Bitcoin has gained approximately 50 percent in the past nine months. BlackRock, the world's largest asset manager, has applied for a Bitcoin ETF. Germany's largest bank, Deutsche Bank, is currently in the approval process for a crypto custody license. And thanks to MiCA, there is regulatory security.
However, the crypto market looked very different last year. In the crypto winter of 2022, Terra-Luna and Celsius stumbled, FTX had to initiate bankruptcy proceedings and the crypto market lost significant value. Additionally, the bankruptcies of U.S. banks Signature and Silvergate had significant consequences for crypto trading. Looking back reveals many weaknesses that are already being addressed. Looking into the future, institutional adoption of the new asset class is at an important threshold.
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Minimizing counterparty risk as a central learning for banks
Similar to traditional assets, trading cryptocurrencies involves various functions such as custody or brokerage. These are strictly separated in the traditional finance (TradFi) sector. However, at FTX & Co., this governance principle was not adhered to as part of a stringent risk management. Misbehavior in one area had an immediate negative impact on the entire company, leading to its collapse. Therefore, banks should ensure that internal governance guidelines exist and are followed when connecting to crypto exchanges and other service providers.
In the implementation of their Digital Asset Banking strategy, banks also encounter a highly fragmented market, with hundreds of centrally and decentralized operating crypto exchanges, OTC desks, and brokers. To ensure a Best Execution policy for themselves and their customers, as required under MiCA, a bank must connect multiple trading venues to its own platform. These venues may have significant differences in prices and liquidity, which can be opportunistically exploited through smart order routing.
Diversification is also advisable in risk management because, in the event of a trading venue's collapse, there is a risk of total asset loss. While connecting to multiple trading counterparts increases a bank's complexity and liquidity costs, it significantly reduces the default risk. It is also necessary to thoroughly review and clarify liability issues during due diligence of trading counterparts. For example, it should be determined who is liable if a downstream trading platform used by a trading counterpart encounters payment difficulties.
After Silvergate and Signature the smart cash management is in focus
This year's collapse of U.S. banks Signature and Silvergate had dramatic consequences not only for the customers invested there but also for the entire crypto trading industry. These banks allowed immediate USD transfers to crypto exchanges, minimizing the assets parked there. Alternative cash management solutions often appear to be underdeveloped.
Stablecoins sometimes exhibit high volatility, and transactions may have delays. SEPA provides immediate liquidity on a Euro basis, but transaction limits and limited market penetration present hurdles for institutional trading. The Federal Reserve's Instant Payment Service, FedNow, must establish itself to achieve the desired network effects. Solutions for off-exchange settlement through providers like Copper ClearLoop or Fireblocks seem to offer an effective way for efficient cash management, enabling funds to be transferred to exchange accounts immediately before a trade.
In addition to a centrally managed liquidity pool, automating liquidity management is a sensible component of smart cash management. This involves automating individual functions such as pre-funding, rebalancing, or settlement. Another modality is dynamic cash management: during trading hours, funds parked at crypto exchanges can be increased, and outside trading hours, reduced or completely withdrawn.
Orchestration of the trading lifecycle and seamless integration
The technical implementation of cryptocurrency trading requires a bank to integrate additional systems alongside its core banking system. A custodian suitable for institutional trading secures private keys that enable secure encryption of crypto trading. Furthermore, a system for executing trade orders that can access various crypto exchanges is needed. Finally, a solution for orchestrating the described functions and integrating additional functions such as liquidity or risk management is required. Currently, Wyden's platform is the only one offering such functionality. In conclusion, banks should always keep their own needs and characteristics, such as risk profile and customer structure, in mind to develop an optimal digital asset strategy.
Banks as established and trusted access points
Established financial institutions have clear incentives to continue their digital asset strategies. From a retail or investor perspective, a regulated bank's digital asset offering provides an elegant solution, bridging the gap between the need for security and convenience.
A regulated bank acting as a "custodian" of cryptocurrencies ensures secure storage of customers' wallets. Furthermore, access to crypto and digital assets is significantly simplified since the bank serves as a one-stop-shop for all asset classes, from traditional assets to cryptocurrencies and DeFi products. Asset advisors can provide comprehensive information on risks and assist with portfolio diversification. Expanding their offerings through staking, tokenization, and other means enhances customer convenience, provides valuable data to the bank, creates additional touchpoints, and simultaneously positions the bank as the central, trusted partner.
If banks can learn from the mistakes of the past crypto winter, there will be no obstacles to the maturation of institutional crypto trading. The technological prerequisites for a professional and interconnected trading ecosystem are already in place. Now it's time to implement them extensively in the banking sector.