In this article of Tesseract Thoughts, our Head of Growth Juuso Roinevirta summarises some of his thoughts on the current state and direction of digital asset prime brokerage.
Prime Brokerage is a widely used term in the digital asset space. However, what it has begun to mean in crypto is very different from what we are used to prime brokerage meaning in traditional finance. This article will explore what prime brokerage means in traditional finance, why true prime brokerage does not exist in crypto (yet), and what true prime brokerage might mean in the field. There’s also a visible set of distinct strategies to achieve true prime brokerage status, which I will touch upon lightly. Let’s get started!
In traditional finance, or TradFi for short, prime brokerage simply means a set of high-quality services offered by financial institutions. These services, almost exclusively, always include a way for the prime broker’s clients to leverage their trading and engage in netting, by which I mean basing margin requirements on the net risk of the portfolio.
Leverage & netting are some of the main reasons for using a prime broker. By utilising the prime broker’s large balance sheet, the client may increase their capital efficiency, or potential return on capital invested, allowing absolute returns from even the tiniest trades.
Prime brokers’ services extend much beyond leverage. These include best execution (executing a trade in the most favourable way possible for the client), custody, flexibility with settlement terms, and risk management. Additionally, some prime brokers also provide services such as research and introductions to potential investors.
For the privilege of receiving all of these services at a single venue, which in itself streamlines the client’s operations, the prime broker receives fees in the form of financing fees for the cost of margin, fees for the cost of execution, and other service fees. As a result, prime brokers can provide their suite of services for a relatively small fee due to the amount of business each client generates.
The lack of prime brokerage in crypto can be roughly divided into two buckets: the scarcity of capital and infrastructural challenges.
Even though crypto market capitalisation and investments in the space have been soaring over the past year, capital is still relatively scarce. Combined with the fragmented market and its young age, the industry is still lacking its super-giants.A The small size of the industry actors and their balance sheets limits their lending potential. Hedge funds and other prime broker clients from the traditional industry are used to dealing with high leverage and large positions, which the current crypto “prime brokers” cannot provide.
The decentralised and independently developed infrastructure poses a myriad of challenges. Unlike in traditional finance, where trust, a well-established network of services, and ultimately legal recourse unlocks access to various services, the digital asset infrastructure has been built upon the principle of not needing to trust anyone. In practice, this means that all accounts at all trading venues must be prefunded to trade at the venue. When there are dozens of prominent exchanges, the costs start to pile up, and the efficiency of capital begins to deteriorate.
Another great infrastructural challenge is born from the independent development of exchanges, which has led to differences, making it hard to compare seemingly similar products between exchanges. This siloed development & lack of standardisation can be observed, for example, in contract & settlement terms, trade execution, and onboarding requirements. Even transferring funds between venues may be subject to very different conditions, fees, and wait times.
So far, those who have labelled themselves as crypto prime brokers usually approach the business from one or two of three angles; focus on 1) efficient order routing, 2) secure custody, or 3) lending.
Those who focus on efficient order routing have integrated with multiple venues to provide an experience close to the “best execution” from TradFi, which usually means a promise of high liquidity, low spreads, and low slippage. Custody focused “prime brokers” emphasise their secure, high-availability custody solution where some assets are often held in cold storage. Lending focused “prime brokers” emphasise a stable supply and the importance of leverage.
Each of these services has its place in the ecosystem, one serving some clients better than another. Prime brokers in crypto still differ considerably from prime brokers in TradFi, and these are the closest we get in crypto today. I believe we are currently at the intermittent stage of development where non-complete services have to be offered to bootstrap the balance sheets & operations to support the development of full-fledged prime brokerage services.
As a handful of firms find a product-market fit and more institutional investors enter the market, the industry starts to concentrate & balance sheets will begin to grow at rapid speeds. Finally, when the offering develops to the point where all three of the above functions can be provided by a single platform, the actual competition & differentiation will begin.
Service providers will spend the following 3-5 years bridging the gaps between digital asset prime brokerage and the services we are used to in traditional finance. The list of requirements for a true digital asset prime broker is long and by no means easy to execute due to the reasons discussed above. However, some of the most important things the industry needs to focus on in the coming years are a solid financial condition & regulatory approach, availability of capital, standardisation of investment products, seamless access to a broad range of products, strong & creditworthy status, secure & audited custody solutions, operational excellence, manageable fees, excellent technological connectivity (e.g., via APIs), high liquidity, reasonable pricing, white-glove service, and robust AML/KYC processes.
Juuso Roinevirta, Head of Growth
A) Some of the super-giants in traditional finance, such as the Agricultural Bank of China (ABC) or JPMorgan Chase (JPM), are larger than the crypto market itself. ABC has total assets of RMB 27.21T1, approximately USD 4.20T, making it 106% larger than the entire crypto market capitalisation at the time of writing (USD 2.04T according to CoinMarketCap). Similarly, JPM has total assets of USD 3.39T2, 66% larger than total crypto market capitalisation.
1) Agricultural Bank of China, 2021. ABC Releases the 2020 Annual Results. Available at http://www.abchina.com/en/AboutUs/news/202103/t20210330_1978050.htm
2) JPMorgan Chase & Co, 2021. 2020 Annual Report. Available at https://www.jpmorganchase.com/content/dam/jpmc/jpmorgan-chase-and-co/investor-relations/documents/annualreport-2020.pdf