Is BitGo’s New Trade Settlement Service the Green Light Institutional Investors Need to Safely Move Into Crypto?
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While many companies dream of becoming “the Uber of” some industry they wish to disrupt, BitGo is trying to become the next Depository Trust & Clearing Corporation (DTCC) of an industry that many institutional investors feel needs a lot more trust and clarity – the cryptocurrency industry.
The settlement issue
When you buy or sell stocks, it appears as a simple trade at the push of a button or a call to your broker. However, on the back end, there is a meticulous process of actually taking your sold stock and moving it to the portfolio/brokerage of the purchaser, transferring the funds the other way, making sure the transaction is properly recorded and not duplicated (or fraudulent), and more. To ensure the integrity and ease of this process, it is done by a single organization, the DTCC.
Traders and investors do not have to worry about settlement of trades and clearing of funds because of this ironclad knowledge that the DTCC will take care of the back end of each trade, every time and without fail. Your funds or stock holdings are never exposed to theft or fraud because the DTCC completes settlement for them before your assets ever leave the safe custody of your brokerage. In the US alone, DTCC performs around 1.4 million settlements per day.
In crypto, by contrast, settlement of trades happens on-chain of the blockchain used in the transaction (e.g., if Bitcoin is traded for Ethereum, the trade needs to be registered in both chains). While the settlement process takes place (which could take hours), your crypto assets are exposed in “hot” wallets – wallets actively connected to the Internet and thus much more prone to hacking and theft than your “cold” wallet, which has a number of extra layers of protection.
The result is that every crypto transaction exposes the investor to risk, while in traditional assets like stocks, bond, and commodity futures, for example, the risk is eliminated thanks to the settlement and clearing services provided by the DTCC.
For institutions, settlement is a three-pronged problem
As BitGo’s own website notes, there are at least three problems with the way settlement is currently done for cryptocurrency transactions.
- Counterparty risk – either you or whomever you are trading with needs to expose their funds before settlement occurs, hoping that the other person, aka counterparty, does not back out of the transaction or otherwise defraud the risking party.
- Inefficient capital allocation – trading on multiple exchanges is both inefficient and a mess for your balance sheet. Keeping your funds and assets in a single safe place while relying on a reputable settlement service should allow investors to focus on optimizing trades and investments, rather than on balance allocation.
- Compliance infringement – when funds need to leave custody in order to settle trades, as they do today with cryptocurrencies, this creates a host of compliance issues, which make it particularly problematic for institutional investors to get involved with cryptocurrencies.
In essence, BitGo is offering to be the intermediary between trading entities, including exchanges, OTCs, single dealer platforms, asset managers, and others. It will do so by connecting all these parties via its clearing and settlement API and/or a web UI that sends all data into BitGo’s proprietary digital accounting system for secure clearing and settlement. BitGo promises to allow participants to choose which partners to clear and settle with, to check counterparty trade limits before making trades, and to customize fund locking options.
Keep in mind that, according to BitGo, all clearing and settlement parties must be qualified custody clients holding funds with BitGo Trust. And this is why BitGo has a chance of realizing its ambitious goal – it is already a trusted provider of crypto custody services. By offering clearing and settlement to its current custodial clients, it provides an additional service in high demand. And by only allowing its custodial clients, BitGo raises the value and necessity of purchasing its custodial services.
This gives BitGo a competitive advantage over those offering only settlement/clearing or custody but not both. It is also great for marketing: want settlement? Sign up for custody. Have custody? Why not add settlement for your peace of mind?
Institutional investors want good returns as much as do retail investors, but their focus is always on minimizing risks. Just imagine a teacher’s union pension fund betting it all on bitcoin “going to the moon” without proper risk mitigating tools in place.
The need for proper clearance and settlement in cryptocurrency markets is nothing new. After all, the DTCC was founded in 1999, cryptocurrencies have been gaining steam since mid-2017, and early institutional interest made these concerns apparent.
So who is to say that BitGo will not get squashed by bigger competitors before realizing its ambition to be the DTCC of the cryptosphere?
For starters, the DTCC itself could flex its reputation in the clearing and settlement space to do for cryptocurrencies exactly what it does for more established financial instruments. Then there is the much talked about Bakkt exchange being launched – after seemingly endless approval delays – by the Intercontinental Exchange (ICE) that just happens to own the NYSE, six central clearinghouses, and a number of other assets worldwide.
There are even some unexpected competitors, like the San Juan Mercantile Bank & Trust International (SJMBT), which could look very attractive to US cryptocurrency investors relocating to Puerto Rico to take advantage of its very friendly capital gains law that allows for the payment of 0% in federal taxes if certain conditions are met.
However the field for settlement and clearing services shakes out, the winners will be the investors, especially institutional investors, and the entire cryptocurrency ecosystem since it still suffers from a perception of being unsafe – a perception that is boosted by the disappearance of funds from even the most popular exchanges, as in the Binance hack.
It is easy to say that companies most actively involved with traditional financial instruments will suffer if cryptocurrencies gain adoption, but that judgement is premature. They may, instead, create new ways for these institutions to profit and to offer more options to their clients. Already, the biggest banks are involved with cryptocurrencies, including one of Bitcoin’s most vociferous critics, Jamie Dimon’s JPMorgan Chase Bank.
Some questions do remain, though. Will all this extra security that copies the traditional financial system destroy the renegade “trust math, not people” spirit of cryptocurrencies? Will the added security and stability decrease the growth rate of Bitcoin and other digital currencies? Narrower price swings, for example, may be good for stability, but not necessarily for profit. Will the same big players come to dominate an industry that came into existence to break the old system?
Brian Sewell is Founder of Zion Trades, www.ziontrades.com, a cryptocurrency trading platform.