From Nodes to New Asset Class - The Evolving Crypto-Financial Tech Stack

Takeaways:

1. The crypto-financial tech stack has reached a level of sophistication and professionalism that helps professional and institutional investors consider cryptocurrencies an investable asset class.
2. Trading and custody solutions for crypto assets mirror the general functionality of traditional capital market infrastructure, but present unique challenges.
3. Adding DeFi to the existing tech stack structure may prove difficult and lead to trade-offs between usability, decentralization, and market demand.

The Bitcoin Faucet was ingenious.

Launched by Gavin Andresen in 2010, the website gave away 5 BTC per day to every person who came along. The main purpose was simple: get as much bitcoin into the hands of as many different people as possible.

Today, the exchange of bitcoin and cryptocurrencies has exploded from a mere trickle to become a large global market.

But a widening crypto world brings with it both challenges and opportunities. Many early adopters of bitcoin and other cryptocurrencies had a keen interest in the technology, but the latest generation of investors is further removed from the fundamentals. They may have a strong belief in decentralization, but only a minority of them will ever run their own full-node or even have a mobile wallet.

They just want easy exposure to the upside of a nearly $3 trillion (and growing) market.

This evolution towards being a completely new asset class also has significant infrastructure implications. As markets become more sophisticated, that base-layer blockchain technology first outlined in the Bitcoin whitepaper is getting connected to other infrastructure which enables the increasingly complex financial products being built around crypto assets. From global spot trading venues with multi-billion dollar volumes to derivatives exchanges and exchange-traded products of various flavours, the tech implications of crypto’s move into the so-called “big leagues” are enormous.

It gives rise to several questions:

How is the current tech stack behind crypto financial services developing? What do investors require from the services they use to access crypto? How will DeFi get integrated into the current web of financial service solutions being built for crypto assets?

Perhaps most importantly, what does the evolving crypto-financial services tech stack mean for investors and users – both individual and institutional?

Trading – from peer-to-peer to financial marketplace

Since the infamous hack of the Mt. Gox exchange in 2013, the technology used to trade cryptocurrencies has been one of the main focus points of the fledgling crypto-financial services industry. At the time of its founding in 2010, Mt Gox seemed a godsend and ended up processing over 70% of all bitcoin transactions at the time of its failure.

But the theft of 850’000 BTC highlighted the technical fragility of a centralized exchange like Mt Gox. In essence, these trading venues take upon themselves most (if not all) of the tasks that are carried out by an array of providers in traditional markets: account handling, custody, order matching and execution as well as settlement and clearing.

Like traditional market infrastructure providers, centralized crypto exchanges rely on an order book and a high-speed matching engine to bring together buyers and sellers. These have improved in sophistication and execution power such that today the largest exchange worldwide, Binance, is purported to process more than USD 750 billion in trading volume.

But while the “integrated nature” of crypto exchanges such as Coinbase, Binance and Kraken allows for a relatively smooth user experience, the custodial nature (private keys of crypto assets are held by the exchange, not users) and the fact that assets are predominantly held in pooled custody with those of other clients, has made them targets – in more ways than one.

Centralized exchanges face the permanent threat of hacks. They can also come under pressure from high usage during peak trading times. And this has led to criticism – including strong words from Ethereum co-founder Vitalik Buterin, who famously said in 2018: “I definitely hope centralized exchanges burn in hell as much as possible.”

Lothar Cerjak is Head Trading and Brokerage at Bitcoin Suisse. He previously led the company’s Institutional Services and Products team and held various management positions at Credit Suisse.

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1. Are crypto markets becoming more and more like traditional markets, also on the technology side? Is this a good thing?

Generally, we can observe an increasing level of professionalism in the crypto trading industry. The infrastructure of crypto exchanges and liquidity providers has constantly been improving and this – combined with higher trading volumes from large trading institutions and increasing trading automation – has brought more efficiency to the markets, which is good. Nevertheless, due to the decentralized landscape and the high paced innovation of the industry, the crypto markets will likely not become as technologically synchronized as traditional markets.

2. Can we envision a future where centralized and decentralized crypto exchanges are more closely connected? Why or why not?

The biggest part of the market liquidity is currently available on centralized exchanges. However, the interest for decentralized finance applications and the capital deployed therein has increased exponentially over the last 18 months. It can also be observed that centralized exchanges are increasingly investing into building DeFi products and infrastructure. This indicates that a way is being paved for more interconnectivity between centralized and decentralized trading venues. Nonetheless, there is certainly more regulatory clarity required for DeFi applications to be fully embedded in the trading procedures of regulated brokerage entities. In addition, the increasingly important topic of scalability is expected to lower barriers to entry for decentralized exchanges by tackling the currently elevated transaction costs, hence making them available for a wider audience.

3. Can the integrated technology and offering of major crypto exchanges like Binance, Coinbase or Kraken really provide the best possibilities for people trading cryptos? Why or why not?

As the crypto exchanges are very diverse in terms of liquidity, domicile, regulatory status, technology infrastructure and client base it is highly recommended to operate through a broker and resilient partner such as Bitcoin Suisse, which is connected to multiple trading venues to ensure best execution for trades. When trading volatile assets in the crypto market it has proven to be a wise choice to not only rely on one exchange but to ‘trade smart’ – in other words letting a trading system source the best liquidity and conditions for trades with a ‘best execution’ service.

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One response to the weaknesses of centralized, custodial trading venues was the rise of decentralised exchanges (DEXes), of which Uniswap, Pancake Swap, and Curve are some of the more prominent examples. Here market participants can pool their assets to create liquidity and market-making is accomplished with the aid of a blockchain-based protocol and smart contracts. Fees can be automatically distributed to users who provide liquidity.

Proponents point out that decentralized exchanges adhere more to the original principles of blockchain technology with peer-to-peer trading, lending and borrowing taking place in a trustless way. In this sense, they represent a “return to the roots” of bitcoin as a peer-to-peer system.

While user experience was somewhat difficult in the beginning, DEXs have greatly improved over the past year and DEX volumes have continued to grow as have new innovations beyond simple swapping of assets. The introduction of Uniswap’s V3 – with more flexibility for the allocation of capital and a new fee structure – now opens up more possibilities, while other exchanges such as dydx offer decentralized options trading.

Despite these innovations in decentralization, centralized exchanges remain the dominant players for trading of crypto assets. New players such as FTX, which saw its market share grow dramatically since May 2020, are also getting in the game and indications are that the space could expand even more with fintech giant Revolut purportedly aiming to build its own exchange.

With so many to choose from, the market infrastructure for crypto assets remains relatively fragmented and the proliferation of DEXes adds to this challenge. With liquidity spread across different venues, price differences may appear and traders lose out.

However, a number of companies, such as CoinRoutes and AlgoTrader have already developed sophisticated smart order routing services which help connect the order books of centralized exchanges to avoid single-exchange lock-in. The same is also happening on the decentralized side of the trading space, with DEX aggregators, such as 1Inch.Exchange, ParaSwap and Tokenion growing in popularity.

These services help bridge the broad global market and even enable best-execution services to allow large trades without affecting price in a negative way.

Crypto custody – how to hodl

The custody of crypto assets has also experienced a significant evolution since the early days of the Bitcoin Faucet. And here again, there is evidence to indicate that the industry is developing strong infrastructure worthy of a new global asset class.

While the basis of crypto custody is simple – hold the private key safely and securely – the technology used to do so may vary, and does, depending on user needs. Paper wallets and rudimentary desktop wallet applications may have offered the power of personal control for early crypto holders, but they do not meet the requirements of institutional investors with billions in crypto assets to safeguard.

Crypto custody as part of the trading process is especially important. Pooled custody of client assets on exchanges has sometimes exposed them to hacks, which according to certain estimates reached an average of $2.7 million per day in 2017 and 2018. While most blockchain protocols themselves have remained secure, the 2nd and 3rd layers of the technology stack used to administer crypto exchange infrastructure, client data and the keys of so-called “hot” (online) wallets can often be vulnerable.

For this reason, crypto-financial service providers were quick to start developing more secure solutions. Starting with the hand-held Trezor wallet, cold (offline) storage of cryptocurrencies moved into more sophisticated systems. Some employ Hardware Security Module (HSM)-based systems, while others use Multi-Party Computation (MPC) to make sure private keys do not need to be physically stored in their entirety nor are revealed to potentially malicious parties.

This suits the needs of institutional investors much better – for several reasons. First, such systems are designed with multiple layers of security and the technology used to keep private keys from being exposed, for instance HSMs, has been battle-tested for other use cases beyond cryptocurrencies. Second of all, there is the possibility to engage multiple persons in the process of transferring assets, something that is often necessary in financial institutions where multiple approvals or levels of oversight are needed. And thirdly, these systems can be audited to ensure their quality and integrity – a key requirement for banks, asset managers and other professional organizations.

Markus Perdrizat is Head Product Management and Custody at Bitcoin Suisse. He was previously leading PwC’s Blockchain Competence Center and worked as Global Oracle Engineering Lead at UBS.

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1. Custody of crypto assets is getting more and more sophisticated – is it also getting more secure, actually? Why or why not?

Since the beginning of crypto assets, custody has been a high-risk business. We’ve all heard stories of people whose assets were stolen, or who lost the private keys required to unlock the digital assets. Billions have been lost that way. However, we established a new level of custody security when we were one of the first custodians to offer HSM-based enterprise custody in February 2018 with the Bitcoin Suisse Vault. Since then, the situation has improved quite a bit for assets that are stored with professional custodians.

2. How do you see the integration of hyper-secure storage and more “active” crypto-financial services like trading and staking? Can you give an example of how this works?

You know, Bitcoin and crypto was a case for early adopters who just believed that Bitcoin will have more value in the future, for a variety of very good reasons. In the meantime, we see thousands if not millions of developers building decentralized financial applications on blockchains that mimic all the functions of the traditional financial services world. With this has come the expectation that also crypto capital needs to earn a yield. Your money needs to work for you, just like in the traditional world. Let’s take the case of staking, which is actually similar to giving somebody a credit and getting it back with interest. Except that with blockchain and staking, you lock up your crypto capital to increase the transaction security of the network, and the network pays a handsome reward for that.

3. Why is it important for banks and other financial institutions to get started with custody of digital assets now?

Digital assets have reached a market size that it’s clear they can’t be ignored. At the same time, crypto technology has reached a level of stability and maturity that make it possible for even a relatively conservative financial institution to start working with crypto companies. Bitcoin Suisse started developing our technology stack 8 years ago, and we now have 100 people working on information technology. Custody allows a bank to establish the required capabilities to deal with digital assets from a regulatory and cyber risk perspective and get more familiar with digital assets before adding more complicated products to the mix.

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With increasing demand among more sophisticated investors and institutions, a growing number of players have developed their own systems for integrated digital asset custody. The world’s largest custody bank BNY Mellon has invested heavily in adding crypto asset support over the last year, with the stated aim of building a custody system at the same level as it uses for the more than $40 trillion in traditional assets it currently has under custody. The latest edition of PwC’s Crypto Hedge Fund report also highlights the fact that crypto funds are moving towards closer integration of custody solutions within their own infrastructure.

One area that may drive demand for high-quality crypto custody services – and force even more development of the crypto-financial tech stack – is the trend towards holding bitcoin and other crypto assets in companies’ corporate treasuries. With strong advocates such as MicroStrategy and Square, which both have bitcoin on their balance sheet, the trend continues to gain attention, especially as inflation and low-interest rates persist.

Staking – towards crypto-native financial services

The new frontier of the crypto-financial tech stack begins with the addition of support for services that are native to blockchain-based assets. One of these is staking.

Early interest in popular proof-of-stake blockchains such as Tezos and Cosmos gave rise to services allowing crypto asset holders to earn staking rewards without the need to operate staking nodes or maintain infrastructure. This was a boon for the first wave of non-technically oriented investors in crypto assets.

The launch of Polkadot (and previously its canary network Kusama) as well as the Beacon Chain of Ethereum 2 in 2020 accelerated the interest in participating in proof-of-stake blockchain networks. This has translated into a current market capitalization (at time of writing) of all major staking currencies valued at nearly $500 billion and the total value staked reaching approximately $380 billion.

Several major exchanges such as Binance, Kraken and Coinbase have built staking services into their client offering. Bitcoin Suisse also offers an integrated service, which connects trading accounts directly with staking accounts.

Michael Gauckler is Head Product Development at Bitcoin Suisse and holds a Master’s in engineering from ETH Zürich and a Master’s in finance from the University of Zürich.

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1. What are the main technical challenges for people who want to stake on proof-of-stake blockchain networks?

Proof-of-stake puts your stakes at risk if you are not an honest and reliable validator in the blockchain network. It’s easy to decide to be an honest validator, which means that you don’t intend to attack or cheat the blockchain. However, there are technical challenges in being a reliable validator: you need to be up to date, i.e., running the right validator software, you need to show up, i.e., have a very high uptime and you need to know what to do when things get shaky, i.e., react quickly and correctly in case of network instabilities or similar events. So, the technical discipline of running validators is the combination of data centre operations combined with deep insights and links into the technology and community of staking projects.

2. Does the industry trend from proof-of-work to proof-of-stake blockchains bring advantages in all aspects or are there any arguments which might limit this trend?

The trend towards proof-of-stake blockchains will certainly continue and lead to a range of blockchains with slightly different designs, strengths and resulting use cases. These range from Decentralized Finance to the Internet of Things and other applications.

The one exception which will likely not follow the trend is Bitcoin. The main argument is its stability, which can be derived from the simplicity of the proof-of-work algorithm in combination with a track record of more than 13 years. Proof-of-stake blockchains are more complex to design and therefore it is harder to assess their stability under extreme conditions or edge cases such as a strong concentration of assets with a few owners.

My expectation is that overall, this trend will continue with this one exception.

3. Do you think that banks and traditional financial institutions may eventually set up their own staking services? Why or why not?

I very much expect that banks and traditional financial institutions will eventually offer staking services. It could even happen in an integrated way that is almost invisible to the clients – like cash accounts which, in some countries, are implicit money markets, i.e., interest bearing accounts. Incentive-wise it’s a give and take: the ones holding a currency should use it to secure the network and are incentivized to do so through resulting rewards. The institutions operating the blockchain systems get a service fee which is deducted from the reward. It’s all about the balancing of incentives and those protocols and institutions striking the right balance will succeed and grow.

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But whereas trading and custody of crypto assets closely mirror the operations of traditional markets, staking services present new challenges. Assets are staked and locked (making them unavailable for trading) for different periods of time, depending on the protocol. Rewards may be distributed at different rates and correct handling of validators and staked assets is essential to maximizing rewards.

In short – this level of the crypto-financial services tech stack requires a significantly higher level of technical acumen and more thought-through processes.

The building of an integrated tech stack that includes staking services also resurfaces the topic of custody. Staking services may be both custodial (private keys are held by the service provider) and non-custodial (keys held by the user/customer). Many large staking service providers, especially crypto exchanges and brokers such as Bitcoin Suisse and Kraken operate custodial staking services. On the one hand, this approach streamlines customer experience and removes a technical burden from clients. On the other hand, it requires a significant level of trust in the professionalism and know-how of the service.

In this sense, the link between custody and staking – along with many other emerging crypto-native financial services – is a key linchpin in the growing technical stack of crypto-finance. It is also likely to evolve quickly as new proof-of-stake blockchain networks ‘go live’ and demand for staking services grow.

The combination of highly secure custody services and crypto tech know-how has made it possible for institutions to begin exploring the potential of staking for their clients. ConsenSys’s CodeFi staking service is one offering specifically aimed at larger firms. Multiple banks, including some based in Switzerland, have launched staking products for their clients. In the current low-interest-rate environment, being able to earn returns of 6, 10 or even 13 percent on crypto assets is extremely attractive.

The full(er) crypto stack – future prospects

Since the days of the Bitcoin Faucet, technical infrastructure and tooling for crypto assets has developed significantly. Professional custodians for secure storage, multi-exchange brokerage system for best execution trading and increasingly easy-to-use staking services- the crypto-financial tech stack has never been more robust – and also diverse.

As a result, more professional investors are comfortable thinking of cryptocurrencies as a new, investable asset class. With strong tech and professional providers in place, exchange-traded products (ETPs) and exchange-traded funds (ETFs) are being launched at a rapid rate, with assets in such products tripling to over $9 billion by some reports.

Across the global landscape, tools and systems to support crypto asset markets are becoming more integrated and user-friendly. It is now possible for both private clients and institutions to access prime brokerage services, control assets from secure, cold storage and even stake those assets and earn rewards, all through a clean, easily manageable interface.

Re-staking of crypto assets, one-click bonding and un-bonding and even tokenization of locked staking coins to enable trading are all examples of how a full-stack approach is benefiting clients and bringing crypto, at least from an accessibility point-of-view, to the level of more well-known asset classes.

But crypto tech is not slowing down. The explosion in decentralized finance (DeFi), with more than $100 billion now in Total Value Locked (TVL), has brought with it many more opportunities. Most of these, such as yield farming, lending and even decentralized payments are inherently crypto-native and unique to the blockchain world. This will challenge the tech stack of crypto-financial service providers even further.

To meet the next wave of innovation, more tools and tech will need to be built. Some already are, with popular retail wallet MetaMask having recently launched an institutional version to offer wider access to DeFi and decentralized applications (dApps). Others, like decentralized lending protocol Aave have announced enterprise-focused versions of their platform. This may lead to more access to decentralized finance protocols and the activity taking place on them, but it may also lead to the packaging of DeFi into more traditional-like structures and eventually compromising on decentralization.

In the end, the flow of innovation in crypto-financial technology continues as strongly as ever, and the tech stack continues to grow, challenging some norms, while also adhering to others.

For many new investors, it may be just as easy to get into bitcoin and crypto today as it was to take BTC from the Bitcoin Faucet – which is a good thing. Those who wait for the ideal user experience or institutional services, however, may just miss out on some early trends like DeFi (or whatever comes next) while the tech stack catches up.