Unifying the digital asset trade lifecycle

[00:12:09] Difficulties faced by financial institutions when trading digital assets today

[00:12:34] Challenges related to risk management and best execution

[00:17:55] Best-practices when it comes to integrating different systems

[00:19:59] Critical functional and technology capabilities that financial institutions are looking for

 

Seamus: [00:00:00] Welcome to METACO Talks. I’m Seamus Donoghue, the VP of Strategic Alliances at METACO. If this is your first time joining, METACO Talks is a biweekly podcast where we invite thought leaders from the digital space to discuss their operations, current events, and the opportunities in the exponential future. It will also be available on your favorite podcast channels after this live broadcast.

I’m very glad to say today’s topic is unifying the digital asset trade life cycle. I have with us today the CEO of AlgoTrader, Andy Flury. Welcome.

 

Andy: Thank you, Seamus. Thanks for having me.

 

Seamus: Let’s start with the usual question. I’d love to hear your personal journey into from the traditional asset space into crypto, and how that has happened for AlgoTrader as well.

 

Andy: I’ll start with a personal intro. I’m an engineer originally. I was an Air Force pilot here in Switzerland in my younger years. Worked as a consultant for Arthur Anderson, a project manager for Siemens. It was an interesting time. We did a project for the Swiss Intelligence Agency, the Swiss NSA so to speak. I’ve also done a few startups; AlgoTrader is my sixth startup already. Right before AlgoTrader, I was a manager at a Swiss hedge fund where automated trading strategies in volatility derivatives.

At that time, we were looking for a solution like AlgoTrader, but it didn’t exist on the market. We originally created the platform just for our own purposes, an in-house solution. During that time, we met other managers, and it seemed that there was a need for such a solution on the market.

In 2014, I left the hedge fund. I started AlgoTrader, originally mostly selling to buy-side clients. Since then, we had the two pivot points. In 2017 we started adding a support for the first few crypto exchanges. As you can imagine, in the meantime we’re doing most of our revenue with crypto clients.

Then fast forward two years to 2019, the first two crypto banks, Sygnum and SEBA went live. Since then, Sygnum is doing all their trading through our product. At that time, we realized, wait a minute, there might be a big opportunity for banks around the globe to now offer a one-off for digital assets to their clients. We decided to launch a new product called a Wireswarm, which is basically an order and execution management system for digital assets.

What we do, we provide connectivity to the largest exchanges, brokers, market makers, through a unified API. We support both agency and principal trading; things like smart order routing, execution, algos, things like that.

Today, since the start in 2014, we have on boarded over 120 clients around the globe. We’re currently about 30 people in our team, with offices here to headquarters in Zurich. We’ve got an office in New York and an office in Singapore. We’re basically a venture capital backed startup. We have investors like Credit Suisse, the EOS Fund, Blockchain Valley Ventures, and Born Capital.

 

Seamus: Interesting. Since you’ve launched the Wireswarm product, how have you seen the market evolve? How has it changed since you launched the product?

 

Andy: We’ve been in the market since 2014, and back then crypto was at a very early stage. We had a few clients already back then that used our software to trade exchanges, like Malbox, for example. We thought, why not give it a try and add capabilities for crypto trading ourselves?

Personally, I didn’t expect much of it, and boy was I wrong! Completely wrong. Now, as I said, this is the bigger part of our business. When we originally launched crypto capabilities in 2017, most of our clients were crypto prop shops. There was a lot of arbitrage trading back then, there were still arbitrage opportunity, there were some retail traders. Everything was very unstable. Exchanges went down very frequently, they changed their APIs like people change their underwear.

A lot has changed since then. Especially in the last two years, we’ve seen an increasing number of buy-side clients, larger hedge funds, more and more crypto funds. Banks have been a bit slow. I’m sure you probably agree, especially over the last only 6 to 12 months we’ve seen demand from banks. They’re now seriously launching their digital asset banking solutions. This took longer than expected, but we’re all glad it’s happening now.

Seamus: [00:05:37] Yeah. We’re seeing the same thing. I think the banks are slow, but once they move it’s like the aircraft carrier; it moves steadily and forward. You described the interesting evolution of the market infrastructure, as you said, the very unstable, not necessarily that credible exchange is going down, et cetera. What have been the biggest challenges for you in scaling your business in that environment?

 

Andy: There are many challenges. First, you’ve got to have a product; developing a product that covers all these use cases, that can serve larger institutions like banks. That’s a challenge. But we’ve   accomplished that some time ago. Then building a sales team, a global one that covers the different regions, that’s a challenge. Building a sales team here in Switzerland, that’s easy, people know each other. Selling to a Swiss client, that’s easy; but selling to US clients, to Asian clients, to build up a reputation in the various regions is hard. That’s still ongoing. Being able to adjust to the various jurisdictions; client requests are different. The way you interact with prospects and clients are very much different, especially if you compare here in Central Europe to American clients. That’s a totally different story, and you need to learn to adapt to that.

I’d say we come from serving buy-side clients, prop shops, hedge funds, lately a lot of crypto funds. Those are usually smaller shops – they have three, maybe five people in a team. That can be done. But serving a global pier one bank, especially with a SaaS offering, that’s hard. You fall under regulation, outsourcing regulation, you’re dealing with many different departments within those banks. That’s a completely different story.

 

Seamus: You’ve described our journey as well. Regulation is everything. If you’re doing banks, primarily, that’s top of that food chain, they’re driven by the regulators. You talked about global expansion; based on your global footprint now where do you see demand coming from? What’s the mix that’s evolving in terms of demand from what type of institutions, and from where?

 

Andy: It’s been a lot of crypto funds, crypto natives. Crypto funds are popping up out of the ground like mushrooms. In the last 6 to 12 months, banks, especially here in Switzerland, in Germany, but also more and more from the US and Southeast Asia, since last week mutual funds in Germany are allowed to hold cryptos up to 20%. US banks have now been allowed to provide custody since last summer. Kraken was the first one to get a banking license; I think there’s probably two or three now. We’re happy to see that.

We’ll be expecting a little bit more from Asia. It’s literally just Singapore and Hong Kong. It’ll be interesting to see what’s going to come in Asia.

 

Seamus: With that institutional evolution and basically geographic distribution, where’s the strongest demand in terms of instruments and assets that they’re looking for? What are the patterns there?

 

Andy: The entry point is always spot markets. Obviously, Bitcoin and Ethereum are first. That’s how all the banks start. Then the top coins’ derivatives have massively increased demand for derivatives, futures options, and perpetual swaps. Which for banks and financial institutions, that’s a challenge – perpetual swaps don’t exist in the traditional space. You’ve got to first build an understanding of how they work. They’re extremely popular among retail trader, but I haven’t seen that much demand from financial institutions.

Another challenge when trading derivatives, in traditional space if you buy a future that’s not the stock to the exchange. You can through clear networks move that to another broker, or another venue. In the crypto space if you buy a derivative, that derivative is stuck to the exchange and you’re exposed to two counterparty risk.

ETFs, still no ETFs in the US. There have been many attempts, it’s still not happening. Here in Europe, we have a few. LiamTek and Vontobel have launched. Luckily, we see some ETFs here. I think eventually everybody wants to get to security tokens, or tokenized securities. If you talk to a bank about the long-term vision, that’s the big goal. That’s where they want to get to. But let’s be honest, until today there’s still no secondary marketplaces. Since Monday, they’re allowed here in Switzerland with the new DLT law, but that’s going to take a little while until we see the first security token exchange go live.

I can say banks have realized now that even though security tokens aren’t alive yet, at least not on secondary markets, starting with crypto assets is a very good exercise. It’s the same technology. It’s blockchain technology. Your CEO Adrien, I remember him saying that dealing with public blockchains is the hard part. Dealing with closed systems, which is probably what we’re going to see for security tokens, that’s then going to be easier. It’s a very good exercise for a bank to get started with this topic through crypto assets.

 

Seamus: [00:12:09] 100% agree on that same technology. We often say that basically you build free crypto and you effectively get whatever comes next in terms of security token markets for free, because it’s the same with potentially lower requirements. I’m very much on the same philosophical strand there.

You mentioned some of the product problems that banks face. What are other difficulties financial institutions, particularly banks, face when they’re trading digital assets today?

 

Andy: [00:12:34] Generally, what we’re helping the bank with is trying to achieve best execution, get the best price for the lowest cost and risk. This whole best execution topic ties in very closely with risk management. In an ideal world, a digital asset banking system has several characteristics that it needs to fulfill to ensure best execution.

To give you a few examples, market-wide connectivity. You need to be able to connect to multiple exchanges, brokers, OTC desks available on the market, so that whatever happens you always have available venues at any time. This diversification allows you to get the best price wherever it is available.

Now, the difficult thing with that is that these exchange APIs are not standardized. Every venue has a different API. They’re becoming more and more stable. Not all of them, we’re still seeing issues even today. What doesn’t work is to pick just a single venue, a single broker. You cannot provide best execution with just a single broker.

Then there is operational risk. The entire pre-trade, trade, post-trade process needs to be automated. This opposes potential reputational damage and financial loss, mainly from human failure. I’m talking about fat finger traits or wrongfully entered deposit addresses. If you do that, your assets are gone. You cannot recover those.

Then there is execution risk. The goal is to execute an order as fast as possible. Any delay means a market timing risk. Ideally, you as a financial institution want to fund your exchange accounts just before a trade to minimize exposure to that exchange. The goal is to get the best possible price in the market, source liquidity from multiple venues. You need something like a smart order router, which is something that we integrate in Wire Swarm. Large orders tend to move the market, and other market participants that are specialized in that will front run your trades. When you’re dealing large size, you need to split up a large order. For that, you need things like execution algorithms, which is also something that we provide with AlgoTrader.

Then there is the counterparty risk. Today, we realized that most of the banks that have launched digital assets are trading with brokers. Why are they not trading with exchanges? That would be cheaper, fees are lower. The problem is the associated counterparty risk. If you trade an exchange, you have pre-fund the exchange account, and with that you lose custody to those assets. In an ideal world, you would hold custody over your funds until the order gets submitted. The problem there is, again, a market timing risk, and also network fees. Especially in times of high volatility, network blockchain fees have spiked. Moving assets to and from a venue can become very expensive.

Then there is the liquidity cost itself. if you trade, let’s say 10 pairs on 10 exchanges, that means that you’ve got to have assets 10 times 10 the amount you want to have on each venue. That can end up in a huge amount of assets you need to pre-fund, and that increases the cost of liquidity.

Last but not least, there is the execution privacy. As we all know, blockchain transactions are public. If you’re a large institution and you move a large transfer to an exchange, it’s easy for market participants to figure out that that’s you. They will figure out this blockchain address belongs to bank such-and-such. It’s very easy to front run these trades. Ethereum transactions take at least 10 seconds, that’s more than enough to place an order on that venue and front run your trades. That’s something many institutions are not yet familiar with.

You have these four, five or six challenges that you need to deal with.

 

Seamus: [00:17:55] That’s a good explanation of the challenges and potential technical solutions.

I’d be curious to know, how difficult is it to integrate these systems? For example, how would a client integrate AlgoTrader?

 

Andy: On the AlgoTrader, let’s take the Wireswarm side, which is the sale side product, that’s pretty easy. We provide banks with a standardized fixed interface. Fixed is a protocol that banks are familiar with. On our side, to the exchanges as I mentioned, typically these APIs are not standardized. It might be fixed, very often it’s something else, it’s rest web socket. We do all that harmonization normalization for the banks, so they don’t have to worry about that.

The trading side connecting to the bank, that’s not too challenging. I think the bigger challenge is that with digital assets, the blockchain is now becoming the data master. Previously for banks, with their core banking systems, the core banking system was always the data master and a holder of the truth. Now with digital assets, that’s not the case anymore. The data master is the blockchain. That’s a paradigm shift for a core banking system. A core banking system has to rely on an outside system and synchronize.

Last but not least, the life cycle of digital assets is very different. Pre-trade funding, post-trade settlement – that requires a lot of flexibility from vendors like us and you guys at METACO, to make it as easy as possible for a bank to get started with digital assets.

 

Seamus: [00:19:59] You want to talk a bit more about the critical functional and technical capabilities that the solution delivers?

 

Andy: Definitely, critical functions and capabilities. We believe that an integrated system will need to consolidate order execution, custody, settlement, core banking integration, all into a fully integrated life cycle. There are many components that this will require; things like best execution, with smart order routing and execution algos.

As a bank, you want to see a global view of your assets. You want to see your assets in custody, in your vault, but you also want to see what are the balances and all the venues with all the brokers, to be able to manage liquidity.

This often involves, today at least, quite a lot of manual work. There’s going to be a treasurer that manages your balances and moves assets around. We’re working on automating this, making it as easy as possible for a bank. That then eventually leads to an automated liquidity management where deposits and withdrawals are done automatically based on a predefined set of rules; the reconciliation with core banking system, or this integration that I just talked about, this paradigm shift; then obviously the KYC AML. There are solutions out there today, but what we see is that many banks use multiple providers and have an automated flagging with manual veto rights.

Sometimes you have suspicious transactions. You cannot trust these systems. Somebody will have to sit down, where is this transfer coming from and can we really trust it?

Last but not least, reporting, especially tax reporting. When I talked to people in Germany, especially in Germany, that’s becoming a huge topic. How do you report your crypto holdings?

 

Seamus: We’re seeing the same thing, both from an individual capital gains perspective and overall tax.

It’s Interesting that you mentioned the paradigm shift. We have many discussions about reconciliation, and we’re always like: reconcile against what? You have the source of truth. But as you say, the way banks think about source of truth is not blockchain yet. It’s starting to happen, but that’s the way it’s going to go.

Given what you described in terms of the needs, what’s your market outlook for how this is going to evolve going forward?

 

Andy: I think over the next few months and years, we’re going to see more and more banks around the globe offering digital assets. Today, there is no single way to handle digital assets. There are many different options for a bank to start offering digital assets, many questions they have to answer that will have an influence on their set up and process.

Just to give you a few examples, there is agency or principal trading. Is it agency is a principal? How do you deal with Fiat? That’s still a big question. For US dollar, you have a Silvergate and Signature Banks that offer these instant transfers, here in Europe we have CEPAC for Euro payments. Up to I think 50,000 Euros you can an instant Euro transfer. Or, you use stable coins. This is more of a topic on your side Seamus. Do you want to offer omnibus wallets or segregated wallets? That has a huge impact on your backend process.

For us, the big question is: is the bank comfortable trading exchanges or will they rely on brokers and OTC desks? How do you do the settlement process? How often do you settle your trades? Do you settle a trade after each individual order? Which is possible, but given the blockchain fees, that might be very expensive. Or do you settle once a day, and just take the potential counterparty risk with your venues? Do you try to provide best execution or OTC through RFQ process? How do you want to deploy your system? Do you want to deploy it on premise? Do you want SaaS? Things like that.

There are many different variations. Every bank we talk to has a different setup.

I think we’re going to see a lot more standardization. I think there will probably be eventually two or three potential ways to offer digital assets that will prevail in the market. There will need to be much more standardization. We as the vendors need to work together much more. The key to successful digital asset banking is an integrated approach that unifies the entire trade life cycle. Order execution, custody, settlement – all this needs to be connected.

All of us, we’re all vendors, we’re trying to sell our technology, but we need to work together. Especially banks, they need not just one single solution.; they often need two or three or four solutions combined. We need to do the homework. We need to be able to provide them with an end-to-end system, an integrated system that includes all these components.

 

Seamus: [00:26:07] Well said, we’d summarize it the same way. There’s one question received here. I think it’s probably a logical question. I think I know your answer, but I’ll ask anyway. How does the key management get done? Given we’re talking about digital assets; it seems a logical question.

 

Andy: Well, that’s more a question for you. Just to make that clear, we don’t deal with keys. We take care of the trading part. We integrated with exchange APIs and brokers, but we are not a custody provider. We work together with custody providers like METACO and rely on them to know how to do this in a safe and secure way.

 

Seamus: I guess the default point here is, trading is still largely centralized, so you’re going to centralize entities.

I have one last question to wrap up. How do you see the intersection with the evolution from the centralized finance to DeFi space, from your perspective?

 

Andy: That’s a very interesting topic. DeFi has taken off tremendously. Today it’s very easy to trade through a decentralized exchange, like Uniswap. You’re just interacting with a smart card. I think it’ll take some time for this to become ready for financial institutions. I hear or talk to a lot of people at banks that are interested in the topic. I personally have not seen a single bank trading a decentralized exchange. I think regulation is going to be critical there; how will that evolve?

We’ve seen lately some rumors that the FATF will apply the travel rule also on DeFi. That’s going to be really interesting. There is no entity, it’s a decentralized system. How are you going to apply that?

That also poses a bit of a risk on DeFi. I don’t know, it’s a very fast journey. Eventually I think we’ll see a convergence. I could imagine also with newer blockchain technologies, Ethereum 2.0, which is much faster than Ethereum 1.0, that decentralized venues become fast enough to pose a legit alternative to centralized exchanges.

 

Seamus: Very similar views. We’re going to wrap up there, it’s been 30 minutes. It’s been a pleasure to have you on here, thanks for joining today.

 

Andy: Thank you very much.

 

Seamus: Look forward to having you back again. We’ll be back on August 20th, with Swen Werner, who’s designed new products, leveraging different emerging technologies including blockchain, digital assets and tokens, to design industry leading and service and operating models at the global custodian state street. We will see you then. Enjoy your summer break until then. Thanks. Bye!

 

Andy: Thank you.