LMAX Exchange: what are the catalysts for the third wave of cryptocurrencies?

David Mercer, CEO of LMAX Exchange Group, discusses the history of crypto, the future of digital currencies and calls for key industry changes to create a more efficient, secure and trusted marketplace

Wave of Change: what are the catalysts for the third wave of cryptocurrencies?

Cryptocurrencies have the potential to revolutionise the way we do business. People understand their long-term potential, yet today they are still misunderstood, underutilised and their divisiveness has earned them an almost pariah status. However, context is everything and assessing where we are in the development of the cryptocurrencies is crucial to appreciating their nascent status.  

Cryptocurrencies date back to Satoshi Nakamoto’s whitepaper in October 2008. During this first wave, the early evangelists, scientists and tech engineers, developed a decentralised electronic payment system based on distributed ledger technology. The objective was to bypass mainstream financial institutions after the 2008 financial crisis had eroded trust in the established pillars of finance and their guardians.  

2017 heralded the arrival of the second wave of cryptocurrencies with a bang. Retail investors piled into crypto leading to the creation of a plethora of retail trading platforms. This feverish activity and belief in crypto as a store of wealth saw Bitcoin reach a valuation $19,000 in December of that year, before rapidly coming off the boil. 

As the media hype still reverberates and commentators opine on the absurd volatility we saw in 2017, along with the governance and trust issues that dog the market, my focus has been placed firmly on the factors which will welcome in the third, and most revolutionary, wave of cryptocurrencies: widespread institutional adoption. 

In my view, this third wave of cryptocurrencies is just around the corner, but in order to allow for it to happen, the industry needs to overcome a few barriers:   

Credit 

The third wave of trading crypto begins when cryptocurrency is crystallised as an asset class and institutions begin to trade a regular portion of their portfolio on crypto exchanges. For example, when crypto currencies are normalised, each of us will have a proportion of our pensions in a digital currency – even if it is only a percentage point or two.

For this process to take place we need to establish an internationally trusted marketplace for institutional-only cryptocurrency trading. This hinges on the provision of credit by the banking system, which is at odds with the inspiration behind the Nakamoto whitepaper. However, it is essential for institutions to trade digital currency according to international norms. At the moment, credit – the oil that greases the wheels of institutional finance - doesn’t exist.

Along with trust in financial institutions, credit and settlement play an important role here in providing traditional fund managers or hedge funds with the funds to implement their strategies and trades on the direction of currency pairs. 

Take this hypothetical chain of events: Joe Bloggs trusts Allianz with his pension pot; Allianz entrusts Blackrock as their outsourced investment manager to invest these funds; Blackrock trades with other institutional investors through a digital currency exchange, such as LMAX Digital, thereby trusting their rule book and technology.  

The key differentiator here between traditional exchanges and crypto exchanges is that there is a tracked ledger of each transaction. For example, when Joe Bloggs asks Allianz where his coin is, Allianz will be able to provide him with an exact location and chain of transactions, which is much more transparent than current traditional models.

Regulation

It is a fact that cryptocurrency is more traceable than physical money, because we can use the blockchain to trace its usage all the way back to its origin. This is not something you could say about the £10 note in your back pocket!

Crypto, however, is not yet regulated. Regulators haven’t made up their mind about whether crypto should be considered a currency or a security. Digital assets are the future: retail investors are already trading them and the next generation of consumers will most likely be using digital currencies more commonly than physical fiat currencies. Given the involvement of retail investors, the situation demands positive regulatory intervention. 

The market also needs an efficient marketplace, like the London Stock Exchange, to facilitate digital currency trading. The current marketplace consists of venues targeted at retail investors, but institutional traders are more concerned with the exchange of risk on their investment positions.

Regulation can supplement this exchange of risk. In traditional markets, in order to trade equities, it’s imperative to pass a suitability test to ensure the traders are experienced and qualified to understand the risks involved, hence why the public can’t trade directly. It is the same when buying a home, the mortgage arranger explains all the risks and rules before allowing us to take out a mortgage.

This is not the case with crypto trading. So why is there a discrepancy? Before a person or entity can trade, they should be required to pass suitability tests as they would when seeking to access other financial products and securities. 

Protecting consumer interests by providing clear guidance and checking suitability will lead to a situation where trading flow is segregated between qualified institutions with experienced traders and retail flow, which will be vital to ensure institutional level participation in the market. 

Infrastructure and cost

The next barrier to the third wave of cryptocurrency is the lack of current infrastructure needed for institutional crypto trading. The market requires secure and effective storage, large scale banking propositions and proper payment channels.

As they stand, digital currencies are massively expensive to produce due to their energy consumption and there is no efficient way of mining units. Institutions will have a crucial role in supplying this infrastructure, providing the overall system with protection and more liquidity.

Liquidity is essential to institutional investors, encouraging them to use and trust digital currencies. Creating better infrastructure that aids liquidity remains an important piece of the jigsaw. 

Final recommendations

All of the barriers to bringing about increased institutional participation in the crypto markets can be overcome with the help of a forward-thinking regulatory body. Number one on the agenda should be implementing regulation aimed at making the environment for retail investors safer, protecting their interests with the necessary checks and balances. 

On the institutional side, the most astute regulatory bodies are starting to realise that institutional traders need oxygen and room to develop the nascent crypto trading industry into an efficient marketplace. As the Bank of England’s Mark Carney elegantly puts it - maintaining an open mind, but not an open door. This policy approach has its precedents, FX trading markets are self-regulated after all and have been functioning well for years, with the spot market becoming the most actively traded in the world with more than $5 trillion traded on average every day.