Crypto exchanges have to combine technological innovation with regulatory compliance to attract institutional investors
As the cryptocurrency market expanded dramatically in the past year, institutional investment has become the elusive white whale of the crypto space, potentially capable of transforming the entire industry. However, a number of conditions have to be met before that becomes possible – namely, a clear regulatory framework and platforms that take steps to comply with those regulations.
The Legolas exchange, founded in France and based in New York, is launching a specialized platform for institutional investment, LGO Markets. The new platform aims to combine aspects of traditional financial exchanges with security innovations that Blockchain technology can provide. CryptoComes spoke with Hugo Renaudin, CEO of LGO Markets, about the prospects and implications of institutional investment in the cryptocurrency market.
Crypto regulations and attitudes in France
Katya Michaels: Different countries are in very different places right now in terms of cryptocurrency regulations. Where does France fit on a scale between a crypto-friendly environment like Malta on one end, and the US on the other?
Hugo Renaudin: I would say France sits in the middle. The framework for ICOs is pretty smart now – there is a license that you get. If you are a startup and you don’t have that license, you are forced to communicate that to the buyer.
What’s difficult when you have a crypto business is to have a bank that supports your operations and allows you to sell cryptocurrency to fund your account. For various reasons, a lot of banks are a bit cautious about that, and the regulator which is regulating the banks is not the same as the regulator that’s regulating the ICOs. Everyone is not on the same level, but still I think the regulating bodies are pretty open to innovation in this space.
KM: In terms of the general attitude from the government, the academia and the entrepreneurial community, is there a lot of enthusiasm for cryptocurrency in France?
HR: The government is definitely business friendly, but France is not a country with the highest adoption rate when it comes to technology. Even though we have a lot of entrepreneurs, French people tend to be a bit cautious. A lot of people are definitely looking at it.
We have a high level of scientific culture in France, a high scientific awareness. People look at projects in a very technical way and there is a lot of criticism for those that raise a lot of money while not being at the proper technical level.
However, the French community is enthusiastic about entrepreneurship in general, and the cryptocurrency and Blockchain space in particular.
KM: What is most different or most surprising for you in the US fintech system as compared to France?
HR: The first thing is the scale of the American financial system is so much bigger than the French one. Something that’s not surprising, but different in the US, is the strength of the SEC. The AMF (l’Autorité des Marchés Financiers) is by no means as strong as the American regulator. The SEC is super powerful and it’s super important to be very compliant with them.
There are more different types of actors here – small businesses and financial companies, more small firms, small brokers, small banks. There’s a multiplicity of actors in the financial world in New York – less of that in France, just because the market is smaller.
Another thing is that traditionally the financial industry in the US is more open to adopting new technologies such as cryptocurrency. The financial markets for Bitcoin are likely to happen first in the US and only then in France.
Specifics of institutional investment
KM: You’ve said that LGO Markets is a next generation crypto exchange – what does that mean? What does it introduce that hasn’t been done before?
HR: We are not reinventing the wheel here. If you look at the cryptocurrency exchange ecosystem, it’s done in a very strange way. The architectures of a cryptocurrency exchange and a traditional exchange, like the NASDAQ or New York Stock Exchange, are very different.
Crypto exchanges like Gemini, Coinbase, Kraken, and Bitfinex have millions of users, millions of direct connections. This means a huge risk in terms of security, huge problems in terms of KYC and AML, and in terms of custody it makes it impossible to segregate the funds.
These exchanges have all the funds aggregated in one big bank account that belongs to the exchange.
Effectively, cryptocurrency exchanges are not only exchanges, but also custodians. This doesn’t make any sense from a traditional financial perspective.
Exchanges should not handle the custody risk on behalf of their clients, and clients should not trust exchanges to hold their funds.
When you look at how the NASDAQ stock exchange is structured, they have a lot fewer clients, maybe hundreds or thousands, not millions. These clients are all institutional – brokers, market makers, funds. They are all regulated. They have their own clients as well, but there are very few direct connections to the exchange.
Because of that there is less security and KYC/AML risk. You can open what’s called a brokerage account, which belongs to the client and allows them to trade on the exchange. That’s the setup in the traditional exchange space. Exchanges are not custodians in the stock and equity world.
We take this architecture, which exists in the traditional financial markets, and we apply it to the cryptocurrency asset class.
As I said, we are not reinventing the wheel, we are just taking the same old model that works very well in the equity world and applying it to the cryptocurrency space.
The architecture is not an innovation per se, but the way we handle custody is. We do not store cryptocurrency for our client. Instead, we designed a client wallet that can be thought of as a brokerage wallet. If you hold Bitcoins in your personal wallet, you can send those to the brokerage wallet and use them to trade.
In terms of technology, it’s a two out of three multi-signature wallet. That means there are three keys that exist, and you need two of these keys to initiate transactions. That itself is unusual and something that exists on our exchange only. In terms of custody, we are the only exchange that allows our client to hold their Bitcoin.
Another innovation is on the price discovery. When we built LGO, there was a lot of media coverage about cryptocurrency exchanges manipulating the price. Many people believed that they had been front-run by exchanges, that the price had been manipulated and that they lost money because of it.
We use Blockchain technology to actually prove that we do not manipulate the market. We get orders from our clients, send those orders to a Blockchain, wait for it to be validated, retrieve it, feed it into our system and then we trade.
Our clients can check that their order has not been erased, has not been front-run, has not been manipulated. We guarantee the transparency of the price on our exchange.
Evolution of cryptocurrency exchanges
KM: Many crypto exchanges are striving to become part of the established financial system However, as they become institutionalized, do you think that crypto exchanges as a form will still have a rationale to exist?
HR: It’s a very interesting question. We see cryptocurrencies as a financial asset and we treat them as securities in our operations. It’s all about processes and technology. I think that cryptocurrency exchanges that exist right now don’t have the architecture which is fit for the institutional world. Those will likely disappear or stay at the retail level. That’s not to say that crypto exchanges which are geared toward the institutional investor, like ours, will disappear.
Holding cryptocurrencies is not the same as holding securities – there are technological issues which can be a barrier to entry for traditional stock exchanges. You have to marry both worlds.
KM: What are some of the specific features that institutional investors are looking for in a crypto exchange as opposed to retail?
HR: First of all regulation, so that institutional investors can trust the exchange. The second thing is custody. As an institutional investor, you are managing your clients’ money and you are required to prove that you are managing the risk of how you store money. This custody aspect, the way the funds are stored, is super important for institutional investors. Price transparency is essential as well, because you need to show your clients that you are giving the best price.
KM: What are the implications of institutional investment for the market?
Institutional investment will tremendously increase the market capitalization of the whole asset class with additional inflows. It’s going to change the volatility because there will be less panic trading.
With professional trading, there is strategy and it is more rational. So, I also think that all the bad assets, the bad coins, those that have no rationale behind them, those that are scams – will get sorted out eventually.
The future of crypto investment: lessons learned
KM: Some ICOs like Tezos, though backed by real technology, can face post-ICO issues with internal conflicts. Do you think this is a typical conflict that we are likely to see a lot?
HR: I think the Tezos conflict is not going to happen again. First of all, the setup of the ICO with the Swiss foundation was crazy. You don’t need to do that anymore – you can do an ICO in France, or in other countries. In terms of the structure of the ICOs and the legal context, it’s getting more rationalized now, although it doesn’t solve the issue of governance in the crypto space.
You have to think of it as Internet 1996-97.
The industry is not where it can be yet. There have been a lot of bad projects, there will be a lot of bad projects. The question is what we learn from the mistakes.
With Tezos we learned that the setup was absolutely crazy and a tech company doesn’t need that much money.
These are healthy problems because in a way they allow you to cure the whole ecosystem Those are mistakes that will never be made again.
KM: Given what you’re working on, you must believe that clarifying regulation and compliance is a necessary step forward for the cryptocurrency space. In general, what conditions in a country ensure that it can stay on the forefront of innovation?
HR: The most important thing is to give a clear definition of what cryptocurrency is and create a regulatory framework. It’s very difficult for institutional investors to buy Bitcoin or any other cryptocurrency for this simple reason – they don’t know in which regulatory “box” it belongs.
It’s about being smart – allowing new actors and favoring them to enter the market, punishing bad actors, helping good actors to build their product and ease their regulatory burden. There is a lot of value to be made in the space, in terms of jobs, in terms of wealth creation for individuals and society as a whole.
It’s tough because sometimes regulators don’t fully grasp the whole technological aspect. They often stop at the fact that it was used on the dark web, used for money laundering.
KM: Sometimes it’s difficult from the other side as well, because in the crypto community there is a feeling that it was created to be regulation free.
HR: Sure, but if you want Bitcoin to have an economic reality, you need to be pragmatic about it and you need to somehow let the regulators find a good framework. Because if Bitcoin is only going to be used on the dark web and things like that, it will never be a reality. If you want Bitcoin to be widely used, then you need to validate it with countries and legal authorities.