Brian Nibley

<div id="highlights-block_62bdbf2c4696b" class="highlights">
 <ul>
 <li>The Responsible Financial Innovation Act could provide the regulatory clarity that investors have been looking for</li>
 <li>Under the current proposal, bitcoin and ether would likely be labeled as commodities, while most altcoins would be considered securities</li>
 </ul>
 
</div>



By and large, blue-chip institutions have been forced to wait on the sidelines when it comes to entering crypto markets. There’s no global consensus on a regulatory framework or rules of the game that provide the necessary clarity for a large institution to deploy capital.



Fortunately, we are seeing signs that this appears to be changing.



US Sens. Lummis and Gillibrand have introduced a bill that would provide much of the needed regulatory clarity that investors have been hoping for. The Responsible Financial Innovation Act would define many crypto-related terms such as smart contract, digital asset, and virtual currency. Most importantly, the bill would classify some cryptocurrencies as commodities and others as securities.&nbsp;



Under the current proposal, bitcoin and ether — which account for the majority of crypto’s market capitalization — would likely be labeled as commodities, while many other coins would be considered securities. Because regulators across the globe have differing opinions on the question of classification, this bill could be instrumental in settling the debate. Once this framework has been established, it would provide a basic foundation for regulators, making it easier for other nations to replicate rather than starting with a blank canvas.



<h3 class="wp-block-heading">Global crypto regulatory landscape</h3>



Looking around the globe, there’s no clear agreement on how to regulate crypto. Nations span the spectrum — from making bitcoin legal tender to attempting to ban crypto outright and everything in between.



Central America’s El Salvador declared bitcoin to be legal tender in September 2021, with the Central African Republic following suit less than a year later. By embracing bitcoin, these nations hope to spur innovation, boost tourism and empower their largely unbanked or underbanked populations.



In the US, the muddy waters of regulation are gradually becoming clearer. The IRS classified crypto as property in 2014, with relatively minor regulations coming in since then. Some of these include the Financial Crimes Enforcement Unit, or FINCEN, <a href="https://complyadvantage.com/insights/cryptocurrency-regulations-around-world/" target="_blank" rel="noreferrer noopener">imposing</a> new data collection rules on exchanges. Biden’s infrastructure bill also included a provision to <a href="https://cms.blockworks.co/infrastructure-bill-advances-in-senate-crypto-amendments-await-vote/" target="_blank" rel="noreferrer noopener">classify exchanges as brokers</a>, making them subject to anti-money laundering and combatting the financing of terrorism (AML/CFT) reporting and record-keeping.



The state of New York recently instituted a partial ban on proof-of-work mining, while states including Wyoming, Florida and Texas have become more lenient, with Texas now hosting approximately <a href="https://www.cnbc.com/2021/10/09/war-to-attract-bitcoin-miners-pits-texas-against-new-york-kentucky.html" target="_blank" rel="noreferrer noopener">14% of America’s total bitcoin hash rate</a>.



And now, with new legislation on the horizon, some long-awaited regulatory clarity could be within reach.&nbsp;



<h3 class="wp-block-heading">The Lummis-Gillibrand and CFTC solution</h3>



As mentioned, the Commodity Futures Trading Commission, or CFTC, will likely gain regulatory authority over the majority of crypto’s market capitalization if the Responsible Financial Innovation Act passes. For further insight on the implications of this, we spoke with David Mercer, CEO of <a href="https://bit.ly/3I1cIJq" target="_blank" rel="noreferrer noopener">LMAX Group</a>, the operator of <a href="https://bit.ly/3NJHQ1z" target="_blank" rel="noreferrer noopener">LMAX Digital</a>, the leading institutional crypto currency exchange:



“The fact this is a bipartisan proposal is a positive and important step forward for the entire global crypto community. A well-considered framework from a renowned regulator will support the institutionalization and growth of the crypto market which is currently stymied by the offshore nature of trading and regulation. It is a demonstration that policy makers are taking crypto seriously.”



As far as the CFTC vs. SEC debate is concerned, LMAX Group is decidedly agnostic:&nbsp;



“Whilst we have no strong view on the particular regulator, it is good news that globally respected ‘non-island’ regulators are considering their approach to regulating this nascent asset class.”



<h3 class="wp-block-heading">Is crypto a commodity, security or currency?</h3>



Law makers behind the Lummis-Gillibrand bill classify bitcoin as a commodity because its supply and network have no central governing body or team behind them. The profit potential for bitcoin isn’t tied to “the efforts of others,” meaning it could fail the <a href="https://www.investopedia.com/terms/h/howey-test.asp" target="_blank" rel="noreferrer noopener">Howey Test</a>, ruling it out as a security. It’s much harder to make a similar case for other coins.&nbsp;



Classifying bitcoin as a commodity would provide some much-needed regulatory clarity. Still, some claim that the CFTC doesn’t hold the same regulatory oversight powers as the SEC, making it more difficult for regulators to clamp down on fraud and scams.



The vast majority of altcoins would likely be classified as securities, given that most of them pass the Howey Test, which the SEC uses to determine whether or not something is a security. The Howey Test has four key metrics:



<ul class="wp-block-list"><li>An investment of money</li><li>In a common enterprise</li><li>People buy it with the expectation of profit</li><li>The profit potential is derived from the efforts of others</li></ul>



In contrast, Mercer said the LMAX Group views bitcoin differently.



“BTC is a currency whilst Ethereum and other layer-1 blockchains such as Litecoin could well fall under a securities or commodities umbrellas; the tokenized, or DeFi economy including staking would appear to be securities but they are also diverse in nature so some may differ in the rights and returns they demonstrate.”



<h3 class="wp-block-heading">What nations need to reach regulatory consensus</h3>



If North American and European nations could all reach similar agreements on crypto regulation, that could be the catalyst for significant amounts of capital to enter the space. Other large economies, such as the BRICS nations and others in South America, Asia, and Africa, could then easily follow.&nbsp;



Or, as an alternative, it’s possible that an increasing number of nations could adopt bitcoin as legal tender, sidestepping the need for regulation altogether, at least when it comes to the world’s largest cryptocurrency.&nbsp;&nbsp;



David Mercer had the following to say on the matter:



“Ultimately our view is that the CFTC, or other renowned global regulators, would be excellent stewards and supervisors of this new asset class and bring greater stability and integrity to&nbsp; crypto market structure. We do not believe there is a need for any new regulatory body and all products and participants can be accommodated broadly within existing frameworks.



A well-considered initial framework from renowned regulators will lend credibility to crypto and only aid the institutionalization of the market.



Crypto and DeFi cross a wide cross section of traditional finance, and it’s likely that all regulators, SEC, CFTC and the Fed will have to create a framework in the long term.”



This content is sponsored by <a href="https://bit.ly/3I1cIJq" target="_blank" rel="noreferrer noopener">LMAX</a>.



<hr class="wp-block-separator has-alpha-channel-opacity"/>



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Can Nations Agree on Crypto Regulation?

David Canellis

<div id="highlights-block_dbdd9835e194a0b5d8c4e1b776fdd5da" class="highlights">
 <ul>
 <li>LMAX Group CEO David Mercer believes crypto could overtake gold within the decade</li>
 <li>The firm’s institutional clientele showed strong conviction in bitcoin and ether during the recent chaos</li>
 </ul>
 
</div>



Institutional crypto exchange LMAX Digital just recorded its largest trading day for the year —&nbsp; fueled by bullish sentiment among the world’s top traders.



According to LMAX Group CEO <a href="https://twitter.com/mercerdavid?lang=en" target="_blank" rel="noreferrer noopener">David Mercer</a>, the exchange’s whale-like clientele appear relatively unscathed, despite chaos triggered by the <a href="https://cms.blockworks.co/terra-halted-again-exchanges-delist-spot-trading/" target="_blank" rel="noreferrer noopener">collapse</a> of algorithmic stablecoin UST and its sister token, LUNA.



Mercer told Blockworks $3.3 billion in trades flowed through LMAX Digital last Thursday.



“My institutions traded more than ever,” Mercer said. “They&#8217;re the biggest proprietary trading firms in the world, in Chicago, New York, Amsterdam and London. Their conviction in bitcoin for certain remains undented, with their belief in ethereum apparently the same.”



Mercer declined to specify the firms in question. But the likes of Jump Trading and DRW’s Cumberland fit the profile.



For scale, LMAX Digital saw $1.5 billion daily on average last year, with its top day reaching $6.6 billion on May 19, when bitcoin collapsed from $59,000 to $34,600.



In any case, Mercer said uncertainty and fear pushed LMAX Digital volumes higher. Mercer saw institutions “fleeing to quality,” as his platform “doesn’t dabble in some of the more experimental coins.”



Last Thursday, both bitcoin and ether — the largest cryptocurrencies by market capitalization — rose about 6% during intra-day trading, although some native tokens of crypto exchanges <a href="https://cms.blockworks.co/native-crypto-exchange-tokens-hint-at-first-sign-of-broader-market-recovery/" target="_blank" rel="noreferrer noopener">performed</a> better.



Mercer believes <a href="https://cms.blockworks.co/cryptocurrency-luna-lurches-as-terra-usd-volatility-continues-erasing-billions/" target="_blank" rel="noreferrer noopener">Terra’s demise</a> has a hidden silver lining.



“I might have a slightly different view to most people,” Mercer said. “I mean, people use crypto in a very wide framework. To me, bitcoin is half the market, because as a currency, it’s very stable and robust.



On the other hand, Mercer dubbed decentralized finance (DeFi) an ecosystem of science experiments.&nbsp;



“Pegs generally break, especially if they&#8217;re flawed,” Mercer said, citing sudden devaluations of numerous currencies over the course of history, including George Soros’ successful “attack” on the British pound in 1992, the Euro-Swiss franc collapse in 2015 and the Argentinian peso in 2002.



Still, Mercer wouldn’t call algorithmic stablecoins such as Terra dumb ideas. It was a good idea, backed by some very great minds, he reasoned, “but it didn’t work, and it was upset by normal market dynamics.”



<h3 class="wp-block-heading">The case for collateralized (and audited) stablecoins</h3>



Instead, Mercer is a fan of collateralized stablecoins, such as Circle’s offering, USDC. LMAX Digital accepts USDC.



LMAX Digital combines USDC with USD in one order book and handles margin trade in the stablecoin.



“Don&#8217;t get me wrong, probably 97% of my trading is crypto-to-fiat,” Mercer said. “But some customers arrive and they say, ‘Look, I&#8217;ve got this USDC. It’s easier if it’s in USDC, rather than US dollars.’ That’s fine — I accept USDC and can transfer it immediately, to the extent that those order books are the same.”



But why not USDT? Mercer cited Circle attestations via accounting giant Grant Thornton, which states that every USDC is backed by a US dollar or US Treasury. This doesn’t make USDC a “particularly sexy stablecoin,” Mercer said, but it is collateralized, liquid, and “one is equal to one.”&nbsp;



USDC’s well-documented collateralization allows LMAX Digital to confidently merge its fiat dollar order books with its USDC books.&nbsp;



“We don&#8217;t offer Tether today for one simple reason: that one-to-one ratio is not guaranteed,” Mercer said.&nbsp;



Tether constantly assures the market each USDT is properly backed by a mixture of money market deposits, corporate bonds and the like, but Mercer doesn’t have full faith in the reports Tether produces.&nbsp;



The LMAX chief said Tether needs more transparency before he would accept USDT.



“I&#8217;m a simple guy,” he said. “I’m in traditional markets. Tether is telling me there’s $70 billion USDT in circulation? Just show me the portfolio. I don&#8217;t understand why that can&#8217;t happen. I just want $1.”



As such, Mercer said he would happily embrace <a href="https://blockworks.co/tag/cbdc">CBDCs</a>, or central bank digital currencies  — digital fiat issued by central banks. Fiat is too clunky for crypto markets, and he considers reducing friction in the ecosystem to be the primary use case for stablecoins and CBDCs, saying “it should oil the wheels.”



<h3 class="wp-block-heading">Bullish on crypto’s future</h3>



Finicky stablecoins aside, Mercer is remarkably bullish on crypto’s future, although digital asset trade makes up a small percentage of LMAX Group’s revenue.



Six exchanges fall under the LMAX Group umbrella. LMAX Digital, the institutional crypto platform, represented 15% of LMAX’s total volume, but 40% of revenue last year.



Overall, the group recorded $110 million in revenue from about $6 trillion foreign currency volume, with crypto contributing about $550 billion.



Remarkably, LMAX Digital’s BTC-to-USD pair was its eighth-biggest currency pair across the entire group — euro-to-dollar was No. 1, dollar-to-yen was second, and sterling-to-dollar was third.



By 2025, Mercer believes it will be possible to trade bitcoin against everything: gold, the S&amp;P, euros, the FTSE, nickel and aluminum, “just the same way you can trade dollars against everything.”



He also predicted crypto will overtake gold within the decade. Crypto is currently worth about $1.5 trillion. Gold is between $10 and $12 trillion.



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Big Money Crypto Traders Still Bullish on BTC and ETH, LMAX CEO Says

Sam Reynolds

<div id="highlights-block_60f054253aff2" class="highlights">
 <ul>
 <li>LMAX Group has announced an investment round with J.C. Flowers &amp; Co, giving the investor 30% of the company for $300 million at a $1 billion valuation </li>
 <li>LMAX Group CEO said that J.C. Flowers is investing in the cohesion of institutional FX trade and crypto</li>
 </ul>
 
</div>



A few years ago LMAX Group CEO David Mercer knocked on the doors of 34 of the world’s biggest banks to try and get them onboarded to his institutional-grade digital assets trading platform LMAX Digital. <a href="https://cms.blockworks.co/building-the-plumbing-for-institutional-capital-markets/?utm_content=170465284&amp;utm_medium=social&amp;utm_source=twitter&amp;hss_channel=tw-153396300">Back then, they all said ‘not now, David</a>’. Fast forward to today and LMAX Group has closed a round with one of the world’s pre-eminent financial investors valuing the company at $1 billion.



The transaction remains subject to regulatory approval.



According to a press release, J.C. Flowers &amp; Co is set to take a 30% stake in LMAX Group for $300 million in a secondary share sale by LMAX Group employees. LMAX Group says that they will use the fundraise for a global expansion, particularly in the U.S. and Asia. In addition to a digital assets desk, LMAX Group also operates a sizable foreign exchange business.&nbsp;&nbsp;



“J.C. Flowers invested in the business model. The vision we share is that LMAX Group becomes the preeminent player in global capital markets and the market leader of FX and cryptocurrency trading,” Mercer told Blockworks in an interview. “With our technology, we can leverage any asset class in the world. We took it and applied it to crypto right alongside foreign exchange”.



Mercer is quick to point out that LMAX Digital, the crypto desk, with its small group of institutional traders, is second only to Coinbase in volume. <a href="https://investor.coinbase.com/news/news-details/2021/Coinbase-Announces-First-Quarter-2021-Estimated-Results-and-Full-Year-2021-Outlook/default.aspx">Coinbase reports</a> 6.1 million monthly transacting users.



“LMAX Group is an exciting and well-respected company with a leading position in a market with great potential, making it a highly compelling opportunity for our Firm,” Chris Flowers, Managing Director and CEO, J.C. Flowers &amp; Co, said in a release. “The LMAX Group exchange infrastructure offers&nbsp;efficiency and transparency, both of which are in high demand by the growing numbers of institutional&nbsp; participants in foreign exchange and cryptocurrency trading.”



40% of LMAX Digital clients also trade another asset class, Mercer notes, and he said that the company is planning to use the fundraise to further the cohesion of FX and digital assets.&nbsp;



One cohesion of the asset classes will be the expansion of LMAX Group’s FX trading hours to match crypto’s. Before, the company listed its FX products 24 hours a day, 5 days a week. But, it will be expanding them to match crypto’s 24/7/365 market.&nbsp;



“That’s the future. People want to trade 24 hours a day, 7 days a week. We believe LMAX Group will lead the way in this new era of capital markets,” Mercer said. “Otherwise this great technology will just sit in a data center, collecting dust.”

Financial Services Investor J.C. Flowers & Co. Takes Stake in Institutional-Focused LMAX Group

Jacquelyn Melinek

<div id="highlights-block_60d383824ed3f" class="highlights">
 <ul>
 <li>“We’ve seen that demand pulled away on the basis of people losing money — on derivatives platforms — and that money isn’t immediately replaceable so that demand will take time to build up again,” said Campbell Millar, chief operating officer of LMAX Group. </li>
 <li>“Crypto can come back dramatically, it swings and sentiment changes a lot,” said Joshua Lim, head of derivatives at Genesis Global Trading. “We can see new highs and I have no doubt the basis will be wider than where it is now.”</li>
 </ul>
 
</div>



There was a big dip for the bitcoin spot market earlier this week, but the futures market is still seeing some demand. Bitcoin futures have held at historically low premiums to bitcoin in the spot market, with futures trading about 5% higher, giving the basis trade a thin platform to stand on.



The basis trade, which is when someone buys a commodity at spot prices to take a long position while simultaneously having a short position through derivatives like options or futures.&nbsp;



Earlier this year, “there was extreme demand for crypto and everyone wanted access to it,” said Campbell Millar, chief operating officer of LMAX Group, which operates LMAX Digital, an institutional exchange for bitcoin.



Since spot bitcoin has fallen from its record highs of about $63,000 in April, the “only thing that has changed is demand,” Millar said. As excess demand has disappeared, the market has corrected significantly from overboard conditions after the Coinbase listing, Millar said.&nbsp;



“We’ve seen that demand pulled away on the basis of people losing money &#8211; on derivatives platforms &#8211; and that money isn’t immediately replaceable so that demand will take time to build up again,” he said.&nbsp;



If the market continues to slow down and there’s a sudden rapid increase in [demand] for crypto, that could lead to some increase for the basis in the market driven by demand, he added.&nbsp;



On the long side of the trade, retail market participants were “adding levered exposure at premiums far above spot, and it was accelerated by the price action being bullish for crypto throughout the quarter,” said Joshua Lim, head of derivatives at Genesis Global Trading. “The demand from retail was only partially countered by institutional capital who went short the basis, looking to close the gap between futures and spot.”&nbsp;



Although the premium margin for bitcoin futures is at historical lows, institutional positioning is bullish right now, with not as much retail leverage in the system, Lim said. This means funding for futures is cheap because retail participation is lower due to the selloff.&nbsp;



“Crypto can come back dramatically, it swings and sentiment changes a lot,” Lim said. “We can see new highs and I have no doubt the basis will be wider than where it is now.”



On Tuesday, June 22, bitcoin rallied after falling below $30,000. The decline could be attributed to a handful of elements, but <a href="https://cms.blockworks.co/bitcoin-rallies-after-tumbling-below-30000-stocks-climb-after-fed-hearing-markets-wrap/" target="_blank" rel="noreferrer noopener">negative sentiment from China’s clampdown</a> on cryptos continued to chip into the marketplace as the largest digital currency hit a new five-month low on Tuesday morning.  



China’s central bank, The People’s Bank of China (PBOC) said the digital currency “spawns the risks of criminal activities such as illegal asset transfers and money laundering, and endangers people’s wealth” in a note on Monday, June 21. And over the weekend 90% of China’s bitcoin mining was estimated to be shut down, according to a <a href="https://www.globaltimes.cn/page/202106/1226598.shtml" target="_blank" rel="noreferrer noopener">report</a> on Sunday from the Global Times.



Within the negative news, bitcoin fought its way back up to about $34,000 on June 22, with the spot market currently trading a little bit below that range at $33,670 as of 1:19 pm ET on June 23.&nbsp;

Market Players: Excess Demand Dropped but Bitcoin’s Basis Trade Can Swing Back

<div id="highlights-block_60d0a7a1bcf27" class="highlights">
 <ul>
 <li>Institutional interest in digital assets is there, but there has to be more user-friendly infrastructure to get the next wave of institutions onboard</li>
 <li>After all, institutional investors are where the money is. LMAX Group&#8217;s 500 customers do nearly as much volume as Coinbase’s 2.8 million active users</li>
 </ul>
 
</div>



More and more institutions have gotten onboard with digital assets, but while early adopters have blazed a trail in order to get the next wave of investors on board trading crypto needs to look like any other commodity panelists on a recent Blockworks <a href="https://cms.blockworks.co/webinars/the-market-structure-special-flows-liquidity-and-arbitrage/" target="_blank" rel="noreferrer noopener">webinar</a> said.



In order to widen market access for institutions there needs to be better credit intermediation, David Mercer, the CEO of LMAX Group, which operates an institutionally-focused digital assets exchange, <a href="http://www.lmaxdigital.com/overview" target="_blank" rel="noreferrer noopener">LMAX Digital</a>, said during the session. Mercer laid out the ‘A,B,C’ of crypto, or, Access, Banking, Credit, which are the key factors institutions — as well as retail investors — consider when deploying capital to crypto. 



“There&#8217;s a lot of plumbing in capital markets. And the plumbing either is non-existent in crypto or it&#8217;s blocked,” Mercer said. “We’re going to need that B and C in the A-B-C to come into the market.”



Without these key pieces of infrastructure like banks and clearing houses, which are part and parcel of any other type of securities or commodities market, trading digital assets looks foreign and intimidating to many. Mercer gave an anecdote from one of his clients that wanted to dive into digital assets but was skeptical due to the learning curve involved.&nbsp;



“About three weeks ago a client said to me, ‘David, don’t talk to me about blockchain’. Don’t talk to me about wallets. Don’t talk to me about security and keys. I don’t care,” he said. “So, we’re going to need better credit intermediation for that.”&nbsp;&nbsp;



Of course there are plenty of institutions, like well known car companies and other funds, that have no problem acquiring their own digital assets and dealing with custody. They have the team in-house to deal with it.&nbsp;



“But there&#8217;s a lot of them that just want to follow their existing plumbing, their existing credit network. They don’t want to open up another credit relationship,” <a href="https://cms.blockworks.co/lmax-groups-david-mercer-banks-will-start-trading-digital-assets-this-year/" target="_blank" rel="noreferrer noopener">Mercer</a> said. “These banks and credit intermediaries will have to come in and [start onboarding digital assets].”



Because, according to Mercer, if you go to Wall Street right now and ask any private banker they will tell you that their customers are taking money out to trade on a crypto exchange or buy a crypto asset.&nbsp;



“They’ll want to provide that service to those clients. They own those clients today. If they don’t service those clients they might lose them forever,” he continued. “And they don’t want to do that because those relationships are valuable to them in equities, wealth management products, mortgages etcetera.”



All this isn’t to say that there’s not an interest. Mercer said that in 2017 he knocked on the doors of 34 banks to try and get them onboarded. At the time, they all said ‘Not now, David’, but this year alone 11 of the 34 are now taking market data, three are fully onboarded.



And what will it take to get the remaining 31 of the 34 onboarded?



Again, plumbing.&nbsp;&nbsp;



“Not only is there no plumbing that connects to the legacy financial system,” Michael Sonnenshein, the CEO of <a href="https://grayscale.com/" target="_blank" rel="noreferrer noopener">Grayscale</a> Investments, said “But the pipes aren’t even pointed in the right direction.”



But <a href="https://cms.blockworks.co/gone-crypto-why-sonnenshein-left-traditional-finance-to-lead-grayscale/" target="_blank" rel="noreferrer noopener">Sonnenshein</a> reminds us that it&#8217;s still early. And there’s a lot of work to do in order to get these pipes connected and the remaining 31 of Mercer’s prospective clients onboarded.



But this work is being done, and an ecosystem of tools is being developed, some of which Sonnenshen’s Grayscale is working on.&nbsp;



“It’s still early. We are excited to see this connectivity happen. It will draw in a lot more capital into the asset class, and it will draw in the incremental user and adopter of this ecosystem and asset class,” he said.&nbsp;



And all of this matters because LMAX Group traded 75 billion in crypto in May with just 500 customers. Imagine if it had 5,000.

Building the Plumbing for Institutional Capital Markets

<div id="highlights-block_60ac1ae069929" class="highlights">
 <ul>
 <li>The basis trade involves buying a commodity at spot (taking a long position) and simultaneously establishing a short position through derivatives like options or futures contracts</li>
 <li>In mature, liquid markets, practically every single trader, hedge fund, and associated high frequency trading algorithm constantly searches for basis trade opportunities and capitalizes on them</li>
 </ul>
 
</div>



Crypto markets have come a long way. Back in the days of <a href="https://en.wikipedia.org/wiki/Mt._Gox" target="_blank" rel="noreferrer noopener">Mt. Gox</a> being the biggest exchange, few with significant capital to put to work would ever have dared to dream of risking a single penny in bitcoin. And that’s assuming they even knew it existed.



Needless to say, things have changed quite a bit. The epic rise of bitcoin in 2017 &#8211; 2018 and the ICO mania that accompanied that rally brought crypto into the general public awareness for the first time.



The ensuing bear market or “crypto winter” then resulted in many losing all interest. It was a fun ride, but the party had ended. Crypto was a cool fad that had run its course.



A few keen market observers saw the potential this new asset class had, however. Some of them founded companies or built out new divisions of existing companies to serve market needs that would soon come to fruition.



In the first half of 2021, bitcoin and crypto markets find themselves at a crucial inflection point. With a market cap and liquidity that may have seemed unbelievable just a few years ago, crypto still pales in comparison to major capital markets. Liquidity is thin for big institutions, who also lack market access and often must expose themselves to significant credit risk just to dip their toes in the market.



Still, many are interested and some are already participating. Not only because of the appeal of the asset class itself, but due to trading opportunities that don’t exist elsewhere. Some have risk/reward ratios that are too attractive to ignore. Perhaps the most significant of these is what’s referred to as the basis trade in bitcoin.



<h3 class="wp-block-heading">The basis trade explained</h3>



The basis trade involves buying a commodity at spot (taking a long position) and simultaneously establishing a short position through derivatives like options or futures contracts. At some point, the two will converge, at which point a profit will be realized.



The risk is virtually zero, and the profit almost guaranteed.



Sounds too good to be true, right?



In a way, it is.



In mature, liquid markets, practically every single trader, hedge fund, and associated high frequency trading algorithm constantly searches for basis trade opportunities and capitalizes on them. That crowding narrows the spread between the spot and futures prices, reducing the profit potential that can be realized from this strategy.



Of course, crypto markets are not the most mature or liquid.



For more on the nature of the basis trade when it comes to crypto markets, we spoke with David Mercer, CEO of LMAX Group, which operates <a href="https://www.lmaxdigital.com/overview?utm_source=BWG&amp;utm_medium=link&amp;utm_content=overview&amp;utm_campaign=44317" target="_blank" rel="noreferrer noopener">LMAX Digital</a>, the number one institutional exchange for bitcoin in the world and the second-largest overall by volume. (LMAX Digital works with institutional clients only.)



“FX trades $7 trillion a day. The entire market cap of bitcoin is <a href="https://www.cnbc.com/2021/04/06/cryptocurrency-market-cap-tops-2-trillion-for-the-first-time.html">$1 trillion</a>,” noted Mercer.



The relative lack of liquidity and market access (more on that later) in crypto leads to a market condition known as “contango” when the futures price trades at a premium to spot. Mercer described it this way:



“Typically, bitcoin trades in what we call contango ­– the futures price is well above the spot price. In commodities markets, typically that’s because you have to store the asset, you have to deliver the asset, hence why the futures price is higher than the spot price, because you have all those fees to add onto the spot price…the opposite is backwardation, where the futures trade below the spot.”



However, the basis trade in crypto isn’t all it’s cracked up to be on paper. While Mercer noted that the futures price in bitcoin often trades at prices as much as 20% to 30% above spot, that doesn’t reflect the actual profit potential of the basis trade in bitcoin:



“A large proportion of that yield is actually eaten up by credit risk.”



<h3 class="wp-block-heading">Credit risk for banks</h3>



This brings us to the next point, which involves credit risk for banks dabbling in the bitcoin market.



Why is the futures price for bitcoin so high? This is a factor that could change soon, as big market players are expected to gain the access and liquidity they need in the near future. This will, of course, dampen the appeal of the basis trade in bitcoin.



“The futures price is satisfying the relentless demand for crypto exposure. There’s not enough fiat…it’s very hard to get the requisite amount of fiat into the system to buy the spot on a non-leveraged basis,” <a href="https://cms.blockworks.co/lmax-groups-david-mercer-banks-will-start-trading-digital-assets-this-year/" target="_blank" rel="noreferrer noopener">Mercer</a> noted.



In addition, the issue grows even more complicated by the use of stablecoins:



“A lot of the futures market isn’t fiat, it’s actually stablecoins…those stablecoins actually fragment dollar liquidity even more.”



This combination contributes to the dramatic and persistent condition of contango. As these factors change, so too could the spread between futures and spot.



<h3 class="wp-block-heading">Crypto markets grow up fast</h3>



While it has taken 12 years to get to the level of adoption we see today, current market inefficiencies could be stamped out in the near future. Mercer predicts that by 2023, the current contango in bitcoin will be much less pronounced:



“I expect the contango in bitcoin to compress in short order, between the next six and 24 months.”



While that’s generally considered a long time in the crypto world, it signals how rapidly the market has begun to mature. Consider the fact that just a year ago, few in the traditional investment community took bitcoin seriously. Its market cap was under $200 billion, while today that has risen to over $1 trillion.



Now we’re talking about the market approaching a level of liquidity and efficiency that, within the next few years, will rival its mainstream capital market competitors.



Mercer seems to have little doubt that bitcoin is well on its way to becoming accepted as a mainstream store of value or medium of exchange:



“As bitcoin becomes an accepted asset or currency, the market will become more efficient and more liquid.”



At that point, traders might look to other, less mature tokens to continue the basis trade in crypto.



“Perhaps that contango will move onto other tokens,” like Ethereum, for example, which is the second-largest crypto by market cap and also has a futures market as of early 2021.



The basis trade in bitcoin could be going away soon, and that’s a good sign for the market.



<h3 class="wp-block-heading">Providing market access</h3>



As the number one institutional exchange for bitcoin in the world, LMAX Digital has a key role to play in helping the bitcoin market grow. Institutions trade bitcoin using <a href="https://www.lmaxdigital.com/overview/?utm_source=BWG&amp;utm_medium=article&amp;utm_content=1&amp;utm_campaign=mar2021" target="_blank" rel="noreferrer noopener">LMAX Digital</a> because they know the platform and they trust the infrastructure. When asked how the exchange could serve customers looking to enter the market, Mercer said, “It’s trust and technology.”



There’s not much the exchange can’t do when it comes to crypto or markets in general, he said. “You name it, in terms of market access, we can provide it.”



While retail exchanges have a bad habit of crashing during times of peak market activity, LMAX Digital does not. “We haven’t had a down millisecond for seven years.”



Sometimes called the “best kept secret in crypto,” <a href="https://www.lmax.com/press-centre/lmax-digital-celebrates-third-anniversary" target="_blank" rel="noreferrer noopener">three-year-old</a> LMAX Digital provides an easy and reliable way for institutions to get the crypto exposure they crave. 



Today, LMAX has traded More than $400 billion of cryptocurrencies since launch in 2018 with 50 million trades completed in last year alone, and 450 institutional investors now trading on LMAX Digital globally.