Why Galaxy Digital bought BitGo

Mike Novogratz was already running one of crypto’s best-known financial services shops at Galaxy Digital. But he noticed the firm was missing out on clients looking for a “full-stack” financial service provider.

That’s a big part of the reasoning behind Galaxy’s $1 billion acquisition of BitGo, the second-largest crypto custodian behind Coinbase. 

Galaxy, an investor in BitGo, had previously offered custody services via a different third party: BitGo's rival Bakkt. In the end, building a full stack apparently means bringing custody in-house. 

But Novogratz has other technical projects in mind now that BitGo’s engineering talent is part of Galaxy. "(BitGo founder Mike Belshe’s) got 60 engineers which are hard to come by," he said in a recent interview with The Block.

With custody in place, Novogratz says Galaxy is in a better position to offer services like prime brokerage — and even try its hand at decentralized finance (DeFi).

Custody: far from boring 

Belshe, who founded BitGo in 2013, said that despite custody's sleepy reputation in traditional finance, it is key to building a financial services company in the crypto market. It’s also still developing as a business, thanks to the fast-changing digital asset scene.

"I believe that, unlike other asset classes where custody is a boring business, I think because of the rapid innovation, it is actually critical because of the unique questions. What if you want to stake your asset, work with a new type of asset? What if you have three types of assets?" he said.

Custody services have long been expected to eventually commoditize, which would cause the revenue for a company like BitGo to compress. But that compression has slowed and Belshe thinks it's being overstated. 

One insider at a competitive firm, who spoke anonymously, said that fees have flattened and that the range is 25 to 45 basis points. Two years ago, the normal was 60 basis points, the person said. To be sure, large investors can get sweetheart deals that dip below five basis points. 

But that person also pointed out that similar things have been said for years — and haven’t been true — about exchanges. "I remember in 2014, when all these exchanges were cropping up people said exchanges won't be able to charge 50 basis points, but firms like Coinbase have actually raised their rates," the person said, referring to the fees they charge traders. Coinbase notably raised fees to trade for certain clients in 2019.

Belshe argues that fees for custody services have stabilized because access to crypto is still difficult for large investment firms. On-ramps for institutions are limited compared to traditional markets.

From prime brokerage to DeFi

According to Novogratz, adding custody puts Galaxy in a better position to offer prime brokerage services, which he calls a “straight-up-the-middle” pitch to investors.

On Wall Street, prime brokerages sit between investors and the market, providing investors the tools needed to efficiently trade across various venues. It's still a new business in crypto. A few firms are just beginning to offer some of the staples of prime brokerage, including the ability to extend margin across venues and access to a large number of trading counterparties.

"Between corporate treasuries to pension funds," Novogratz said. "We are hiring up our sales team to cover all of those account bases."

In Belshe's view, endowments present the most interesting growing client base. "Their job is to protect wealth," he said. "Their business is risk aversion and they've decided that the best way to protect assets is by allocating to crypto."

Prime brokerage is “one of those places where it helps to have custody,” said Novogratz. “Then you can do derivatives products. You don’t want to buy? Here, you can sell puts."

Having a client hold their coins with Galaxy will make it easier for the firm to assess that client's risk when creating a bespoke derivative or setting rates for a loan, for instance. 

Galaxy may also put its new engineering talent to work building new blockchain applications. BitGo, notably, has already developed an ecosystem around wrapped bitcoin — an Ethereum-based token that allows holders of bitcoin to trade the cryptocurrency on popular decentralized exchanges.

"Far, far, far more important when I think about where the business is going it is building on the blockchain," said Novogratz. "It is DeFi. While I have been an investor in a lot of great DeFi protocols, we have been users in a lot of these, we haven’t been a builder on the blockchain."