Crypto hedge funds seek Wall Street-style segmentation following FTX’s fall

Cryptocurrency hedge funds got burned in FTX’s bankruptcy and are now looking into bringing the financial segmentation that made Wall Street more stable.

FTX used to be a popular venue among professional traders and institutions, resulting in great losses once the liquidity problems of the platform have surfaced. Now those institutional customers are looking for a system that would give them more safety — something that is usual when trading stocks, but would be unusual in the crypto world.

Institutional investors are forced to directly deposit their collateral on the trading platform. This puts them at significantly more risk compared to using a trusted third party that acts as an escrow. If the platform goes bankrupt, the escrow remains secure.

Nickel Digital Asset Management had a partly-insured 6% exposure to FTX, the firm’s portfolio manager David Fauchier told Bloomberg during a Nov. 30 interview that “the era of posting collateral to offshore exchanges is over.” He explained that the firm’s conduct radically changed after its experience with FTX:

“We’re refusing to post collateral directly to almost all venues, meaning we can’t trade there despite a great opportunity set, which is super frustrating. We’re hammering them every day to implement some form of off-exchange settlement solution.”

Fauchier said that FTX may have finally brought some momentum for the implementation of Wall Street-like collateral systems on crypto trading platforms. Copper Technologies — a company that provides such as service in the crypto space — told Bloomberg that none of the top five crypto trading platforms are integrated into its system.

FTX had signed up to integrate Copper’s institution-friendly collateral service, but then failed to ever implement it. Still, now the company anticipates that it will be able to announced more exchange integration in the coming months. Copper head of research Fadi Aboualfa said:

“Asset manager and market makers are demanding integration of the solution as they will no longer be able to lure in investors regardless of promised returns if they park assets on any exchange.”

What observers from traditional finance fail to notice and point out is that the digital-native nature of cryptocurrencies will allow those systems to develop far beyond what we see in Wall Street today. While reassured by large and old trusted institutions, traditional financial institutions cannot directly check the balances of the accounts where their assets are being kept — they have to trust that those assets are indeed there.

With cryptocurrencies — on the other hand — checking if the assets you deposited at a third—party custodian were moved or not would be trivial. Even better, a simple two-out-of-three multi-signature wallet would be enough to ensure that the asset could not be transferred without the consensus of one counterparty and the third-party custodian, eliminating a good portion of the trust that is needed in the traditional counterpart to such arrangements.