Part 1: Crypto from an FX trading point of view
Welcome to the first part of the Okcoin & smartTrade Technologies guide to crypto onboarding for institutions. This four-part series covers all aspects of trading crypto, relevant to institutions involved in foreign exchange trading:
- Part 1 breaks down the basics, namely how crypto and FX compare from an asset, market, and trading standpoint.
- Part 2 covers institutions’ practical needs: Regulatory requirements, risk management, tech stack, and more.
- Part 3 compares the two fields from a financial point of view: Risks, fees, management, and products.
- Part 4 covers crypto’s market microstructure, key participants, workflows, and more.
If you’re interested in learning more or ready to start onboarding, you can reach out to smartTrade and Okcoin’s teams.
Crypto interest of traditional finance institutions has been surging for the past two years with Okcoin seeing a 450% increase in institutional clients’ interest in 2021 only. On the banking side, smartTrade Technologies reports a similar trend:
“Many of our clients, such as SEBA, are trading crypto products already and over 50% of the remaining banks and brokers in our portfolio are considering adopting cryptos trading within the next 12 months.”John Stead, Global Head of Pre-Sales at smartTrade.
Why would traditional finance institutions be interested in trading crypto or even in establishing a crypto offering? The two main reasons clients report are:
- Finding additional sources of yield
- Adding a long-term (non) correlation factor to their portfolio
Despite this spike in interest and these strong motivations, crypto can seem far removed from the world of traditional finance and interested institutions often wonder if they can trade crypto with their existing infrastructure. The answer is yes: While there are indeed many differences between crypto and FX trading, there are also many similarities. Let’s take a look.
Trading currencies vs. cryptocurrencies
Just like there are many currency pairs, there are many cryptocurrencies. A cryptocurrency can often be used as a medium of exchange, just like the U.S. dollar. It is digital and uses encryption techniques to control the creation of monetary units and to verify the transfer of funds. Cryptocurrencies usually secure their transaction ledger thanks to blockchain technology. Here’s more about how blockchains work.
The two most well known cryptocurrencies are Bitcoin (BTC) and Ethereum (ETH). An important distinction between Bitcoin and Ethereum is that Bitcoin’s supply is fixed while Ethereum’s can change. Ethereum also has more flexibility to host complex applications and so-called “smart contracts”.
While there are hundreds of other cryptocurrencies, an important subgroup is constituted by stablecoins. Stablecoins are cryptocurrencies pegged to a traditional currency, in most cases the U.S. dollar. All of these cryptocurrencies can usually be exchanged either directly against USD or against a USD stablecoin such as USDT or USDC – making trading crypto a somewhat familiar experience for FX traders.
How do crypto markets compare to FX markets?
There is an obvious sense in which FX markets and crypto markets differ: FX is centralized through banks while crypto is, or aims to be, a decentralized ecosystem. Without third-parties like exchanges and market-makers, crypto is meant to operate on a peer-to-peer basis and its transactions are supposed to be recorded on a public ledger. But, in practice, things can be a bit different, with third parties playing a bigger role than usually advertised and with transactions often occurring outside of the blockchain’s public registry (so-called “off-chain” transactions).
Pricing is perhaps where FX and crypto differ the most. Both FX and crypto prices are driven by supply and demand of course but in crypto there is no central authority to influence pricing – making supply and demand its main pricing drivers. In FX on the other hand, central banks occasionally influence prices, both directly, by intervening in the markets, and indirectly, by influencing the money supply. This influence is weaker and more indirect in the case of crypto.
One booming similarity, as mentioned in the introduction, is that, since 2020, many of the same participants trade FX and crypto. Our expectation is that this trend will keep on going in the next few years, making crypto market dynamics increasingly closer to that of FX.
How do you get easy access to crypto trading?
For risk, legal, and compliance reasons, many banks are often not able to buy or hold crypto directly, so the easiest route is often via indirect exposure instruments. So far, the most common way for institutions to get exposure to crypto without buying crypto itself has been through futures and ETFs. Crypto non-deliverable forwards (NDF) and non-deliverable options (NDO) however, are increasingly popular tools.
As with FX, these last two instruments allow traders to have exposure to the underlying crypto currency – for example Bitcoin or Ethereum. Since NDFs and NDOs are widely traded in foreign exchange markets, they are now well standardized. These instruments are traded over-the counter, offer flexible 24 hours a day access, and the ability for contracts to expire on bespoke days.
Okcoin for example is the third crypto exchange to have become a member of ISDA, paving the way for bilateral OTC crypto derivatives. This trend makes it increasingly easy for FX desks to integrate crypto derivatives in their existing trading and compliance workflow.
In parallel, top players like smartTrade and Okcoin have adopted institutional-grade processes, recording everything from data, decisions, routing, and more to ensure trade documentation is ready when oversight rules clarify.
The regulatory landscape is evolving rapidly however, allowing more banks to trade crypto directly. An example of this is Switzerland which, due to FINMA’s progressive regulatory regime, has seen a strong interest in all forms of crypto both delivered and non deliverable. Japan also sees a lot of interest in the crypto space and the FSA looks likely to remain progressive here also. Other jurisdictions will surely follow in the months and years to come.
Breaking down a typical use case
Here’s what a typical use case looks like for a bank who wants to get exposure to crypto using smartTrade and Okcoin:
Let’s break down the process:
- The bank sources pricing information from a mix of exchanges (like Okcoin), banks, and non banks.
- The pricing is cleaned and aggregated into a central book.
- Traders and internal systems can view pricing via aggregator GUIs and APIs.
- They can then place orders and algorithms directly against the market (DMA) or by using Smart Order Routing (SOR) to achieve best execution.
- The inventory at each venue and any required rebalancing is managed by the bank or the third party custody provider.
- The Distribution module creates internal streams. Traders shape streams, add mark-ups then pass to sales for additional client margins.
- The client pricing is distributed to execution/making venues (mobile, SDP, Sales OBO, MBP and FIX API).
- The returning orders are checked for inventory via a third party wallet provider and other risk controls.
- The resting orders are held in the OMS until triggered (auto or manual).
- Instant orders and triggered orders are passed to the Auto Hedger. Depending on the configuration, the risk can be taken (principal basis) or automatically hedged (agency basis) using configurable parameters and SOR logic. Principal risk can be managed manually by traders, via inbuilt algorithms or remotely via APIs.
- Once the trade is completed, trade notifications are passed to all relevant parties and recorded on the ledger and any other relevant systems.
- AlgoBox allows institutions to upload their own proprietary code to complement or replace existing business logic i.e. market making, position management etc.
- AI Analytics allows institutions to use advanced machine learning and predictive analytics to understand and manage flows and client behaviour better.