First it was digital asset custodians. Now it is aspiring prime brokers who are grabbing the spotlight in the evolution of the cryptoasset market as it tries to become an institutional investor-friendly industry, but with regulations still so murky cryptoasset prime brokers can only be pale reflections of their traditional prime brokerage peers.
Although institutional investors are the backbone of the traditional securities market, they have yet to wholeheartedly embrace the cryptomarket. Institutional adoption is key to the crypto market achieving mainstream success which is where prime brokers, as useful middlemen, come into the picture. BitGo, Coinbase, and Genesis Trading seem to have nabbed the most media attention with smaller firms, such as Bequant and Anchorage also putting their hat in the prime brokerage ring. Crypto-custodian and exchange Coinbase entered the prime brokerage arena through its recent acquisition of prime broker Tagomi in an all-share deal, while Genesis Trading bought the UK’s Vo1t digital asset custodian to add to its arsenal of lending and trading capabilities. BitGo’s launch of BitGo Prime followed the start of its lending services and its takeover of Lumina, a service used by institutional investors to manage their crypto portfolios and track their tax obligations.
Wyoming’s Avanti Financial Group says that it will also offer prime brokerage services after it expects to win regulatory approved as a digital asset custodian from Wyoming’s Division of Banking in early 2021. “Wyoming is currently spending a great deal of time and money developing supervisory manuals for the digital asset activities of banks and trust companies,” says Christopher Land, general counsel for Wyoming’s Division of Banking in Cheyenne, Wyoming. “It is critical to get this right to safely integrate digital assets into the wider financial system.” Wyoming is vying for market share with New York and South Dakota as fertile ground for digital asset service providers. State laws differ so cryptofund managers need to ask about which state has jurisdiction over their prospective service providers because their distinctions could affect a the cryptofund manager’s rights.
Regardless of their origins, the common goal of all cryptoasset prime brokers is to nab smaller cryptoasset fund managers in the short-term and win over larger US registered investment advisers with more stringent legal requirements down the road. Prime brokers go a step beyond the basic safekeeping services of custodians in providing the three Ls: liquidity, lending and leverage. “The process for a cryptoasset manager to select a prime broker is practically speaking no different from that of a hedge fund manager with one major exception: the regulatory framework underpinning the cryptoasset industry isn’t as clearcut as it is for traditional assets,” says Joel Telpner, senior partner in charge of the fintech and blockchain practice at Sullivan & Worcester in New York. Prime brokers may be subject to state rules, but not the additional statutory requirements imposed, for example by US securities laws and regulations. The customer protection and other requirements of the Securities and Exchange Commission and Financial Industry Regulatory Authority may not apply to prime brokerage activities with respect to Bitcoin if the prime brokerage is not a US-registered prime broker, explains Telpner. By contrast, the handful of well-known traditional prime brokers, such as Goldman Sachs and Morgan Stanley, fall under the oversight of the SEC and FINRA which have stricter customer protection and asset segregation rules.
All of the firms aspiring to be cryptoasset prime brokers also happen to be digital asset custodians so none have a unique selling point when it comes to offering cryptofund managers one-stop shopping for both services. “Custody is the foundation of the prime brokerage stack and the better integrated it is into the range of prime brokerage offerings the more secure assets are and the better user experience an investor will have,” says Nathan McCauley, co-founder of digital asset custodian and prime broker Anchorage in San Francisco responding to e-mailed questions. Although his stance may be correct, it is unclear whether if all or even any of the digital asset custodians meet the SEC’s definition of a qualified custodian. The SEC’s “custody rule,” requiring RIAs to select a qualified custodian to safekeep their assets, refers to US banks and trust companies as fitting the bill. However, since the regulatory agency has never classified the most common cryptocurrencies such as Bitcoin and Ether as securities, it is uncertain whether the rule applies to cryptofund managers who are also RIAs. Legal experts are conflicted, yet they still tell their clients to pick a cryptoasset custodian which is also a trust company thinking that doing so might help them win institutional monies.
Despite their insistence to the contrary, it is also uncertain whether even the digital asset custodians operating as trust companies meet the SEC’s criteria for a qualified custodian for RIAs. There is legal dissent over how the SEC defines the requirements of a trust company for the purpose of acting as a qualified custodian. The SEC’s custody rule says that a qualified custodian must either take US dollar deposits or act in a fiduciary capacity, but only banks can take dollar deposits; trust companies can’t. What’s more, the Office of the Comptroller of the Currency has said that acting as a custodian doesn’t equate to acting as a fiduciary. (As FinOps Report went to press, the OCC had opened the door for federal savings associations and national savings banks to hold cryptocurrencies on behalf of their customers) Some legal experts tell FinOps Report that strictly speaking the Murray, Kentucky-based Kingdom Trust, which does not offer prime brokerage services, is the only digital asset custodian which fits the bill of a qualified custodian, since Kingdom Trust does act as a fiduciary in its business lines outside of digital assets. Other digital asset custodians neither take dollar deposits nor act as fiduciaries. The London-based Bequant, also an exchange, custodian and fund administrator acknowledges that it does not meet the SEC’s definition of qualified custodian as it has applied for regulatory approval with Malta’s Financial Services Authority. However, it is eager to step into the US institutional pond. “We are looking at entering the US market with a partner that would fulfill the SEC’s definition of qualified custodian” says Bequant’s chief executive George Zarya, who declines to name potential candidates.
Now comes what might be a confusing potential dealbreaker for some registered investment advisers. Presuming they buy the argument that they have picked a firm for prime brokerage services that is also a qualified custodian, the same firm’s prime brokerage services may or may not be subject to the same state regulatory oversight as its custody services. South Dakota, for one, expressly prohibits trust companies from offering prime brokerage services. The Palo Alto, California-headquartered BitGo which falls under South Dakota trust law for its digital custody services offers prime brokerage services through an affiliate in Delaware as a limited liability company and through another affiliate in the UK, acknowledge company officials. In January 2020 Anchorage said it had launched Anchorage Trading, as an agency brokerage for prime brokerage services, but at press time it could not be determined which state had legal jurisdiction over the business. In media reports, Anchorage said it offers services through Anchorage Hold, a limited liability company in Delaware and Anchorage Trust, a trust company registered in South Dakota. Both firms are subsidiaries of Anchor Labs, a Delaware corporation headquartered in San Francisco. Coinbase and Genesis offer digital asset custody services as New York registered trust companies, but the legal status of their prime brokerage businesses could not be determined by press time. Wyoming law explicitly allows for banks operating as special purpose depository institutions to offer both custody and prime brokerage under the same bank corporate entity.
For asset managers willing to accept legal uncertainties, the quality of trade execution particularly for active traders appears to a critical differentiator among wannabe prime brokers. Prime brokers eliminate the need for a cryptoasset manager to forge its own relationships with multiple trading venues which have different order books and onboarding requirements thereby making it operationally challenging for cryptoasset managers to access liquidity. BitGo, Coinbase, Genesis, Bequant and Anchorage say they offer trade execution services, but cryptoasset managers must do their homework to understand what sets each apart from the other. “Can I trade from my custody account, do my assets need to move onto an exchange before I can trade, and do I need to prefund my account are the three questions cryptoasset managers should ask their prospective prime brokers,” recommends McCauley.
The disparate rules of each crypto exchange won’t allow cryptoasset managers to meet legal requirements for best execution, but Wyoming is reportedly working on new standards for best execution for crypto prime brokers that meet federal guidelines. Offering exchange-like platforms, Coinbase, Genesis and Bequant beg the question of whether they would favor their own platform over others. Although it is likely they would insist not, the possibility might certainly raise eyebrows with some institutional investors. BitGo touts its neutrality as a benefit for cryptoasset managers seeking institutional funding. “We have no conflicts of interest because we are not an exchange or marketmaker,”says Nicholas Carmi, a Wall Street veteran from Lehman Brothers and Deutsche Bank who now heads up BitGo Prime. “We operate on a riskless principal basis, which is better than acting on an agency basis,” he adds without elaborating. The new BitGo Prime aggregates pricing from multiple exchanges, counterparties and marketmakers itself; it requires full prefunding of prime brokerage accounts.
Anchorage has publicly said that its brokerage operates on an agency basis, which allows for greater transparency than principal trading. Zarya insists that Bequant PRO, its prime brokerage service, operates separate from Bequant’s exchange, which is one of several exchanges Bequant works with including Binance, Ituobi and OKex. Bequant also works with several OTC desks and clients can use Bequant’s smart order routing technology or manually execute orders where they prefer. All prime brokerage customers have access to the order books of all the trading venues through a single unified dashboard that helps them spot best prices and arbitrage opportunities and more effectively manage risk, says Zarya. Coinbase, which did not respond to emails seeking comment by press time, has publicly touted Tagomi’s merits as an agency brokerage. Genesis could not be reached for comment.
It is critical for cryptofund managers to understand the legal distinctions between principal, agency principal and agency trading so that in case of a failed trade they know whom to sue. “In a principal or riskless principal transaction, the prime broker is the counterparty so the partner to a principal or riskless principal transaction may have recourse against the prime broker,” says Richard Levin, who chairs the fintech and regulation practice in the law firm of Polsinelli. “In an agency transaction, the parties will more than likely have to take action against each other.”
Providing cryptocurrency lending and leverage are next in line in the cryptoasset prime broker’s bag of offerings designed to mimic the experience hedge fund managers would have with traditional prime brokers. Lending cryptocurrencies offers additional revenues and so does leverage– the industry jargon for trading on margin or borrowed money from the prime broker in exchange for putting up cryptocurrency as collateral. Coinbase reportedly does not provide leverage, but its rivals offer both lending and leverage. Therefore, cryptofund managers should ask about fees and procedures around safeguarding of customer assets.
Asset safety has become one of the biggest concerns for crypto fund managers as it is critical to achieving institutional investment. Asset segregation comes in two flavors: the pure separation by name of the accountholder or the comingled segregation which means that the assets of all cryptofund managers are stuck together in an omnibus account but still separated from the prime broker’s own assets. In the later case should the prime broker go bankrupt it will be difficult for any court or other administrator to determine to whom the assets belong. “Wyoming’s regulatory stance of bailment when it comes to asset segregation is a vast improvement to other state regulations,” argues Caitlin Long, chief executive officer of Avanti in Cheyenne, Wyoming. Long who led a Wyoming blockchain coalition creating Wyoming’s laws defining digital assets and custodian responsibilities insists that in the event of a bankruptcy, the common law concept of bailment for asset segregation guarantees that assets will be automatically returned to the cryptoasset manager. In addition, Wyoming law requires that legal ownership remain with the cryptofund manager even if physical control is transferred to the bank.
BitGo’s Carmi says that his firm segregates accounts under individual wallets, while Bequant’s Zarya says that clients have “separately managed” accounts. Even so, several legal experts tell FinOps Report that there is no guarantee that segregation of client assets will always be respected in a bankruptcy proceeding, because it depends on the legal classification of the firm. As a rule of thumb, receivers of defunct banks or broker-dealers must generally honor statutory segregation laws while the US Bankruptcy Code allows judges to break contracts for trust companies. However, that rule has never been put to the test in the crypto market.
Sooner or later cryptoasset fund managers will also have to deal with the hairy prospect of rehypothecation or the prime broker’s lending out of assets that are used as margin. The practice can generate plenty of additional revenues for managers and prime brokers alike, but there is a catch. There is no certainty of what will happen to the collateral if the original counterparty goes bust or yet another counterparty down the lending chain defaults. Wyoming expressly prohibits rehypothecation, while South Dakota allows it and New York only permits it with the customer’s explicit consent. Cryptofund managers worried about rehypothecation had better ask what the prime broker’s policies are unless they want a rude awakening. BitGo, for one, does not rehypothecate client collateral, says Carmi.
If the thought of a cryptoasset prime broker or counterparty going bankrupt isn’t enough to worry about, the potential for a cybersecurity breach should be. “Most fund managers don’t understand is that cryptoassets are actually bearer assets making security even more paramount,” cautions Josh Schwartz, chief operating officer of Curv, a New York and Tel Aviv-based digital asset security firm. Crypto prime brokers and custodians, typically rely on a combination of cold storage– requiring a private key with multiple schards or pieces held by several parties and multiple signatures to access assets– and hot storage which allows for immediate access to cryptocurrency. Is such a scenario foolproof? Close enough but no cigar, according to Schwartz. If the cryptoasset fund manager loses the private key, it is doomed and there is no protection for assets moving from cold storage to a hot wallet for trading.
Curv’s cloud-based software as a service model relies on multiparty computational protocol (MPC), a category of cryptography, to completely eliminate private keys — the single point of failure with other security offerings — from the the process. How? MPC allows multiple parties to collectively compute on output without ever sharing their respective inputs and offers more security than even cold storage with the instant availability of a hot wallet. Cryptoassets can be deposited or retrieved in a matter of minutes instead of hours. What’s more, says Schwartz, MPC makes it operationally easier and less expensive for cryptoasset custodians and prime brokers to segregate customer assets into individual addresses. Curv has also purchased insurance from Munich Re covering up to US$50 million in losses in the event of a cyberbreach. “While we anticipate no customer of ours should ever have to file a claim on our service it can have the peace of mind that comes with another layer of protection for their assets,” says Schwartz. “Any institution seeking to secure comparable insurance coverage would go through months, if not years, of audits and would likely be unable to obtain a single policy of the size and expansive coverage.”
Genesis is the first cryptocurrency custodian and prime broker to use Curv’s MPC and Curv is in talks with undisclosed others. In a May 2020 blog, Anchorage’s president and co-founder Diogo Monica says his firm relies on biometric signatures with sophisticated behavioral analytics to authenticate users. When asked about BitGo’s cybersecurity protocols, Carmi emphasizes that there was the “highest level of security and operational efficiency” to meet the needs of institutional investor clients who are often operating in a fiduciary capacity. “The company understands that responsibility and trust means going above and beyond the requirements to remove doubts and establish peace of mind,” he says. “This includes pushing the envelope with standards, such as SOC2, Type 2, working with the most trusted brands in the industry, and pioneering the highest quality insurance available in the market today.”
Cryptofund managers who think that their prime brokers in the cryptospace are anything like their peers in the traditional space, had better think again. Just because they quack like prime brokers doesn’t mean they are prime brokers; they may try to offer similar services, but they don’t fall under the same regulatory requirements by far. Cryptofund managers don’t even know how rigorously their prime brokers will be overseen by their state financial services examiners and licenses aren’t automatically transferable across state lines. It depends on the legal entity involved. “The crypto prime broker or custodian has to determine what the legal requirements are for it to service customers in a state other than the one in which it is organized and regulated,” says Telpner. “For example, those legal requirements could require it to be a money transmitter. Case in point: Anchorage has publicly said it doesn’t offer its services in New York, but wouldn’t explain why. Cryptofund managers may be hampered in their selection process depending on the state in which they are located unless their prime broker is also licensed in that state.
Ultimately, for all of the crypto prime brokers’ valiant efforts, the Tower of Babel of state regulations and the lack of oversight under longstanding traditional securities laws could stymie cryptofund managers, particularly registered investment advisers from using a third-party service provider. “The maze of state laws that apply to trust companies and money service companies is a major impediment to the development of a coherent model for trading and custody of digital assets,” says Levin. “For now cryptofund managers will likely have to balance their operational and liquidity needs with asset safety and legal uncertainty,” says Telpner.