The Future of Capital Markets
a CoinShares work-from-home series
In this series, our team at CoinShares will speak with three technology entrepreneurs building new types of market infrastructure, and our CoinShares Capital Markets desk. We explore the fundamental technology innovations driving new applications in cryptocurrency markets and how they might apply to capital markets more broadly.
At CoinShares, our mission is to expand access to the digital asset ecosystem while services as a trusted partner for our clients. We achieve this by building regulated investment products and financial services, including exchange traded products, managed investment strategies, and capital markets services.
CoinShares invests in innovative companies building the digital asset ecosystem, focusing on making early stage equity investments in financial technology companies. Note that CoinShares, associated group entities, or the directors of the firm may be investors in one or more of the companies or assets discussed in this series. We have made an attempt to note instances where a relationship exists between a company and the Group.
In this first installment, we're going to delve into the first two components of the trade lifecycle - price discovery, and execution.We are joined by Anand Gomes, co-founder and CEO of Paradigm, Paradigm is building institutional-grade messaging with workflow automation for digital asset traders.
In this episode, Anand and Meltem discuss the evolution of markets and execution venues in the crypto space, and delve into Paradigm's vision of unbundling execution from clearing and settlement, and what this structural change means for market participants across asset classes.
The Challenges of Trading Crypto at Scale
In the early days of bitcoin, most trading was done on the basis of a spot quote, where a counterparty would simply quote a price at which they would sell bitcoin. The trading ecosystem has, fortunately, come a long way since those early days and there are not a large variety of markets, trading venues, and more contract types, including derivatives like the perpetual swap contract popularized by BitMEX.
While much of the talk about crypto markets seems to focus on speculative trading on retail platforms, there’s a large cohort of professional firms - lenders, structured product issuers, OTC firms, market makers like our CoinShares Capital Markets desk, and specialist brokers and dealers who are creating and providing solutions to traders. Hundreds of millions of dollars of digital assets change hands on a daily basis, and more firms are getting involved in the market. However, the evolution of a more professional trading ecosystem has been hampered by a number of challenges stemming from the inability to translate the traditional trade lifecycle into a manageable process.
Today’s discussion is all about the first two components of the trade - price discovery, and execution. Let’s briefly delve into what these terms mean.
Price discovery is the function of buyers and sellers arriving at a price for a specific contract at a given time. As this implies, it requires the existence of an informal or formal market where this conversation can take place. Price discovery is a function of numerous factors, including:
- Buyers and sellers, meaning how many are there, do they trade agency, i.e. matching buyers and sellers, or prop i.e. taking balance sheet risk, where are they based
- Market structure, meaning the process of executing, clearing, and settling, and any centralized entities who coordinate these activities. For example, in legacy markets, some assets are required to be centrally cleared and settled.
- Available information about the market, which informs sentiment. Not all firms have the access to the same type or volume of information, which changes their appetite for risk.
- Risk management choices, including both market risk (at the asset level) and counterparty risk (the credit risk of the person they’re trading with).
While the market for spot price discovery is robust and a global price for bitcoin has developed, the market for futures and options still presents significant challenges in price discovery. While the market for spot price discovery is robust and a global price for bitcoin has developed, the market for futures and options still faces significant challenges related to price discovery: There are multiple exchanges and venues where price discovery is fairly robust for smaller trades but large or significantly complex orders, like a multi-leg option or future spread, are consistently difficult to execute without incurring significant slippage and causing orderbook disruption.
One interesting challenge emerging from the evolution of crypto markets is the plethora of execution venues, including relationship-driven venues like chat and voice (over the phone), electronic venues like exchanges and other market aggregators, and informal venues like local bitcoins, peer to peer trades (everyone has met a WhatsApp “broker” who always has a 10,000 BTC block trade), and other such arrangements. When you have numerous venues ranging from formal - with a standard contract - to more informal, with bespoke contracts, price discovery becomes a process of hunting for bids and asks. There are very few places where multiple bids and asks are aggregated outside of exchanges and messaging boards.
As a result, trade execution is fragmented and challenging to manage. While solutions like prime brokerage are emerging in the spot and futures market, sophisticated trading strategies can be difficult to execute without building your own trading engine. Platforms tend to suffer from a lack of sophistication, coordination, and a host of other issues when it comes to trade execution.
Enter Paradigm, a Platform for Automating Execution & Trading Workflows
As a former energy trader, Anand initially began building Paradigm for the energy market but quickly realized it was more powerful for the nascent crypto market. Paradigm is focused on large or complex trades that tend to disrupt traditional order books, suffer from slippage and are notoriously difficult to execute efficiently.
For example, today, Paradigm estimates 30% of all crypto volumes cannot be done on screen, meaning they cannot be executed without significant slippage, orderbook disruption and lots of execution related pain for the trader. These trades tend to be negotiated on Telegram or by phone, and executed over chat. Examples include multi-leg option trades (Strangles, Call and Put Spreads), futures spreads, and even just plain outright puts, calls, and futures. These types of multi-leg trades generally have no standard contract, are not quoted anywhere and therefore have no accessible market for price discovery, and suffer from significant execution risk.
The Paradigm vision is simple in theory but extremely powerful in practice: trade anything, with anyone, and clear and settle it anywhere using a single point of access. And they can do this at scale, because unlike a traditional venue, Paradigm has decoupled the execution layer from the clearing and settlement layer, providing the user with customization at the asset, dealer as well as the clearing/settlement level while providing a seamless execution experience via automated price discovery and settlement.
Offering this degree of choice at these different layers has never been done before, even in the traditional markets. This holds true for most of cryptofinance as well, wherein price-discovery, execution and settlement are bundled together on the same platforms such as exchanges, OTC desks and even the one-stop-shop, prime-broker platforms Most large firms tend to prefer trading bilaterally, where they conduct the entire trade lifecycle within their own systems, often ones they’ve built over the years.
From Paradigm’s perspective, this is a compelling way to help firms get access to a wide range of institutional crypto access points through one interface, without mandating the use of a specific clearinghouse or specific settlement venue. Anand describes the platform as having similar attributes to Tradeweb (RFQ trading) and Bloomberg messenger but with a unified service and infrastructure wrapper.
Breaking Down the Trading Workflow
While Paradigm is currently focused on crypto markets, Anand and I both agree there is a potentially massive opportunity to transform the structure of other markets. One of the more interesting features in Paradigm is how you can write your own contract (expected to launch in Q3 2020), collect quotes, and execute a bilateral trade, where you can use a decentralized settlement protocol like, say, Arwen to settle your trade from our cold storage wallet or third-party custodian directly without ever touching a trading venue or exchange, and subsequently, without ever exposing yourself to that counterparty risk.
When a trader logs onto the platform, each chatroom, which is called a trade channel, has a simple button for RFQ or “request for quote.” Setting up an RFQ is simple and modular, with the following steps:
- Choose the settlement venue (Paradigm currently supports derivative venues such as Deribit and the CME but will soon be adding cold storage, custodian and wallet to wallet settlement options)
- Choose the Product (Bitcoin Options, Futures)
- Strategy (Support for some very complex strategies such as Risk Reversals, Strangles, Butterflys et al)
- Once you’re happy with the parameters, you send that RFQ to that dealer.
- Dealers can then respond immediately with one net price for the strategy (versus leg-by-leg execution)
- User clicks buy/sell (i.e. one-click execution for a multi-leg strategy)
- Paradigm then automatically submits that trade to which settlement venue has been selected via an API submission
All of the above happens in a span of a few seconds. Because Paradigm is simply a technology provider and never touches the asset itself. As we’ll talk about throughout this series, it’s starting to look more and more likely that in the future, it will be possible to build markets where assets never touch an exchange or a centralized coordinator, but rather execution and clearing is managing programmatically via smart contracts, and settlement is done directly between counterparties using on-chain escrow. We’ll delve into this more deeply over the next few days.
Translating These Innovations to Legacy Capital Markets
Like many firms in the crypto space, our team at CoinShares has been talking to a lot of folks in the commodities space and now, the FX space, particularly EM FX or other markets that are still heavily driven by dealers. Anand believes there are many asset classes outside of crypto that have unique structural characteristics that make them especially suitable to the Paradigm RFQ model. Examples that comes to mind include eurodollars options and energy options, or more broadly any asset or order that is complex/custom, illiquid and/or traded in large size.
The theme of this discussion is the future of capital markets, and we of course can’t talk about capital markets without touching on the structural challenges we’ve seen since 2008. After 2008, the financial sector implemented a number of rules that were supposed to reduce systemic risk, including increasing capital requirements, increasing transparency and reporting requirements, and putting restrictions on prop trading.
One of the biggest challenges in legacy markets is it’s really challenging to quantify and qualify risk, as we saw in 2008 and are seeing again now. There’s a dense web of counterparties and market participants, and when you add leverage, things start to get very complicated very quickly. In 2008, there were a lot of undercapitalized counterparties taking on massive and complex forms of risk with no idea of how to deal with a black swan event. So much of the regulation, post the crisis, was focused on fixing four broad issues: increased transparency and reporting, increased margin/capital requirements, a push to the central clearing model (well-defined/standardized margin and default waterfalls) and decreased prop-trading (relevant for banks).
There are many analogies between the systemic risk in legacy markets and what’s happening in the crypto space. Just like legacy markets, structural weakness in the crypto market highlights where systemic fixes are needed. The market will force more systemic fixes in the crypto market like increased capital and margin requirements, a push towards better/standardized liquidation methodologies and systems, circuit breakers, and general best practices at the infrastructure layer. Anand notes that market disruptions, like the one from two weeks ago, can almost instantly undo all the growth these markets have seen over the previous 3-5 years and that it is important for crypto firms to realize that evolution in the crypto ecosystem shouldn’t come at the expense of additional pain to market participants, especially given that crypto is still dominated by retail.
Check out the recording to catch these topics, an overview of Paradigm’s RFQ platform, and much more.