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.#Bitcoin##BitcoinDrop#
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