Bitcoin — Institutions, Arbitrage, and Premium, Oh My! (Part I)
2020 has been an exciting year for Bitcoin. The current macro environment has led more and more individuals “down the rabbit hole” and notably this cycle, they are not alone. Institutions are quickly waking up to the narrative surrounding Bitcoin, with global demand greatly outpacing new supply.
Multi-billion dollar management firms are now advising their clients on a Bitcoin allocation going forward, with individual investment funds popping up to fulfill this demand. Just last week, SkyBridge Capital (a $9bn hedge fund) announced they have launched their new Bitcoin only investment vehicle with $25mm of capital, citing increased institutional demand as we head into 2021. MicroStrategy recently announced the company has completed their acquisition of an additional 29,646 BTC at an average price of $21,925 after their recent convertible issuance. This brings the firm’s total investment to 70,470 BTC at average price of $15,964 ($1.125bn).
While these headlines are no doubt exciting, the purpose of this piece will be to explore how these large institutions are gaining exposure to Bitcoin and what is driving these trends. The process of putting on a trade of this magnitude is vastly different than what retail buyers may be familiar with.
Increased adoption from these entities will continue to drive innovation in the emerging Bitcoin native economy, providing enhanced security solutions, additional fiat onramps, quality educational material and overall ease of access to the network for newcomers. These advancements will have a positive benefit to all participants in the long term and should be welcomed by the Bitcoin community at large.
Buying Bitcoin — The Retail Perspective
Many of you reading this article probably already own Bitcoin (or have been sent this by someone who does). You may have used popular apps/exchanges such as Cashapp, BlockFi or Swan for your purchases. These platforms have a quick onboarding process, easy to use interface and serve as a great way to purchase you first Bitcoin. Investors may choose to keep their Bitcoin on these exchanges or withdraw to a hardware wallet such as a Coldcard or Trezor. Regardless of where you may be on your Bitcoin journey, the actual act of buying and storing your Bitcoin is fairly similar for most individuals.
These companies are well known in the retail world of Bitcoin, but how do companies like MicroStrategy, MassMutual and the like go about taking multi-hundred million dollar positions?
Buying Bitcoin — The Institutional Perspective
In traditional financial markets, large institutional entities like hedge funds, pension plans, sovereign wealth funds and other asset allocators utilize what are known as prime brokerages for the majority of their needs. These services are typically an internal unit at large banks such as Morgan Stanley, Goldman Sachs or JP Morgan. They sit between the firm and outside clients, providing an all in one service package including custody, trade execution, financing (margin and lending) as well as market research and risk reporting. The ease of having all of this information consolidated into one place has led to widespread adoption of prime services in capital markets today.
The need for a similar suite of services has grown in the digital asset industry over time. Companies including Genesis Trading, Coinbase Prime, BitGo, Galaxy Digital and Fidelity Digital Assets have begun to fulfill this need, offering varying degrees of services to meet rising demand. While there still remains a need for a full “one stop shop” prime offering for digital assets, as the market continues to mature, it is only a matter of time until participants are able to choose between multiple options, driving competition and ultimately enhanced service offerings.
Custody is arguably the most important service that primes can provide to institutions looking to increase their exposure to digital assets. The cryptographic nature of Bitcoin requires a basic to advanced understanding of both hardware and software to ensure the safeguard of assets. We have all heard stories of lost Bitcoin due to forgotten passwords or failing hardware etc. and with Bitcoin, there is no recourse or centralized entity one can go to in the event of lost or mismanaged funds. While the core ethos behind Bitcoin is its decentralized nature, mega corporations and institutions will need to feel comfortable (aka using a centralized custodian) that their assets are secure before investing large sums of capital. The cascading effects on the ecosystem of mainstream adoption will be a positive value add for all Bitcoiners going forward.
Liquidity is another major hurdle that might hinder institutional entrants. In today’s world, access to a uniform execution price is largely bifurcated across exchanges. In the picture below, we can see how even large, highly liquid exchanges have varying degrees in their bid/ask spread (the difference between the current buy/sell orders in the order book). While this may not be a huge deal for individuals purchasing small amounts, any institution looking to allocate several million dollars or more will want to ensure they are getting accurate and efficient trade execution, minimizing price slippage.
Prime brokerages address this need by offering over-the-counter (OTC) and multi-exchange trade execution services. In the former, a client would may submit an RFQ or “request for quote” for a specified amount at a specified price. This can also be thought of as a block trade, where two parties agree to enter into an agreement outside of the typical public exchange order book. This type of trade satisfies both parties, providing the buyer and seller straightforward terms and trade execution for a nominal fee. Prime brokers use their network of industry relations and other market participants (trading desks or dedicated OTC firms) in order to facilitate these transactions for their clients.
Multi-exchange trade execution services can help clients limit their exposure to multiple third parties, reducing counterparty risk and increasing capital efficiencies. By aggregating order flow across exchanges, primes can offer their clients enhanced order execution and reduces the burden of having to open and fund multiple accounts to trade.
Financing is another important aspect of the prime brokerage package. This can be broken down into two major areas, margin financing and securities lending. Margin financing is fairly simple, clients can borrow additional funds (cash) to trade with by posting existing assets on their balance sheet as collateral. By depositing $100, you can now trade with $200 worth of assets, potentially increasing your rate of return but being subject to a margin call in the event of the trade working against you. In return, the prime broker would charge interest on the cash lent out and ensure the client meets their margin requirement for the duration of the agreed upon terms. Securities landing is similar but instead of cash, the asset used as collateral or borrowed would be (in this case) Bitcoin or other digital assets. The most common use of these services is to take a short position in the underlying asset or to execute arbitrage trades denominated in that asset (direct BTC investment into Grayscale’s BTC trust for example).
There are many reasons to use these financing services. A firm may wish to increase their existing position, take advantage of arbitrage opportunities or enter in more sophisticated hedging strategies through the use of derivatives.
As more institutional players enter the digital asset industry, prime brokers are poised to provide a similar service experience they are used to in the traditional capital markets. Current prime offerings in the digital asset industry are more akin to boutique firms rather than full-fledged bulge brackets but are quickly fulfilling the gap to meet rising demand.
I hoped to keep this article succinct, providing an introductory view into the world of institutional digital assets. In the next part, I will aim to go into greater detail on various strategies currently used by these institutions as they embark on their Bitcoin journey, covering topics such as the Grayscale Bitcoin trust premium, futures basis trading, and other derivative focused trades.
BTC Block Height: 662811
BTC Price: $23,325.57
