Digital Assets Report


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Crypto prime brokerage comes into its own

The digital assets market has experienced significant growth, supported by the rising participation of hedge fund managers and institutional investors looking to capitalise on the returns this new asset class has to offer. But as an emerging area of interest, the infrastructure to support investment and trade is still in development.

Rise in specialist providers

Hedge fund managers have lamented the lack of prime brokerage services specifically tailored to crypto assets, with limited access to crypto prime brokerage services being raised as one of the top concerns in the 2022 PwC Crypto Hedge Fund Report. Further, the report reveals an increasing number of cryptocurrency hedge funds are turning to independent custodians to ensure secure storage of assets, demonstrating the growing institutionalisation of the digital assets arena.

The term “crypto prime brokerage” currently encompasses a wide range of services, including custody, financing, market access, market research and technology. The aim of prime brokers is to provide a comprehensive solution for hedge fund managers and institutional investors and support the investor appetite for these assets.

This has cleared the way for the rise in specialist crypto prime broker services. And when selecting partners in this area, there are several considerations hedge fund managers should take into account.

Supporting institutionalisation of digital assets

The development of crypto prime brokerage services has played a vital role in supporting the institutional adoption of digital assets. The building of a strong ecosystem and technical infrastructure to facilitate safe trading is critical in creating a robust, long-lasting asset class which can withstand various market pressures.

Though hedge fund participation in the crypto market has been rising, until 2021, only a small percentage of top hedge funds had the capacity to directly hold or trade crypto assets. This is where crypto prime brokers, like Aplo, have come into their own; they have been stepping in to bridge the gap and provide synthetic exposure to digital assets.

“Through such services, hedge funds can benefit from cryptocurrency returns without having to deal with the investment operations behind the assets,” says Oliver Yates, CEO, Aplo, “This access to synthetic exposure has further encouraged hedge fund allocations to these assets, facilitating market entry and mitigating risk.”

Streamlining reporting procedures

When selecting a crypto prime broker, hedge fund managers must address specific factors to ensure they are being given a secure, effective service. These elements include the provider offering robust reporting mechanisms and risk management. They also must comply with licensing requirements, and ensure the safety of customer funds. 

“Crypto prime brokers must provide solutions that streamline reporting procedures, such as self-service platforms that automatically collect transaction data for fund administrators and auditors,” outlines Yates, “In addition, collaboration with top fund administrators guarantees thorough data coverage, spanning all customer actions including trades, borrowing, and staking.”

Risk management and compliance are crucial considerations for hedge fund managers, especially when venturing into a new asset class, such as digital assets. Therefore, a reputable crypto prime broker should hold both brokerage and custody licenses,  thus enforcing proper governance, security procedures, and robust cybersecurity systems for custodial services. Licensing in reputable jurisdictions adds an additional layer of trust. 
To comply with Know Your Customer (KYC) and Anti-Money Laundering (AML) requirements, the prime broker should also provide comprehensive compliance measures.

Another key consideration is the safety of client funds. Especially following the FTX collapse, this is of paramount importance. So when considering partnering with a crypto prime broker, hedge fund managers should assess the way the prime broker handles deposits, collateral, and mitigates market manipulation and fraud. Further, understanding funding requirements and risk mitigation strategies is essential to protect investors’ interests and ensure the overall security of the investment process.

Compliance considerations

Regulation is a frequent bone of contention in the digital assets space, as legislation is still in the development phase across several jurisdictions worldwide. However, many serious players in the industry are welcoming tighter controls as it gives those able to handle the new environment more credibility.

This is also true in relation to crypto prime brokers. There are several compliance factors hedge fund managers must consider when selecting a third-party partner in this regard. Yates details: “The prime broker should be registered with and supervised by a competent financial authority in a strong jurisdiction. Reputation with regulators is crucial, and any past attempts to avoid jurisdictions or failed license applications should be carefully evaluated. Also, due to the current regulatory uncertainty in the United States, hedge fund managers should ensure that the crypto prime broker they choose has a regulatory footprint beyond the US. Rather, they can consider jurisdictions with a mature regulatory framework and that fall within the scope of the Markets in Cryptoassets (MiCA) Regulation1.”

These considerations can have an impact on a hedge fund manager’s investment strategies across digital assets. For instance, the jurisdiction of the crypto prime broker may impact the manager’s access to deep liquidity pools, as crypto-exchanges remain the primary source of liquidity in the market. “Therefore, opting for a jurisdiction where crypto-assets are treated as a segregated asset class with a dedicated regulatory framework reduces uncertainty around token classifications and opens up additional investment opportunities in areas such as staking and decentralised finance (DeFi),” Yates explains.

Leveraging advantages for optimal investment strategies

Prime brokers specifically tailored to offer services to the crypto market can offer managers several advantages compared to traditional brokerage services. These are primarily in terms of liquidity and trading capabilities. Yates notes: “Traditional brokerage services often suffer from a lack of liquidity and product diversity. This can prevent institutional investors from exploiting their experience to its full capacity within the crypto markets. In contrast, crypto prime brokers like Aplo provide diversified liquidity sources, including exchanges, liquidity providers, systematic internalisers, and, in some cases, decentralised exchanges (DEXes).”

As outlined earlier, many hedge fund managers as yet do not have direct market access to crypto assets. This can be provided through a prime broker, where hedge fund managers can route orders directly to select exchanges, ensuring optimal fees and benefiting from the broker’s back-office capabilities. 

Another service a crypto prime broker can offer is Smart Order Routing (SOR). This allows for execution across multiple exchanges, centralised or decentralised, to secure the best aggregate price. “Additionally, high-touch trading services offered by crypto prime brokers leverage their trading experience and balance sheets to perform complex trades, such as swaps, benchmarking, and block trades,” Yates points out.
Crypto prime brokers also assist hedge fund managers in selecting the best execution policy based on their financial objectives and prevailing market conditions. By leveraging these advantages, managers can optimise their investment strategies, capitalise on market opportunities, and enhance their overall portfolio performance.

Emerging Trends and Innovations

Given the fast pace of development across the digital assets landscape, crypto prime brokerage also must transform and keep stride with the changing industry. Looking ahead, several new trends and innovations are emerging to shape the future of crypto prime brokerage. 

Cross-margining, for example, allows traders to utilise their total account balance to cover potential losses across multiple positions, enhancing flexibility and efficiency in managing margin requirements. However, it also carries higher risks, meaning institutional traders must have robust risk management strategies in place in order to do this successfully.

Another significant development is the emergence of crypto clearing houses. Such entities in the crypto space would offer substantial benefits to institutional investors. They provide a centralised hub for trade execution and clearing, reducing and even eliminating default risks and therefore enabling margin, collateral, and asset settlement across multiple venues. Yates notes: “By reducing counterparty risk and margin requirements, clearing houses streamline post-trade processing for digital assets, enhancing efficiency and security. Hedge fund managers can seize these new opportunities by staying informed about emerging trends, engaging with reputable crypto prime brokers, and adapting their investment strategies to the evolving landscape of the digital asset market. Moving forward I can even see a day when crypto will operate on a T+2 settlement basis in line with mature markets like equities. While not a necessity given crypto’s inherent ability for instant transfers, such a system could enhance capital efficiency, aligning it more closely with established financial markets. ”

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