Cryptocurrencies have been on top lines recently. More and more institutions are popping into cryptocurrency market, who are either long established in traditional finance market, or startups rooted in this new area. An emerging business process is Prime Brokerage (PB). This article aims to explain the roles and functions of prime brokerage in cryptocurrency market.
What’s Prime Brokerage (PB)
PB service emerged in cryptocurrency market since late 2019 / early 2020 with a wide coverage of services. Let’s define PB service first to those without systematic finance market knowledge.
PB stands for Prime Brokerage, the concept and term are generally attributed to the U.S. broker-dealer Furman Selz in the late 1970s. Before then, brokers have scattered functions of either trading, clearing, settlement or custody. Fund managers usually work with several broker-dealers simultaneously thus causing huge workload of record consolidation, data reconciliation and performance calculation across brokers and exchanges. Furman Selz realized clients’ demand for a one-stop solution that combines all functions, and pioneered PB service to release fund managers from heavy crypto buy-side portfolio management operations. Recognizing the business model and potential, large investment banks soon entered the market to compete for PB business.
After decades of development, now PB service is defined as: one-stop financial service provider, including trading execution tool, asset custody, clearing, settlement, commission withhold and collection, margin loan, KPI calculation, risk control, crypto buy-side portfolio management across multiple accounts, trading analysis, liquidity management and other investment banking & asset management services.
Depending on client business and their demand, PB service can be categories into 3 tiers
1) Basic: asset custody and operations outsourcing, which are basic brokers services
2) Core: trading and leverage facilitation, which define the core value add of ‘prime’ broker
3) Additional: consulting and administration services, which bring additional benefit to clients
PB service scope
PB’s core value-add comes from two ways.
First value-add is that PB saves operational efforts from fund managers’ (or institutional investors) by business process outsourcing. Fund managers or traders in institutional investors would want to focus on strategic thinking, keep in depth analysis, and sharpen their trading strategy. However, (especially in their early phase) fund managers have to be distracted by operational topics, e.g., margin trading to increase return (low-cost fund), open / close position rapidly with minimal impact to market price (trading execution), portfolio management and periodical reconciliation (clearing and settlement), and even reports to regulatory parties (crypto compliance reporting) … A good PB will take over those direct market access operation jobs, and hence fund managers can focus on their trading.
Second value-add is for LP fund like bank / wallets, or family offices, who would like to earn yield on their fund by investing to asset managers. They will contract asset managers, allocate fund or trading accounts to every team, but they face the challenge of keep track of the trading risk. PB can support LP by introducing asset managers, keeping transparency of fund allocation, and controlling the risks. PB in this case is their ‘Siri’ along investment. ‘Hey Siri, which account has risk and what’s your suggestions?’
PB has different paths in cryptocurrency market
PB has been bringing value-add to both LP and asset managers in traditional finance market. Since in cryptocurrency market there are also LP and asset managers, there will be nature demand for PB in cryptocurrency market too. To think about how PB will develop in cryptocurrency market, we can categorize them into two different types.
Type 1 runs either custodian firm or wallet service in cryptocurrency market, who are essentially asset custody. Their role is the safety vault for clients in their early phase, while client will expand their wish list during growth
- Clients want to trade directly with the asset in custody
- Clients need short-term fund but want to keep cryptocurrency position (margin loan)
- Clients want to gain yield with their asset
Those services already fall into crypto PB scope. A custodian firm would have to provide those PB services in order to keep client loyalty and earn continuous income. Also, PB service will significantly increase the revenue compared to plain custody service due to the added value.
Type 2 institutions are those started from crypto buy-side investment or sell-side lending. They have their own fund or financing source, and earn yield from investment or margin lending.
Type 1 started their business with customers with custody demand by their advantage in creditability and security then expand their offering to financial services, while Type 2 attracts customers with trading demand by competitive trading features. In the long term, those two types will eventually develop themselves into one-stop financial service provider by strengthening their full offerings.
Think about the future of cryptocurrency market, most the players in the whole market should fall into buy-side, asset managers, prime brokerage (PB), custody / wallet, etc. In which, crypto PB’s importance will be recognized by more and more institutions and PB will play a bigger role in the cryptocurrency ecosystem.
Key success factors for PB
Besides credibility as the fundamental base, a successful PB must excel in resources and services.
Resources include low-cost fund (can be money, stable coin or cryptocurrencies for margin loan) and low commission channels. Low-cost fund might result from a strong equity shareholders or good financing channel, which explains the advantage of PB rooted from traditional finance. Low-cost commission might come from the clients’ trading volume of PB firm, while some PB have inhouse quant trading team which brings advantage in commission.
Services can be measured by width and depth. What does it mean? Width means a PB should cover full scenarios, including exchanges, trading products and all kinds of services (execution, clearing, settlement, margin loan, risk control and etc.). By covering the mentioned services, a PB can claim to have ‘good width’.
However, some PB choose to deep dive into niche scenarios instead of covering every possible scenario. In other words, they have depths in their PB area. We’ll list various PB services for a better understanding of service ‘depth’ as below.
Trading execution: order placement speed and latency, various types of algo trading (conditional orders, stop loss, take profit, iceberg, TWAP, VWAP…) smart order routing among multiple venues for optimal execution price, aggregated liquidity, other professional trading tools like arbitrage tool, or manual high frequency trading.
Custody and clearing: solid technical solution for fund security, fast clearing across different assets, purchase / dividend / redemption calculations (for details refer to previous article.
Margin loan: higher leverage ratio made possible by strong RMS (risk management system), mixed collateral, cross margin among different trading venues
Risk management: Live monitor of risk parameters including Net value, drawdown, exposure, liquidation line, leverage ratio, passive alerts or active deleverage when threshold triggered, manual interference, options Greek and stress test etc.
Asset transfer: centralized venues (exchanges, hot wallets…) to decentralized venues (wallet address, DeFi protocol), centralized — centralized, decentralized — decentralized asset transfer
Others: research and analysis to LP fund or asset management, pre- and post-investment operation support, customer support, and other crypto compliance reports.
PB system is complex but yet standardized
Both professional talents and professional IT system are necessary to launch PB service successfully.
In trading module, PB should provide
1) single point of access to liquidity: integrate all trading venues, all kinds of trading products (spot, future, options…) and ensure low latency (millisecond level)
2) order execution system (OEMS) module for conditional orders, algo trading etc.
Sometimes Trading module has to be adapted from the very basic infrastructure upon highly customized demand, e.g., for high frequency quant traders.
In trading risk management system, PB should monitor the risk situations with live market, and take deleveraging or liquidation actions when the pre-defined risk rules are triggered. There will be lots of parameters in crypto RMS, and the number of parameters grows with the complexity of trading strategy or fund product design as the rules become more sophisticated. The challenges are to design the rules that properly reflects the risk, track the right raw data and calculate the risk parameters, and take immediate risk control actions upon different levels of alert. To execute this series actions, the system must keep high performance on timeliness, accuracy… And the crypto risk management infrastructure must have risk control insights from trading experience.
In clearing module, the crypto real time data, eg: net value, calculation of trading profit (loss) and bonus are necessities. Clearing module is to ensure the data and information are reflecting the reality. To know more details, please refer to other articles.
In asset transfer module, trading teams need to frequently rebalance inventory among multiple trading venues, and the speed becomes crucial especially during market volatility period. On the other hand, asset security is the fundamental base. PB can reinforce asset security by API key (secret) management, transfer address whitelist, approval process…
Furthermore, permission module also plays an important role. Since PB service involves many internal roles and external participants, the screen (or terminal, or dashboard) for different roles is naturally differentiated. Even in the same terminal, there will be multiple requirements for permissions such as authorization and classification. Permission and account module must be implemented to ensure each type of users can access the right functions.
Make or Buy?
It’ll be a huge project to provide above PB services by building the system inhouse. A company aiming for crypto PB business should plan half to 1-year on system R&D (depending on their service scope), which is too long for the fast-moving cryptocurrency market.
Actually, the whole system package is highly standard for those who understand the nature of PB business. Though starting with different scope, every PB will eventually develop into identical 100% full service providers. It explains the existence of professional IT system vendors like Hundsun, Kingdom in China and SunGard (acquired by FIS in 2015), SS&C in US, all providing the whole PB system solution. So that all the PB service providers can focus on their core competitiveness like sourcing better resources and talents instead of IT system R&D.
In cryptocurrency market, an ideal IT solution provider should have full knowledge on traditional PB service and system, and rich experience in cryptocurrency market. 1Token combines above advantages by 10 years in both traditional finance and cryptocurrency market, and has developed mature PB solution to cover all above system demand. So financial institutions can focus on their business and services, and let 1Token build their tools.
MoM business is closely linked to PB business
Because by analyzing the essense, MoM is a ‘PB’ that acts like a buy-side.
MoM stands for Manager of Managers. It means the master fund manager keeps research and invests suitable asset managers to generate excess return. The different between MoM and FoF (Fund of Funds), is that FoF manager sources fund to and invest by buying the fund shares directly. While MoM manager sources people asset managers from the market, make investment by sharing sub-account with capital, and regularly monitors their performance. In short, FoF invests in fund, while MoM invests in people.
In China, the common way is LP put fund in their own exchange account, and share sub-account credentials to trading teams (managed account model). Which is standard MoM.
If we deep dive into the value chain of PB and MoM business, it’ll show
MoM: LP — Master fund — Multiple asset managers (each asset manager runs a sub-fund)
PB: LP — Prime brokerage (PB) — Multiple clients
In cryptocurrency asset management business, master fund of MoM and PB has similar functions, and shares common process like integrating trader / asset managers, controlling risk, clearing and settlement. The difference is that PB earns commission from brokerage business, while MoM gain yield by sharing trading profit.
1Token provides one-stop system solution for cryptocurrency institutions
1Token CAM system provides front-, mid- to back-office IT system to global mid-large institutions in cryptocurrency market.
Global leading financial institutions in China are using 1Token CAM system on their core business process, e.g.
Prime Brokerage: Matrixport, Amber Group
- All institutions, including buy-side, sell-side and custody, such as asset manager, FoF / MoM, PB, structured product seller, borrowing / lending platform, mining pool, institutional miner, manual / quant fund, OTC liquidity provider
- All main modules, including trading, clearing, settlement, risk management, RFQ, transfer / wallet, permission hierarchies etc.
- All asset types, including fund, (structured) derivatives, margin loan, DeFi farming, hash power / mining machine, etc.
- 1Token teams has lending, financing, derivatives system experience in traditional market and quant fund, brokerage and mining system in cryptocurrency market
- 1Token core team previously worked at Scivantage (acquired by refinitiv), a well-known financial system provider in US traditional finance market, serving Bank of America, Deutsche Bank, Vanguard, Scottrade and other well-known sell-side institutions
- 1Token system has covered front- to -back office modules of various assets through 10 years of experience, also customization is possible based on client demand
- 1Token system has proven robustness by serving daily $300 million trading volume via broker system and prop trading system, with peak volume $800 million
- 1Token system supports local deployment, uses separate open-source module to keep confidential information (e.g. API key) and make regular 3rd party penetration test by leading digital security firms to address large-mid institutional clients’ concern on data security