Sophisticated trading outfits are getting ahead of their contemporaries and investing heavily in cryptocurrencies, even as the markets evolve. Indeed, for some, that’s half of the attraction. By James Rundle
Back in the late 1980s and early 1990s, electronic trading was still very much a frontier science. Securities exchanges, electronic communication networks, and others were popping up left, right and center, but the industry was still feeling its way as it went.
It would be some time before market structure evolved to support the kind of activity seen in equity and futures markets today, and for many in the technologically sophisticated principal trading world, that’s pretty much how it feels now with cryptocurrencies.
“There’s a lot of discussion about what this space will look like in the future, and how it’s going to evolve,” the president of one major Chicago-based proprietary trading firm tells Waters. “It’s been a really exciting space to be involved in—it almost feels like the early days of electronic trading, with all these venues starting up, you’re connecting to them, learning how they operate, and it’s been a good experience.”
After speaking with some of the largest prop shops, tech vendors and exchanges in this space, one thing is certainly clear: While the sell side is still hesitant to fully engage with cryptocurrencies, Chicago’s prop community is going full steam ahead. And it doesn’t show any sign of slowing down.
Institutional involvement in cryptocurrency markets really began picking up steam in early 2017, as bitcoin began a massive bull run that would see its value peak at around $20,000 per coin in the last days before Christmas. During that period, the US Commodity Futures Trading Commission (CFTC) certified a bitcoin options trading venue and clearinghouse, LedgerX, while two of the largest commodity exchanges—the Chicago Mercantile Group (CME) and Chicago Futures Exchange (CFE)—self-certified the listing of their own bitcoin futures.
The futures, in particular, have proved to be a key moment in the development of bitcoin and other cryptocurrencies into institutional-grade asset classes. The process by which they were listed kicked off a nasty, three-way fight between the exchanges, the futures commission merchants (FCMs) that guarantee clearinghouses, and the CFTC itself, which said it had no authority to either stop the listings or regulate the underlying cash markets that the futures draw their reference prices from.
Four months later, conversations around the self-certification process are still raging, and the CFTC has promised to look into the process. But for these prop firms, which have invested faster and more heavily in their involvement in crypto markets than any other segment of the institutional trading space, it’s far less of an issue than it is for FCMs.
While the dealer banks did bring up sensible questions around risk management in clearinghouses that deal with these products, and those should be resolved, ultimately it’s not something that keeps them awake at night, according to the prop traders who spoke to Waters for this story.
“We’re principal trading firms. We like new products, we like innovation,” says the CEO of another major Chicago-based principal trading firm. “I’m not speaking about whether it’s sensible from a risk standpoint, or whether there are concerns about all of this that should be taken care of. I just like them now—it provides more opportunity for us to engage in new markets.”
“The best one is Gemini, I think, the biggest is GDAX, but it’s still not the CME or Nasdaq. Some of the others—wow. The thing will go down and nobody answers the phone for six hours. That’s a challenge and there are risks in that, but then again, it’s new, and it’s kind of fun that way.”Head of a Chicago-based principal trading firm.
Actual statistics on institutional involvement in crypto markets are hard to come by, and they vary wildly between cash markets, operated on digital currency exchanges (DCEs) such as GDAX and Kraken, and the futures markets. During the CFTC’s Technology Advisory Committee meeting, which was held on February 14, CME president Bryan Durkin broke down the participation rates for the contracts, saying that 27 percent of the product’s volume has been attributable to market-makers, with the remainder customer volume. Of that, the buy side represented around 15 percent, proprietary traders around 70 percent, and banks a little over 1 percent.
Institutional engagement is, perhaps unsurprisingly, far higher in futures markets than it is in cash markets, too.
“Looking at the futures, I would guess there’s more involvement in the futures from the prop firms than there is in the cash markets, because the prop firms feel more comfortable with futures markets, and it’s a lot lower burden to integrate there,” says a regulatory expert at yet another Chicago-headquartered principal trading firm, which has aggressively built out its crypto strategy.
In other asset classes, the insertion of sophisticated, institutional prop-trading firms into markets has generally meant a concomitant rise in low-latency, high-turnover strategies. This is not necessarily the case in crypto markets at present, however. Part of this is due to the fact that DCEs simply aren’t set up to handle that level of technologically advanced trading. Most were set up in the past few years to handle the growing retail market, even if they’re still viewed as being relatively sophisticated when compared to similar segments in equity trading.
“I think there are some inherent speed bumps; there are platform challenges that some of these larger bitcoin exchanges have in terms of reliability, stability, determinism,” says Rick Lane, CEO of Trading Technologies. “Firms that have been successful in high-frequency trading (HFT), or in low-latency automated trading in derivatives or equities, have come to enjoy a certain level of determinism and a certain expectation of reliability, and I think a lot of them take that for granted. They’re in for a shock when they trade on these crypto exchanges that were never built with them in mind.”
Vendors such as Trading Technologies have been at the forefront of professionalizing the crypto markets, by offering their institutional trading and hedging tools for use on exchanges such as GDAX, widely regarded as being the largest of the DCEs and the one with the highest levels of institutional participants.
Even here, vendors say, the demand from prop trading firms has been tremendous.
“In the course of talking to customers and—most importantly—potential customers, sometimes it’s 10 minutes in and sometimes it’s 45 minutes in, but they always say: ‘This sounds really interesting, can I trade crypto on it?’” says Steve Tumen, a former prop trader and the CEO of Deep Systems, which is planning to release a cross-asset trading platform for digital currencies in April. “It’s unbelievable. I expected a little bit of it, but we got a lot.”
That echoes the experience of others. Trading Technologies released its bridge to GDAX in early March, just before the Futures Industry Association (FIA) conference in Boca Raton, but CEO Lane says that prop firms had some early access to the tools.
“There was a lot of pent-up demand for this,” he says. “Some very large prop-trading firms were actually live on this before [the general release] because they were saying ‘give me anything you can.’ That group hit the ground running, and love having access to GDAX alongside the future on the same platform, with the same tools that they’re used to. But I think we’ve all been a little bit surprised at how much interest there’s been in the second wave, with people signing up and onboarding to the platform just to trade GDAX in some cases.”
“Over time, more and more trade is going to go onto regulated exchanges of some form or fashion as the industry matures, and it becomes clear which regulations apply and in which context.”Regulatory expert at a Chicago-based prop shop.
Still, while algorithmic trading and advanced electronic trading might be making inroads, there are still hurdles to overcome. The DCEs are aware of this, with the largest, such as GDAX, investing heavily in expanding its compliance and oversight procedures, while yet more are taking the prop trading community seriously.
“We started getting into it last summer. We’re on eight exchanges, plus LedgerX and we have a couple more in the pipeline. But banking, moving the assets, moving currencies is the challenge,” says Chris Hehmeyer, CEO of Hehmeyer Trading, a Chicago-based prop shop.
Prop firms themselves, as well as vendors, are starting to step into the breach. Hehmeyer, for instance, recently opened a commodity pool allowing institutional investors to gain exposure to bitcoin. Meanwhile, firms such as Irisium, formerly Ancoa, are beginning to provide their institutional-grade surveillance platforms to DCEs, in this case, Bitfinex. Still, the gaps between the level of sophistication in established asset classes, and those in the cryptocurrency space, are clear.
“The best one is Gemini, I think, the biggest is GDAX, but it’s still not the CME or Nasdaq. Some of the others—wow,” says the head of yet another Chicago prop shop. “The thing will go down and nobody answers the phone for six hours. That’s a challenge and there are risks in that, but then again, it’s new, and it’s kind of fun that way.”
In addition to continuing technology issues in the market, there have also been pushes to move futures contracts from a financially settled basis to a physically settled one. While exchanges have been grappling with the process around this—it would require involvement in coin wallet storage, and a host of concerns around cybersecurity—startups such as London-based Coinfloor have begun to announce physically delivered efforts in this area.
As with the self-certification process, prop shops take a slightly different view to the sell side when it comes to physical versus financial settlement. While the CME and CFE are content with their current method of price settlement—CME uses a benchmark rate averaging across the four largest DCEs, while CFE draws its price from the Gemini Exchange—principal traders see weaknesses with the current model that can lessen the utility of futures as a hedging tool.
“You often have crossed markets, sometimes significantly if there are structural reasons why people can’t get money in and out of exchanges,” says the regulatory expert. “There is a lot of volatility, there are timing issues, there are a lot of different concerns about market manipulation—all of these things mean that it’s hard to say, at any one given time, what a bitcoin is worth.”
It’s the guesswork, he says, that can be inherent in determining a fair-value settlement price that makes it tricky to plump for financial settlement. He points to established commodities, such as corn, pork bellies, oil or gold, that have established physical delivery settlement mechanisms in place as being models for the financial/physical argument.
“That seems to be a more stable mechanism for settling futures trades,” he says.
Every market participant spoken to for this article, however, said that these types of discussions were natural during the early stages of an asset class’s development. Indeed, some suggested, the future of cryptocurrencies may not even lie on the DCEs as they currently exist.
Some even suggested that, given the technical difficulties that plague DCEs at present, the market may be ripe for established exchange operators to step in. Trading Technologies’ Lane says that if he were an established market operator, it would be a “no brainer to strike while the iron is hot.”
Likewise, the regulatory expert says that he expects trading to move on to more highly regulated platforms over time, not just as institutional involvement deepens in cryptocurrency trading, but as regulators puzzle out how this new market fits into the established rules.
“Over time, more and more trade is going to go onto regulated exchanges of some form or fashion as the industry matures, and it becomes clear which regulations apply and in which context,” he says. “I think, for institutions getting involved in this space, they’re going to feel more comfortable being on regulated markets of one form or another, so I think that’s another direction the market is likely to move in.”
Overall, a sense of excitement, and—whisper it quietly—fun, is one that shines through when talking to prop traders who are engaged with cryptocurrency markets. Many, like the president of the principal trading firm, say it feels like the late 1990s and early 2000s again, when markets began moving en masse from the pits and the floors to the screen.
Others point to how it may hold the key to revitalizing an industry that has been, for some time now, in decline. Low volatility, capital pressures, regulatory reform and the cost of maintaining infrastructure have been squeezing the principal-trading space for some time, as evidenced by the declining number of companies in the space that have either shut up shop or been absorbed into larger rivals.
“You looked around and there were so few people that were entering the futures markets, compared with years ago,” says the CEO. “I think it’s really exciting to see how many people around the world are embracing new products, and trading these contracts, and really getting involved with it. To me, there’s a groundswell around that, but I think it’s a really exciting opportunity for our industry to create and institutionalize the skills we have, the knowledge we have in operating markets to legitimize that.”
The effects of crypto, he continues, could be even more far-reaching than simply the expansion of existing institutional players. The educational effect that the cryptocurrency boom has had on the general populace, in terms of its knowledge of markets, is also something remarkable—not least due to the fact that unlikely figures, such as the chairman of the CFTC, Chris Giancarlo, have become rock stars of the fervently active crypto Twitterati.
“You’re going to end up, at the end of the day, with a lot of people who are really interested in markets overall. They are going to be a lot more familiar with futures markets. When Chairman Giancarlo made a statement about bitcoin or the regulation of digital assets, the amount of followers [he gained on Twitter], it was just staggering. The people around the world who now have a connection or some affinity with the man who’s running the CFTC is really interesting,” he says.
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