulation, are likely to resolve themselves as market infrastructure evolves. But let’s not underestimate the regulatory, compliance and risk challenges that the institutional world is facing. Institutional teams are working along regulators to design a regulatory framework that would work for both existing players and new ones, all without slowing down innovation.”
This article by Mike O’Hara was originally published on the A-Team Insight blog on 7 October 2021 here.