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Regulated vs unregulated, how institutional investors choose exchanges in crypto

Owing to the Covid-19 outbreak, the first half of 2020 has turned into a critical juncture for the relatively young crypto industry, now forced to mature quickly as the world’s financial system seeks refuge in the digital space. Alongside average traders, more and more big investors are coming into the fold and exploring how crypto assets can serve as safe havens for their multi-million dollar funds in times of crisis. According to the world’s leading Bitcoin investment company, Grayscale, the influx of money to cryptocurrency trusts in the first quarter of 2020 has historically doubled compared to the previous quarterly high, reaching over half a billion dollars with $160 million of that being raised by new investors.

In this context crypto exchanges that are currently active in the market are becoming increasingly subject to scrutiny by institutional and corporate clients willing to start their journey in this digital new world. Generally speaking, reliable and trustworthy platforms always take precedence. But in the crypto sphere, the choice is compounded by many security concerns, such as exchange hacks, that frustrate people and have to be resolved. With that in mind, institutional players with a lot at stake are much more careful about safety issues and pay a great deal of attention to secure platforms and their respective trading instruments.

Unregulated exchanges expanding the diversity of crypto-derivatives

A 2019 survey conducted by Fidelity Investments shows that over 70% of institutional players prefer indirect crypto investment in the form of crypto-derivatives. Purchasing cryptocurrency through various crypto-related products is a good long-run strategy as it is much safer and more profitable than buying digital assets themselves, which, combined with existing poor security practices and the large number of professional investors entering the industry, has contributed to the proliferation of the crypto-derivatives market. In recent years, the trading volume of crypto-derivatives has been boosted from ten to twenty times larger than that of the spot market. However, the supply of derivatives on most exchanges targeted towards institutional investors is still limited to futures and options, allowing clients to gain profit from further price movements.

According to CoinGecko, there are 32 exchanges – most of them are unregulated – in today’s crypto market supporting crypto-derivatives with BitMEX, OKEx and Huobi being in the open interest top 3. As for the daily trading volume, here the last of these three holds the lead ahead of Binance and Biki, which can be explained by the January launch of Huobi Brokerage to better serve institutional clients. The straight-to-market approach of these venues has enabled them to create a brand-new type of futures trading that trades close to spot market prices through funding payments. Exchanges call them perpetuals, meaning that they have no expiry date, unlike traditional contracts. At the time of writing, the total daily volume of perpetuals was around $16 billion while the same measure pertaining to traditional futures sat around $4.2 billion. So, it seems like unregulated crypto exchanges are attracting big players too. At the beginning of 2020, Binance reported that futures accounted for approximately 75% of their full Bitcoin volume. Meanwhile, the Binance team has expanded the supply of perpetuals and recently introduced Ripple and EOS contracts on its platform. Additionally, unregulated crypto exchanges like Deribit, LedgerX and Quedex are also offering Bitcoin options trading.

Are unregulated exchanges a good option?       

However, almost every exchange mentioned above has been hacked or compromised by the lack of transparency related to the mass defaults of highly leveraged traders. Just since 2019, BitMEX, OKEx and Deribit have all experienced flash crashes costing hundreds of millions of dollars. The point is that unlike regulated exchanges with rulebooks clearly defining necessary anti-default measures, crypto exchanges do not force losing leveraged traders to pay everything back – the only thing they are deprived of is their collateral funds –  and instead of that, they establish special insurance funds to cover defaults. But if this insurance fund isn’t sufficient to cover everything, exchanges will literally force other users to pay for defaults through either socialized loss or auto deleveraging. As such, it’s much riskier for institutions to deal with unregulated exchanges as the cost of possible losses may be too expensive. The higher leverages together with good trading experience provided by well-known unregulated derivatives entities are more likely to meet the requirements of retail traders looking to make larger profits while trading smaller futures contracts. 

Some exchanges try to compensate for their lack of transparency by implementing the latest in cryptographic safety features, in order to persuade professional players to trust them. Among leading derivatives venues, only Huobi has remained resistant to hackers’ attacks with 2FA, multisig cold wallets and a security reserve fund employed to keep their users safe. But if you’re searching for the same security standards for direct crypto investment, the spot crypto exchange outplaying its competitors in terms of safety is HitBTC. Despite the fact that its team has never claimed their focus to be on big market participants, it’s only logical that HitBTC would be an institutional favorite, given the exchange’s fixed withdrawal fees and flexible trade rates which are both beneficial for high-volume trading. Moreover, HitBTC is one of a few exchanges enabling institutional traders to strategize on another level with the help of FIX API, regarded as the most efficient protocol for operations across all asset classes. HitBTC had also been atop of CoinMarketCap’s liquidity ranking prior to CMC changing its methodology in favor of retail traders. Tight KYC procedures play into the hands of professional investors as well, while at the same time they deter average traders that are not ready to share a large amount of private data in order to withdraw their assets quickly. As a result, HitBTC may have a lackluster reputation among retail players, but it looks like this hasn’t changed its wide appeal to more selective institutions. 

Choosing an unregulated exchange for institutional investors depends on upcoming regulatory development, too. With the “Crypto-Currency Act of 2020” set to shed some light on who is responsible for controlling crypto assets in the USA, there will be a big shake up in the industry should stricter rules related to security and transparency be established.
The need for well-established exchanges

But while the future is still uncertain, institutional investors’ demand for long-standing entities like Brian Armstrong’s Coinbase and Winklevoss Brothers’ Gemini remains solid. This shouldn’t be surprising, given how crucial it is for big market participants to build relationships with partners that are able to remain reputable throughout the years. Moreover, Gemini is the first US-licensed crypto exchange while Coinbase may be registered as an SEC-regulated brokerage in the not-to-distant future, which also plays to professional investors. When it comes to safety, these exchanges provide a decent range of security features, including proper custodial, fiduciary and insurance solutions, and have gotten the thumbs-up from plenty of famous institutional investors like BlockTower and Cboe Markets.

One more fully regulated US exchange with a substantial toolkit for institutions is Kraken which emerged in 2011. Its official website claims that Kraken was “built for institutions of all shapes and sizes” and it carries out this mission effectively. Kraken is really famous in the crypto space due to its comprehensive safety features, which put it on equal footing with the likes of HitBTC, which, however, outperforms Kraken in terms of liquidity and number of trading pairs.

As for the crypto-derivatives market, the compliance of the exchange carries weight as institutional investors primarily use these contracts to manage possible risks while operating with money they don’t personally possess. Except for the aforementioned Kraken, where futures trading is also available alongside spot markets, there are other, more supervised platforms. Mainstays of the traditional financial sector, the U.S. Chicago Mercantile Exchange (CME) and Chicago Board Options Exchange (CBOE) were the first to successfully put Bitcoin futures on sale for licensed brokerage companies. Since then, the CME, which is regulated by the Commodity Futures Trading Commission (CFTC) and the National Futures Association (NFA), has been enjoying the trust of institutional clients as one of the few established trading platforms to support this class of digital assets at 5 BTC per contract. While CBOE decided to stop listing new Bitcoin futures last March, CME has launched options on Bitcoin futures, becoming the first established exchange to add this type of crypto-derivative. Currently, CME keeps strengthening its leading positions as it competes with its rival, Bakkt, owned by the Intercontinental Exchange (ICE).

Bakkt got started in September 2019 and is another exchange operating under the CFTC regulations that enable Bitcoin futures trading and represents another significant step in the development of crypto-derivatives for professional investors. The institutional-grade exchange with transparent price discovery, secure custody and full adherence with KYC and AML legislation is designed to simplify large financial transactions and make the process of crypto trading “on end-to-end regulated infrastructure” more seamless for corporate clients. Bakkt is also aimed at pulling the crypto market, currently burdened with regulatory uncertainty, forward by increasing Bitcoin liquidity and trading volume. Even so, Bakkt is still dwarfed in terms of futures and options trading volumes by CME.

Institutional involvement may change the crypto industry

Along with the surging number of options for institutional investors, their relationships with the crypto market are in flux as well. Yes, the institutionalization of cryptocurrency has very little in common with the idea of decentralization, but in terms of safer and more sensible crypto investment, the participation of large financial institutions is a great sign.

All in all, choosing an exchange for institutional trading depends mostly on the level of regulatory development. The use of corporate platforms implies much lower security risks, but it can come at a price in other areas like liquidity. This is clear when comparing exchanges like Gemini and Coinbase with others like HitBTC. As for derivatives venues, Huobi outplays both CME and Bakkt with almost $5 billion worth of futures and perpetuals being traded there daily. Besides, Huobi and HitBTC robust verification procedures can serve as good alternatives to the security features implemented by establishment exchanges. The coexistence of such different projects gives more options to institutions looking to enter the crypto market and their own terms.   

However, many experts are worried that the influx of large crypto investors or so-called “whales” will lead to more opportunities for price manipulation, turning average traders into pawns in the extremely volatile world of crypto trading. Be that as it may, now that the world is in the middle of global economic turmoil, digital assets have been something of a bright spot, providing hope that they may help reshape the economy in the aftermath of all this madness. Cryptocurrencies have already demonstrated their relative independence and resilience to the factors that have caused the drawdown of equity markets and set the stage for what many are anticipating to be a promising future.

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