Receive free Cryptocurrencies updates
We’ll send you a myFT Daily Digest email rounding up the latest Cryptocurrencies news every morning.
Traditional investors such as pension funds are providing the financing to a broker that is helping hedge funds take bigger bets on volatile cryptocurrency assets.
Retirement plans including that of US defence contractor Lockheed Martin are among the backers of crypto prime broker Hidden Road, according to people with knowledge of the matter, providing the financing that in traditional markets typically comes from banks.
London-based Hidden Road, which last year raised a $50mn equity investment from Ken Griffin’s Citadel Securities and exchange Coinbase among others, has emerged as a crucial player in bridging the gap between traditional investors and digital assets. The group also serves as a potential lifeline for the crypto market, which is facing a deep squeeze on leverage and dwindling trading activity after a series of scandals, including the collapse of exchange FTX.
Prime brokerage is a common way for traders in mature markets such as stocks to get leverage, as a way of juicing their bets. Traditional prime brokers typically sit within Wall Street banks and use the lenders’ vast balance sheets to extend credit to hedge funds, family offices and high-speed traders.
If a hedge fund borrowing money from the prime broker suffers large losses on its investments, then the prime broker or its investors can be left footing the bill.
“It is a very risky investment to make,” said Andrew Urquhart, professor of finance and financial technology at Henley Business School, adding: “If my pension fund said we’re going to get into crypto, I’d be very worried about that.”
Cyrus Pocha, partner at Freshfields, said raising finance from outside investors is not a typical set-up. A prime broker operating in this way may mean “they don’t have a proprietary interest in the repayment”, he added.
Hidden Road declined to comment.
Crypto markets have faced a bruising year following the collapse of exchange FTX and a series of US enforcement actions against Coinbase and Binance. Spot crypto trading volumes have more than halved — dropping to $515bn in July, compared with $1.2tn in the same period a year ago, according to CCdata.
The move by Lockheed Martin’s plan and others marks the latest venture into crypto by pension funds, many of which are seeking ways to improve their own returns. Lockheed Martin declined to comment.
However, a number have been burnt, highlighting the risks of digital assets markets. Canada’s $190bn Ontario Teachers’ Pension Plan and $300bn CDPQ lost their investments in crypto exchange FTX and lender Celsius, respectively.
A person familiar with Hidden Road’s thinking said the company sees itself more similar to a private equity or investment firm that raises outside capital to fund activities, rather than like a bank prime broker.
Founded in 2018 by Marc Asch, who worked previously at Steven Cohen’s hedge funds SAC Capital and Point72, the company is named after the Massachusetts street where he grew up. Hidden Road began as a foreign exchange prime brokerage before expanding into digital assets.
Large market makers including Flow Traders and Virtu Financial already use Hidden Road, which has secured regulatory licences from countries including the UK, Netherlands and Singapore. Its crypto services are not offered to US investors.
Hidden Road also does not trade any assets itself, easing worries about potential conflicts of interest in having one company act simultaneously as an exchange, broker and trader. Venues including Coinbase and Gemini offer prime broking — raising these concerns.
Prime brokerage is an inherently risky business, even for the biggest banks. Credit Suisse took a $5.5bn loss on its balance sheet after the collapse of family office Archegos — a hole that contributed to the bank’s eventual demise.
“It’s a very tough business,” said Harry Jho, founder of law firm Harry Jho LLC, which specialises in prime brokerage, adding that “if you’re providing full financing, you have to be able to assess the credit risk”.
One investor who met Hidden Road described it as “prime broking on steroids” and said there were risks of relying on someone else’s capital.
Some executives also worry about Hidden Road’s size. Its balance sheet is in the hundreds of millions rather than billions of dollars that banks typically have, according to people familiar with the matter. While Hidden Road would be on the hook for any losses, some fear its balance sheet would not withstand a large market event, and the investors providing capital may need to stump up more at short notice.
“I have to look at it from an arm’s length distance to be comfortable. They’re intermediating credit with a pretty thinly capitalised balance sheet,” said the head of one crypto exchange, adding: “To be taken seriously they need to have a significant degree more balance sheet behind them.”
Recommended
To protect itself Hidden Road charges an “exchange risk spread” to protect against the potential failure of a venue. Customers who paid this and traded on FTX through Hidden Road were made whole when the exchange collapsed, people with knowledge of the matter said. Customers say its due diligence is stringent. “They put us through the wringer,” said the head of one market maker.
But the crypto industry has learned the hard way that prime broking can be a precarious service. In the last year Digital Currency Group’s Tradeblock closed while the lending unit of Genesis, another prime broker, filed for bankruptcy.
“It’s completely empty, the whole [crypto] prime brokerage, institutional broking space is wide open,” said Gautam Chhugani, senior analyst of global digital assets at Bernstein.
However, he said the volatility of bitcoin and other tokens makes it a particularly tough asset to manage. Others “have attempted the prime broking models in different ways and some blew up”.
Be the first to comment