Should traditional financial services providers offer cryptocurrency trading and related services?
...And if so, how could they go about it?
Before the background of the latest rallies across a wide spectrum of cryptocurrencies during the past months, most prominently the Bitcoin, executives from traditional banking institutions, financial intermediaries and institutional investors (hereinafter the Institutions) have frequently approached us to get clarity on the following three questions:
Should they also offer cryptocurrency trading to their clientele?
If so, how should they best go about their “pilot project”?
And if they choose a sourcing arrangement, what are acceptable terms?
In this article, I would like to share some of my learnings from previous client engagements. Hopefully, you find this insightful, while helping you to avoid some common pitfalls.
1. The strategic relevance of cryptocurrencies: Who are your target customers? And what do they want?
It is totally irrelevant whether one likes cryptocurrencies and, for instance, believes that the Bitcoin will be worth a gazillion dollars one day. Or whether one believes that this is all total nonsense, that cryptocurrencies should actually be banned from existence, and that they anyways have no fundamental value. The reality is:
Cryptocurrencies are in general likely here to stay, though they may need to evolve. And the reality is: An increasing number of people adopt them with each day passing, at least selectively. Now, that in itself does not make the cryptocurrency concept more or less valid, nor the underlying blockchain technology. But it makes this phenomenon rather sooner than later too big to ignore.
The rising number of early adopters thereby cuts across the traditional socio-demographic classification grid to not only include some nerds or rebellious millennials. They notably also include those segments of affluent and wealthy individuals, who have historically been the target buyer segments for traditional financial service offerings.
According to a recent Forbes article, Millennials accounted for “only” 57% of cryptocurrency buyers in 2020, while Gen-Xers represented roughly 30%. Digging deeper into cryptocurrency holdings, and referring to Figure 1, 27% of cryptocurrency positions were in the possession of Millennials, 21% by Gen-Xers, 7% Gen-Zers and 3% #Baby Boomers. It is thereby interesting to note that nearly 80% of investors are men with an average annual income of $130k, of which 70% have a Bachelor’s degree or higher (and 40% a Master’s degree or higher). So, this is by no means an uneducated bunch. Equally interesting, and looking for instance more closely into US statistics, 21% of all cryptocurrency holders call Bank of America their primary bank (in contrast to only 6% naming a digital bank their primary financial institution).
Put differently: Cryptocurrencies are not only reserved for those looking for digital-only offerings. There is something more profound in the making.
Figure 1: Population of cryptocurrency holders as of December 31st, 2020
But how big is the cryptocurrency market actually? According to a study conducted by Markets & Markets, the global cryptocurrency market was estimated to represent an annual value of a mere $1.03bln in 2019, though expected to grow a 6%+ CAGR into 2024. Now, that doesn’t sound particularly impressive. But how about this: By the end of January 2021, aggregate cryptocurrency market values have surpassed $1trln in countervalue (with Bitcoin representing the vast majority), placing them on the fifth place between the JPY and the INR amongst the biggest pools of money in circulation. Now, that’s quite a different ballpark figure, isn’t it!?
So, no wonder traditional Institutions have this potentially tectonic shift on their radar. And they should, because the resulting opportunities and threats are not only immanent (to the socio-demographic composition of their current customer books), but also permanent. Firstly, this is due to the ongoing demographic shifts in their own customer books, which the heirs of current clients will bring about. And secondly, the aforementioned early adopters will undoubtedly drag along also other socio-demographic segments, as we are getting past the tipping point. So, it might be reasonable for Institutions to evaluate the business opportunities and threats involved herein not only in light of the demand from existing customers, but also in light of (likely) changes to their customer books over time.
So, no wonder traditional Institutions have this potentially tectonic shift on their radar. And they should, because the resulting opportunities and threats are not only immanent (to the socio-demographic composition of their current customer books), but also permanent.
2. The benefits of including cryptocurrencies in investment portfolios
This does not mean that cryptocurrencies will necessarily establish themselves as the new form of payment. One reason is the lack of basic characteristics of money, most important of which the absence of price stability. This hampers cryptocurrencies’ function as a measure of count and as a means of exchange. Besides, it just takes time for market participants to rewire their mental frames and to fully adopt a new currency. Introduced in 1999 as the single currency of the European Monetary Union, the Euro is a good example. This ignores that governments rightfully do have an important say in this, which may alter the dynamics in either direction over time (e.g. CBDC).
But notwithstanding the aforementioned, cryptocurrencies possess particular risk/return characteristics, which actually make them desirable from a portfolio theoretical stance point. Many fellow scholars have already examined this, including Brière et al (2015), Eisl et al (2015), Hang (2016), Chuen et al (2017), Guesmi et al (2018) or Klein et al (2018); just to name a few. And their empirical findings seem to broadly support the hypothesis that the inclusion of cryptocurrencies in a portfolio context leads to superior risk-/return-combinations. That is: They enable higher levels of expected portfolio returns at equal portfolio-level risk, or lower levels of portfolio-level risk for any given level of expected portfolio return. Put differently: Cryptocurrencies create a diversification benefit.
Now, the perma-sceptics might still argue that the specific risk-/return-characteristics of cryptocurrencies do not automatically justify their inclusion in an investment portfolio, because of their supposed lack of fundamental value. The main argument is that the intrinsic value of cryptocurrencies cannot be determined by the means of traditional valuation methods. This argument is one-sided, as it would equally apply to any other risky asset type lacking cash flow characteristics. Another argument is that cryptocurrencies cannot be tied to an underlying economy, unlike fiat currencies. But even that is an ill-designed line of argumentation. There actually is a quantifiable economic rationale underpinning cryptocurrencies, quite the same way it is applicable to social networks. There are supplementary valuation challenges, though, such as the derivation of a reliable proxy for the value of network multiplier effects within the ecosystem, or the presence of distributed value capture across network participants. But that does not disprove the presence of an underlying economic rationale in the first place. So, it seems worthwhile to get over the quasi-religious argument pro / contra cryptocurrencies, and to recalibrate one’s focus on the underlying shift in investor and consumer preferences.
3. Beware of the complex and interdepend changes ahead, whilst staying pragmatic with your design choices
This is what an increasing number of Institutions is doing these days, as they eye on integrating cryptocurrency-related offerings into their existing suite of wealth management products and services. May that be the result of a wholehearted strategic decision (backed by solid demand from current and potential future customers). May it be the desperate search for countering the protracted margin erosion of the core product shelf. Or may it be an opportunistic attempt to enhance the institution’s “modern” brand perception, whilst trying to capture some attention as the buzz further unfolds. No matter the motivation, each Institution trying to break into this space will have to face some important questions.
On the one hand, there is a market infrastructure issue, given the high degree of fragmentation in terms of players and tradeable instruments. Due to limited or partly even missing regulation in some jurisdictions, an estimated 500+ crypto-exchanges have mushroomed around the world, offering trading in around 20k pairs across market segments. Thanks to numerous vendors, seeking to secure their part of the ever-growing revenue cake, it is fairly “easy” these days to launch an exchange on the back of out-of-the-box and white-labelable software solutions. This has led to a highly heterogeneous landscape of market actors, which vastly differ in terms maturity levels. Whilst the most reputable players continuously invest into their technologic infrastructures to assure orderly market operations at industry-grade levels of security, many smaller challengers are far less reliable. And this not only leaves traditional Institutions with the initial task to separate the wheat from the chaff, but also with the challenge to continuously navigate this ever-evolving marketplace.
But this is only part of the puzzle to solve, as there are many more relevant questions to be answered (see also Figure 2). In short: If an Institution indeed intends to embark with crypto-related offerings, it will have to establish a proper understanding of the resource and capability requirements all along the entire front-to-back value chain, and the different interdependencies, which such a decision inevitably brings about. And this will span across organizational, technologic, methodologic, procedural and human dimensions, encompassing in turn the governance, risk, commercial, operational and financial aspects of running such an offering. This can quickly become a complex undertaking, possibly necessitating the involvement of savvy third-party specialists.
Figure 2: Guiding questions to evaluate the organizational impact
To illustrate this in greater detail, Figure 3 provides a high-level outline of what the possible system landscape extensions / impacts good look like in case of a full integration. This implies that there is a preliminary design choice on behalf of Institutions: Should they immediately aim at a full technical integration, spanning across all corporate functions? Or should they rather opt for a more pragmatic manual or semi-manual integration type, which could evolve over time? Chances are that a pragmatic approach not only suffices, but that a full integration would be an overkill, whilst initially offering an unfavourable cost/benefit relationship.
Figure 3: Potential system landscape adjustments and impacts
4. Use sourcing to gain access to the relevant resources and capabilities, whilst favoring strategic alliances. But beware: Marry in haste, repent at leisure.
This leads us to another design choice: Should Institutions rather develop all the necessary resources and capabilities themselves? Or should they rather opt for procuring them. In order to guide such a make vs buy decision, Institutions should first assess the strategic relevance of the underlying activity and its ability to adversely affect the overall operational performance of the organization (see also Figure 4). For some, the cryptocurrency topic will simply not offer any strategic relevance / fit, so that they will stay away. Others in turn will not only have a solid cryptocurrency business case at hand, but also possess the necessary resources and capabilities to build the offering from the ground up themselves. For the remainder, this will just not be a viable and/or feasible option. Either, they currently lack a profitable investment case, the necessary experiences and skills to build such an offering in-house and/or it will take them simply too long to reach market readiness. Thankfully, they still have another option: Buying / sourcing the necessary resources and capabilities from specialist third parties like one of the many crypto brokers (hereinafter the Vendors). They not only offer trading-related services, but often also integrated service bundles, including custody / storage and other services.
Figure 4: The classic sourcing decision-making matrix and the top-10 benefits of strategic alliances
With one or multiple such Vendors, an Institution could form a strategic alliance, either directly or indirectly (for example via the Institution’s core-banking system provider, to the extent applicable). Strategic alliances are, however, distinctly different from classic purchaser / vendor relationships, and hence need another approach to their assessment and ongoing management. Not only will the partners have to jointly assure the maximum value is created and adequately captured by both sides, but also will they have to implement sound remedies to swiftly intervene when things get misaligned across strategic, relational, financial and/or operational fit dimensions.
Like normal procurement decisions, good practice involves sound ex-ante requirements engineering to efficiently guide the structured selection process, and to support informed decision-making. Ideally, this also involves interviewing the Vendor’s existing clients (including reference implementation demonstrations and an assessment of the Vendor’s project maturity). The aim is thus to look beyond cost and to properly assess the actual availability of the Vendor’s resources and capabilities (quantitatively, qualitatively and temporally), as well as their actual fit with the Institution’s baseline requirements. Given the particularities involved herein, another good practice might also be the implementation of a first explorative pilot project together. A pilot project is an initially small-scale implementation, which is used to prove the viability of an idea. This could concern the exploration of a novel idea or approach, or the application of best-practice standards novel to the involved parties. Pilot projects frequently serve as a preliminary step to clear subsequent procurement hurdles. They are however not trials, though (free) trials can be the best at-scale versions of a pilot projects, as showcased for instance by GitHub or Slack. This point is particularly important, as I am frequently coming across the following question: It is justified for the Vendor to charge for the pilot project? The short answer is: Yes, it is appropriate to price pilot project work, but it depends on the modalities.
Like any for-profit organization, Vendors have to constantly make allocation decisions with regard to their scarce resources, thereby evidently favouring their most profitable use. Frequently solicited by potentially interested buyers, who later on turn out to have simply been shopping around for knowledge or having failed to secure managerial buy-in and/or budget approvals for a potential procurement, vendors have to protect themselves against giving away knowledge and work for free. It is thus good top-to-bottom funnel management practice to price pilot projects. More important are usually however the applicable modalities.
Firstly, this concerns the distribution of project-related risks. That is: What determines the success of the project? And who bears the risk and cost in case of project failure? Not only is the traditional Fixed Price Model fairly inflexible with regard to potentially changing project baselines, which may be necessary to incorporate learning throughout the project lifecycle, but also does it fail to optimally align the involved parties’ interests. For this reason, some form of Incremental Time and Materials Price Model may be far better suited at times. Such an agreement could also include a cost floor / cap, or preferably even tied economic arrangements like target costing, in order to optimally align both parties’ interests. Such a contractual framework also ensures that both parties effectively take ownership in the project success, whilst allowing them to foster a collaborative and ongoing dialogue early on in the process.
Secondly, what will the follow-on business arrangement between the parties look like upon the successful completion of the project? This not only tightly relates to the previous discussion about the alignment of interests, but also extends into the concept of relative bargaining power. For this reason, Institutions should establish an educated understanding of the competitive landscape and the exact contractual terms, which will govern the potentially ongoing business relationship upon the successful completion of the pilot project. Such considerations should be reflected accordingly in the distribution of project cost. The same also holds true for the repartition of the use rights relating to the intellectual capital generated during the project. An agreement, which gives the Vendor the unencumbered right to use the intellectual capital for developing a quasi-identical solution also for other buyers, should logically be priced differently than an agreement, which will transfer all the intellectual property to the Institution for its exclusive use.
Finally, it is good practice to always clarify for the presence of value exchange, both tangible and intangible, when negotiating pilot project pricing. After all, both parties will invest substantial time and effort, while helping each other to advance through learnings and insights, which should be properly reflected in pricing. This also applies to the fact that the Institution will help the partnering Vendor to gain access to an enlarged (and possibly growing) end customer base. And since these end customers will have already been pre-vetted by the Institution in terms of their regulatory compliance, they represent lower onboarding efforts and compliance risks. This clearly has a monetary value. In recognition of the value brought to the table by both parties, a two-sided value-based approach to pricing may thus lead to far better outcomes than the traditional markup or market-oriented pricing. Besides, this also fosters the collaborative spirit, aligned around mutual benefits, which should govern such a strategic alliance. Otherwise, this can quickly turn into a fairly one-side affair, where one can only say: Marry in haste, repent in leisure.
In this article, I have briefly touched upon cryptocurrency trading and related services, and how traditional financial services providers could go about venturing into this space. I have thereby argued that traditional financial services providers should start thinking beyond established orthodoxies and consider more fundamental shifts in consumer preferences. The latest auction of Beeple's digital art non-fungible token (NFT) “Everydays: The first 5000 days” for $69M is just one example for that shift in the making. But despite all possible optimism about the latest crypto shopping spree, as exemplified by the latest price hike in Bitcoin, I have yet also warned traditional financial services providers from preemptively opting for a fully-fledged rollout. Instead, I suggest a more pragmatic approach to staging and pacing. Entering strategic alliances with one or multiple specialised players in the field is one notable option to that effect. To help to navigate this process, I have concluded on some common pitfalls, and how they could be addressed to really live up the spirit of the targeted partnership. Marc Woodfield is a Financial Services & Corporate Finance Professional and Management Consultant from Geneva, Switzerland. Follow Marc on Linkedin. This article was first published on Linkedin in March 2021.