In the crypto Wild West, a dose of Wall Street law and order might lure institutional investors

A new type of trading firm is emerging in the inchoate market for digital currencies: registered agency brokers. 

Across the $300 billion digital currencies market, most institutions engage with so-called over-the-counter (OTC) trading shops. Many of them also function as brokers, who, on top of trading on principal, also answer their clients’ phone calls and trade on their behalf. To many investors coming from traditional asset classes, this practice is concerning, to say the least, according to BitOoda founder Tim Kelly. 

Meanwhile, regulated agency brokers, which serve as the first point of contact when investors want to buy or sell a certain asset, have only recently made their debut — with firms like Tagomi and BitOoda as the crypto counterparts of Fidelity. 

“When I started the firm, I did all the due diligence on crypto, I just couldn't understand that there was no agency broker. There was this tremendous need for non-conflicted anonymous best execution, and that is the role of an agency broker,” said Kelly, who was trading commodities before jumping into cryptocurrencies. 

A problematic trading structure 

Trading directly via OTC desks has definite advantages. For people looking for quick access to cryptocurrencies, calling an OTC desk is one of the most convenient ways to buy cryptocurrencies. Investors only have to tell the desk how much they want to buy, and OTC will land them a deal with a guaranteed price. However, the drawbacks of trading OTC are also prominent, including difficult price discovery and frontrunning, according to Dave Weisberger, co-founder of electronic cryptocurrency order-routing platform CoinRoutes. 

Specifically, the burden of price discovery entirely falls to investors when trading OTC. To figure out the best price, these investors usually have to call up several OTC desks separately for quotes. This annoyance is compounded by the fact that OTC desks can trade against their own clients after quoting a price, creating the so-called “legal frontrunning” problem, according to Weisberger. 

“It used to be if I want to buy bitcoins, I'm going to call up five different OTC desks to see who has the best price, but the instant you do that, the price moves before you get a chance to buy anything,” said Weisberger.  

For example, in 2016, the U.S. Department of Justice charged two traders at HSBC with cheating a client by deliberately buying British pounds ahead of the client's $3.5 billion sterling purchase and reselling it to the client at higher prices. 

Similar worries of frontrunning and a desire for better price discovery in cryptocurrencies is spurring the emergence of cryptocurrency brokers, and this is just part of a bigger trend as the cryptocurrency market becomes more institutional, according to Kelly. 

“You can clearly see verticals being divided, you are going to see exchanges divided, you are going to see buy-side, sale side, and the role of the inter dealers, the agency brokers really going to emerge. That's going to be the story of next year," said Kelly.

Woo the Wall Street money

Meanwhile, institutional investors might be lured to cryptocurrencies by handsome returns but also deterred by its lack of regulations. For one, to attract big financial institutions, the Intercontinental Exchange (ICE)-backed Bakkt went through a lengthy, year-long process before it obtained green lights from the CFTC and the New York Department of Financial Services (NYDFS) to launch its derivatives products. 

As such, agency brokers that look to onboard institutional investors are seeking oversight from regulators and third-party agencies. The Wall Street Journal reported in June that around 35 to 40 cryptocurrency companies had applied to become licensed brokerages or electronic trading platforms, while none of them had been approved. 

In comparison, Tagomi and BitOoda are the lucky ones. In March, Tagomi received a coveted BitLicense from the NYDFS to conduct businesses with New York State-based investors. It has also engaged in conversations with the SEC and the Financial Industry Regulatory Authority (FINRA) “to figure out what it means to be a sort of registered broker-dealer in the crypto space,” according to Tagomi COO Kevin Johnson. Meanwhile, BitOoda has acquired licenses from the National Futures Association as a registered commodity derivatives broker and registered with FINRA as a broker-dealer. Following Tagomi, it is also applying for a BitLicense. 

At the end of the day, these cryptocurrency brokers are hoping that regulations, licenses, and a mature market structure may do the trick to draw the institutional money. 

“They [institutional investors] are going to be a lot more comfortable dealing with traditional agencies, regulated firms, they are going to need to know the regulated and licensed,” said Kelly. 

There are still gaps

At the end of the day, there is still a long way to go before digital asset trading grows into a mature market, and agency brokerage is just the beginning. 

Tagomi COO Kevin Johnson pointed out that although blockchains allow instantaneous settlement, settling trades that involve both fiat and digital currencies instantaneously is still not possible due to the lack of a centralized clearing counterparty. 

"[We] take cues from the traditional finance area, but realize that things are a little bit different for crypto because the nature of how settlement is different and how centralized clearing counterparties do not exist yet," Johnson told The Block.