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Tim Parker
Tim Parker

2020 Will Bring The Rise Of Prime Brokerage In Crypto Custody


2020 Will Bring The Rise Of Prime Brokerage In Crypto Custody

At the same time, in another place and another market, a much newer financial services company reaffirmed its commitment to enter the prime brokerage business. Coinbase launched a prime brokerage offering in crypto for its institutional clients midway through the third quarter. On its earnings call, the company\u2019s CEO highlighted it as a key area of investment.

This week, we take a closer look at the prime brokerage business model and its application in crypto. Earlier this week, the aggregate value of the world\u2019s crypto assets flew through $3 trillion for the very first time. Institutional interest is rising and an effective prime brokerage solution could be the way to unlock it.

Most retail investors have a single brokerage account through which they manage their investments. Their broker will usually look after custody for them and offer additional services such as margin lending. If they have more than one account, they are likely to be distinct: funds in one account can\u2019t usually be drawn to cover positions in another.

Prime brokers make most of their money on the financing side. They lend explicitly through cash margin loans (for long positions) and stock loans (for short positions), or implicitly through equity derivatives (which can be long or short). Like any form of lending, prime brokerage is a spread business: money is made on the spread between what hedge funds pay for financing and what prime brokers pay as the cost of their funding. In 2020, Goldman\u2019s equities financing revenues were down, not because of a lack of hedge fund activity, but because the firm suffered \u201Chigher net funding costs\u201D.

Seven months after disclosing its prime brokerage losses, Credit Suisse decided that it doesn\u2019t have \u201Cthe competitive advantage required to deliver sustainable returns above our cost of capital in this business.\u201D It is shutting the business to free up $3 billion of capital. Revenues were around $800 million in 2020, so not too bad, but costs were high.

In order to service these institutional clients, Coinbase rolled out a prime services product that combines trading, custody, analytics and financing in a single solution \u2013 the kind of thing Goldman and Furman Selz did in equities many years ago. The demand is potentially greater in crypto because custody is a harder problem to solve.

Others in the industry are also developing their prime brokerage activities. We discussed Galaxy here in Net Interest a few months ago. Founded by ex-Goldman partner Mike Novogratz, it is set up as a \u2018merchant bank\u2019 for crypto, focussed on the institutional market. It began offering prime services to select clients during the second quarter, taking in $150 million of customer funds onto its balance sheet by quarter end. Other providers include Copper, which provides some core prime services, notably custody. FTX is a leading crypto exchange that began by targeting large, active traders and is making inroads on the institutional side.

Deep diving into an institutional strategy, there are two distinct uses of crypto-currency investment: 1/ a willingness to be exposed to a new asset (trading firms, asset managers, Family offices) 2/ a cash investment to seek a minimum return (especially in a low or negative interest rate environment) while safeguarding the capital (corporate strategy). In both strategies, risk tolerance is absolutely opposite but the maturity of the actual crypto-world allows them to find architectures, custodians, prime-brokers, that offer solutions which suit them all. Also risk tolerance may be adjusted in setting up a wide range of cryptos in their portfolio (more stablecoins vs exotic coins).

Now that institutional custody is a more mature market, prime brokers are emerging to provide hedge funds and institutional investors more complete services regarding their will of investments. SheeldMarket, Tago


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