By: Brad Koeppen, CMT Digital and Ryan Gentry, Lightning Labs
When the investment bank Lehman Brothers collapsed on September 15, 2008, its failure, and the ensuing capital markets crisis, revealed a fatal flaw in the prime brokerage business: concentrated counterparty risk. By using a single prime broker for all of their needs — trading, settlement, leverage, securities lending — hedge funds and institutions amassed too much exposure to one counterparty. In this case it was Lehman Brothers, which had one of the biggest prime brokerage units on Wall Street. It took years of litigation for some Lehman clients to get back assets in custody of the firm at the time of the bankruptcy.
Learning from their mistake, many funds diversified their risk by using more than one prime broker. The strategy lowered risk, but it raised costs and increased complexity. The single-prime model is simple: one counterparty, one risk statement. Having multiple primes means traders must aggregate risk across firms; this requires more time, capital, and technology.
Now, prime brokers are targeting the booming market for digital assets like Bitcoin. It’s easy to see why. In traditional markets, the business is worth $30 billion a year. With the boom in crypto, old-line primes see an opportunity to add to that total, and startups see a chance at riches. The race is truly on. In 2019, London-based crypto custodian Copper Technologies expanded its “Walled Garden” infrastructure so clients could trade across 15 exchanges. In February 2020, BitGo bought Harbor, the first blockchain company to get a U.S. broker-dealer license. Then, in May, Coinbase, the largest U.S. crypto exchange, bought Tagomi, a trading platform that caters to large, often institutional, clients. That same month, Genesis Capital acquired Volt, a London-based custodian.
Interest in crypto surged after the Chicago Mercantile Exchange launched its Bitcoin futures contract in December 2017. The arrival of robust prime brokerage is giving crypto a similar boost now. When insurance giant Massachusetts Mutual invested $100 million in Bitcoin last year, it did so through the New York Digital Investment Group (NYDIG), a crypto prime broker.
Such reliance on intermediaries like NYDIG or Coinbase is understandable given the complexity of the Bitcoin blockchain, the distributed electronic ledger that works 24/7 to execute and document every Bitcoin transaction. Tell a fund manager at an insurance company to decide between a hot or cold wallet, and you’re likely to draw blank stares (a hot wallet is a digital safe used to store cryptocurrency that has access to the internet. A cold wallet is a digital safe that sits on a computer that’s not connected). The technology around digital assets is evolving the way the internet did: It’s not friendly for all users yet, but it gets better every month. Prime brokers will fill the gap in the meantime.
Good though they may be for market participation and liquidity, the arrival of prime brokers brings counterparty risk to markets that were designed to be free from it. The beauty of Bitcoin and other digital assets is that they can operate without counterparty risk and without the complexity that prime brokerage “solutions” bring to these new markets.
In this paper, we make the case that prime brokers will attract more liquidity to digital markets, and that they may help smooth operations, but in the long term, traders should wean themselves off of prime brokerage to eliminate counterparty risk, keep costs low, and avoid complicating their operations.
We will show that all the technology necessary to handle core prime services — custody, trade execution, financing, and securities lending — exists today and can be bundled by traders into an efficient, risk-free platform. Many of these technologies are native to crypto. Others have been added to the technology stack. They include trustless protocols and smart contracts. Among the most important innovations is the Lightning Network, an open-source protocol that fills many of the gaps that traders encounter when transacting on a blockchain. Lightning technology introduces instant settlement to Bitcoin transactions by taking them off the blockchain, temporarily.
In short, we envision a future where traders — retail, proprietary, or institutional — are the center of the crypto universe and control their own destiny, primarily by being free from that counterparty risk that stalks traditional markets and crypto ones alike. This is the vision behind decentralized finance, or DeFi. Despite the recent rise of the crypto prime broker, most intermediaries will be unnecessary in the long term. We hope this paper contributes to that vision and its definition.
A Word on the Dark History of Crypto Brokers and Exchanges
Digital assets have their own Lehman Brothers. The circumstances were different, but the effects of the Mt. Gox meltdown were much the same. At the end of 2013, the Tokyo-based firm was the largest Bitcoin intermediary in the world, handling more than two-thirds of all transactions worldwide. In February 2014, it halted all withdrawals and days later declared bankruptcy after announcing that $450 million in customers’ bitcoin had gone missing. It remains unclear if they were lost or stolen. Similarly, many of Lehman’s prime brokerage clients had to wait five years to get all of their assets back, an eternity in financial markets.
Problems with crypto brokers, exchanges, and custodians didn’t end with Mt. Gox. Quadriga Fintech Solutions opened the QuadrigaCX exchange in 2013, and it quickly became one of the largest Bitcoin exchanges in Canada. The trouble started in 2017, when bitcoin soared and strained Quadriga’s payment and accounting systems. When bitcoin plunged a year later, customers reported that they couldn’t retrieve their balances. The firm went bankrupt in April 2019. Customers are still owed $200 million, and some investors suspect that company co-founder Gerald Cotten faked his death in India and disappeared with their money.
Most recently, in October, Jon Barry Thompson, founder of crypto escrow company Volantis Market Making, pleaded guilty to defrauding a firm that had entrusted him to buy $3.25 million of bitcoin on its behalf, when he failed to deliver the assets. Cases like Mt. Gox, Quadriga, and Volantis show that the bitcoin adage “not your keys, not your coins” holds true for small investors and large institutions alike. Those failures are vivid examples of why traders should consider self-custody of Bitcoin as trading technology becomes more robust.
The Big Three
Among the most important services that prime brokers provide traders in any market are custody, trade execution, and financing and lending. Primes provide other value-added items, such as introduction to new sources of capital, research, risk management, and compliance, but the first three are the ones that bring traders into a prime relationship. We’ll take each in turn and show how bitcoin technology can be used to ease and eventually eliminate dependence on prime brokers, necessary though they may be now to some traders.
A financial custodian is a specialized, regulated firm that is responsible for the delivery, receipt, recording, and safekeeping of a client’s assets. In traditional markets, custodians charge fees as high as 0.5 percent based on the assets they hold for a client.
In crypto, custody is important and unique because a secret 256-bit private key secures ownership of a digital asset. Lose the key, and you lose the coin. The results can be tragic. Stefan Thomas, a German programmer, learned that the hard way. He lost the password to his IronKey, an encrypted flash drive, where he kept the private keys for 7,002 bitcoin, now worth more than $200 million, according to The New York Times. Some 20 percent of all bitcoin could be locked up or lost, according to data firm Chainalysis.
The fear of losing digital assets has prompted many investors to hand their keys to custodians such as BitGo, Coinbase Custody, Anchorage, Fidelity, NYDIG, and Kingdom Trust. BitGo, likely the largest, holds more than $16 billion of customer assets.
Crypto custodians are likely to grow along with interest in crypto, and their services will make it easier for traditional investors to get involved in the market. But traders need not rely on them in the long term. Blockchain technology was built to obviate custodians, and innovations atop it make self-custody much easier now than it was in 2011, when Thomas, the German programmer, locked his bitcoin away. Coinkite, Trezor, and Ledger make hardware wallets and hardened servers with built-in protections against loss. Casa offers a service that uses multisignature wallets (crypto wallets that require two or more signatures to send transactions) to protect against both theft of assets and loss of keys.
Spooked by the Mt. Gox disaster, many large, sophisticated traders handle custody in-house with proprietary systems that evolve over time as technology improves. Recent innovations ease the secure transfer of assets across venues, from cold storage (an offline wallet) to a custodian like Coinbase, or to an exchange like Bitstamp, or to a Lightning node, the gateway to payment channels on the Lightning Network.
To be sure, proprietary systems have shortcomings. They take specialized knowledge and cost time and money to create and maintain. But given that the world is likely to see more disasters such as Lehman and Mt. Gox, we believe that self-custody is worth the work for large sums of crypto. For smaller amounts, new self-custody tools from Coinkite and others are easy to use and make losses like Thomas’ much less likely.
In any market, a trade is considered to be executed when the order to buy or sell is completed, or filled. In the stock market, trades go through brokers who match buyers and sellers, and those brokers are required by law to find the best prices for their clients, be it on the market, from a market maker, or from an alternative trading system.
One of the primary issues in crypto markets today is fragmentation. Most trading takes place independent of the blockchain, where it all settles eventually. But because the blockchain is constrained by the number and frequency of blocks, on-chain transactions can be slow, and because a miner must expend computing power to verify the trade, on-chain transactions can be costly, depending on the number that must be done at a given time. So, traders turn to various exchanges to find liquidity. Trades on the exchanges are netted instantly and settled on the exchange, but by using them, traders are trusting that the exchange can meet all of its obligations, and, once again, the Mt. Gox problem arises.
Market fragmentation creates other problems. Exchanges require traders to fully fund their accounts with bitcoin and fiat currency (dollars, euros, yen). That means turning over assets to the exchange and incurring more counterparty risk. Worse yet, in the search for liquidity, traders often have accounts on multiple exchanges to access multiple liquidity pools. Because the exchanges operate independently, a long position on one doesn’t offset a short position on another, making for an inefficient use of collateral. Inventory and margin must be managed separately on each exchange.
Traditional markets are fragmented, too. Most developed countries have their own stock exchanges, and there are many exchanges for commodities. Prime brokers make it their business to navigate these venues for customers, executing trades around the world and providing credit to meet margin requirements on disparate exchanges. The prime broker can assess the risk and use capital efficiently because it sees all the trades. But the laws that govern execution in traditional markets haven’t been extended to crypto. So, the question for crypto prime brokers is will they, in the absence of law, always seek out the best price for clients, even if that price isn’t on an exchange that they own, or that owns them? Will Tagomi, now part of Coinbase, send orders to an exchange that’s not Coinbase?
The ultimate solution to the multiple-exchange problem lies in Bitcoin’s very nature as a bearer asset with a reliable ledger: the blockchain. Proof of solvency to a counterparty is built into the system and doesn’t require reinvention by prime brokers. The blockchain provides native clearing and settlement on its own. But because it’s decentralized, and because of the immense computing power required to verify transactions, it can be slow.
Fortunately, there is a non-prime-broker solution: the Lightning Network. Lightning is a software layer that operates on top of bitcoin allowing users to set up payment channels to transact between participants. In the analog economy, a payment channel is a way a merchant gets paid. From a user’s perspective, their Venmo balance could be represented by payment channels. In the Bitcoin economy, payment channels allow users to settle bitcoin transactions between each other, harnessing the security of the blockchain, but without the delay and cost of the blockchain. Best of all, buyers and sellers don’t incur any additional counterparty risk, as they maintain custody of the coins on their side of the payment channel. Some exchanges now allow traders to deposit from the Lightning Network, a game-changer because traders can custody their coins off-chain, relinquishing custody only when entering a position on-exchange. The result is execution experience that’s as good as one might get from a centralized prime broker but with minimal counterparty risk. Traders no longer must keep assets on exchanges, yet they can settle and clear trades (and top up margin) when required.
Financing and Lending
Financing and securities lending are the hardest prime services to replicate in the Bitcoin economy, and gaps remain. But they are essential if digital markets are to become as robust as traditional ones, where traders can borrow stocks for short sales and borrow money for leverage. Fortunately, DeFi technologists are working on solutions.
By its nature, lending comes with counterparty risk. Your lender can fail. Your borrower can disappear. With bearer assets such as bitcoin, debt inherently involves relinquishing custody and taking counterparty risk. Ethereum’s DeFi ecosystem has custodial smart contracts. They allow transactions to occur only after strict conditions are met, and they can hold a trader’s funds without a third-party custodian, but they have been the subject of numerous exploits.
Traditional lenders have ventured into digital markets. Older institutions like Silvergate Bank have partnered with custodians and exchanges to lend against bitcoin deposits.
One alternative is to borrow from the crowd. Solutions like Hodl Hodl Lend and Keep Network’s tBTC offer a peer-to-peer solution that reduces dependence on a single lender by leveraging multisig wallets. These services help traders improve capital efficiency by letting them borrow against their assets. But it’s a double-edged sword. Borrowing to trade means adding treasury management to one’s operations. Borrowing from one entity while trading with another and using a third for custody adds unneeded friction in the current model. Traders either must build proprietary systems to track, borrow, lend, and transfer assets, or pay the new service providers to perform these crucial functions. Plenty of firms are eager to get the business: Tagomi, BitGo Prime, FalconX, and Vo1t (now part of Genesis Trading). Some of these aim to be one-stop shops.
Here again, the Lightning Network may offer a solution. Just as traditional lenders assemble a credit score for borrowers, Lightning has features that can be used to build algorithmic underwriting systems (the node rating system Bos Score is an early example of this). These underwriting systems could be designed to give the highest scores to Lightning nodes that earn the most fees. If those scores become valuable enough, traders running a Lightning node could borrow against their score, issue their own debt and take in capital with promise of a return. Further advances in Bitcoin script and multisignature wallet technology seek to lower the counterparty risk in these operations as much as possible, allowing the crowd to safely lend to elite traders without needing an intermediary.
This paper describes a world where prime brokerage services can be built from the bottom up, horizontally integrated, and decentralized, so that market participants can minimize counterparty risk, act as their own prime brokers, and retain custody of their crypto assets. All of these things are made possible by crypto technology, but that technology is opaque to many of the new investors in digital assets, so the digital prime brokerage business is booming. That may be a good thing now, for liquidity, but it carries risks.
Digital assets trade all the time, every second of the day, on the original blockchain technology. The exchanges and brokerages that are built atop that technology do not operate all the time. Crypto-native exchanges operate 24/7, and many brokerages offer services on weekends and holidays, but those services are subject to change and are often not available. The mismatch hobbles crypto markets and threatens their promise as new markets with new features that make them safer, not more risky.
With technology, which doesn’t obey bankers’ hours, crypto traders can get real time risk assessment, almost instant settlement, and smaller margin-call windows. In traditional markets, margin calls usually happen once a day, in the morning, based on the previous day’s trading, and firms aren’t required to pay until Fedwire, the U.S.’s real-time settlement system, closes. Being able to issue and meet margin calls more frequently would reduce risk for lenders and foster better risk management for traders.
Technology can mitigate risk in other ways, too. For example, crypto-native derivative exchanges have liquidation features that automatically close a customer’s position if it exceeds predetermined margin thresholds, a stark contrast to the days or weeks it can take for a clearing house to auction off a customer’s portfolio. Neither model is perfect, but when imagining a crypto-native financial system, we have the opportunity to create something that better suits the asset class rather than adopting an existing system burdened with flaws.
In the DeFi ecosystem that crypto has fostered, financial innovation is happening at the speed of open-source software development. Traditional finance moves much more slowly. Dozens of startups are reimagining custody, execution, clearing and settlement, lending, asset transfer, and cross margin, all of which adds up to reducing counterparty risk and making markets safer and more resilient.
The next chapter in this story is reimagining prime services from the ground up with the Lightning Network. Bitcoin and blockchain technology were designed from the start to reduce the toxic counterparty risk that undid global finance in 2008. Relinquishing custody of these bearer assets to centralized, unauditable custodians introduces old-school counterparty risk to a new system that can operate without it. We believe that innovations such as the Lightning Network offer solutions that don’t carry these risks.
Imagine a trader custodying their own coins — some on-chain in a cold wallet, some on-chain in a hot wallet, some in multisig wallets acting as collateral for loans, and some in Lightning channels for instant clearing and settlement. The trader could rebalance positions across exchanges with the push of a button. He or she could calculate their risk in real time, and provide those calculations to exchanges and lending services for improved capital efficiency through cross margining: transferring excess borrowing from one account to others.
Many trading firms have already built the necessary risk- and treasury-management systems, laying the foundation to become their own prime brokers. The next pieces — better Lightning integration with exchanges and better borrowing-from-the-crowd tools — are being built today. Trading firms must support the innovation that will keep them at the center of the universe, instead of giving up power to emerging prime brokerages that seek to recentralize deadly counterparty risk. Forward looking prime brokerages may even adopt Lightning technology themselves, and evolve their business models accordingly.