An intro to crypto exchanges, custodians and brokers

Trader Talk

Any responsible financial advisor is well-informed on the inner workings of traditional finance, namely the exchanges, brokers and custodians that play critical roles in their day-to-day business operations. The same should be true when it comes to cryptoassets.

Within the scope of the crypto ecosystem, these entities serve the same general functions — facilitating the buying, selling, settlement and safekeeping of cryptoassets. However, there are several important nuances advisors should be aware of so they can provide clients with prudent advice as they navigate this emerging asset class. The biggest distinguishing features are below:

Crypto exchanges
On a typical exchange such as the NYSE or NASDAQ, it’s not possible to directly exchange a share of Tesla stock for a share of Netflix stock. Instead, you have to first liquidate a position before using that fiat to purchase shares of another company. Crypto exchanges, however, allow investors to purchase crypto using fiat money, as well as trade various coins and tokens in exchange for one another directly.

According to CoinMarketCap, there are 430 different crypto exchanges in existence as I am write this. There are two overarching types of crypto exchanges: centralized and decentralized.

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The majority of crypto trading happens on centralized exchanges (CEXs) such as Gemini and Coinbase, which mimic the format of traditional brokerage platforms. When investors purchase cryptoassets on a CEX, the exchange maintains possession of users’ private keys, thus maintaining possession of the asset itself. This is where the saying, “Not your keys, not your coins,” comes from.

While many retail investors opt for the convenience of CEXs, the crypto community has invented decentralized exchanges (DEXs) in response to the many risks that their centralized counterparts pose (susceptibility to hackers and lack of sovereignty, to name a couple). DEXs are peer-to-peer services that allow direct transactions online between two interested parties.

DEXs such as Uniswap or SushiSwap utilize an automated market-making algorithm, rather than a traditional book of individual buy and sell orders, allowing participants to execute trades without involvement of middlemen. Users can pool two assets that are then traded against each other; the asset’s price is simply determined based on the ratio between the two. DEXs are noncustodial, meaning that a DEX never takes possession of a user’s cryptoassets.

Crypto custodians 
As discussed in my last piece, crypto investors have a variety of storage methods to choose from, whether they be online (hot storage) or offline (cold storage), or self custodied versus using a crypto custodian. Contrary to popular belief, there are custodians in the crypto space, such as Paxos and Anchorage, that meet traditional qualified custodian requirements. The aforementioned firms are in possession of a bank charter from the federal government. In addition, the SEC has deemed state-chartered custodians such as Coinbase as meeting the qualified custody standards.

In short, when it comes to selecting a crypto custodian, advisors have the option to choose from a plethora of state-chartered custodians and qualified custodians, but should be well educated before making their choices.

But wait … there’s more
Cryptoasset custodians often also act as exchanges, unlike traditional custodians and exchanges, which are separate entities. In fact, a large number of firms offer users the ability to buy and sell cryptoassets, as well as offer custody options for their customers. Note that there are exchanges in the crypto space such as CME Group that also operate as brokers, and a smaller subgroup that simultaneously operate as exchanges, custodians and brokers. Yes, you read that correctly — a select number of players in the crypto space simultaneously operate as custodians, brokers and exchanges (most notably Coinbase, Gemini, Kraken and Binance).

Several familiar names are dipping their toes into the cryptoasset space, and advisors will want to keep an eye on them moving forward. Charles Schwab and TD Ameritrade are crypto brokers (and custodians) that offer exposure by way of futures contracts, trusts or blockchain and cryptocurrency-related equities; these brokers do not offer direct access to buy or sell bitcoin, ether or other cryptoassets. Firms operating within the futures market are subject to Commodity Futures Trading Commission oversight. Interactive Brokers also offers exposure by way of futures but has partnered with Paxos to offer users direct access to spot crypto markets as well; those who want direct access to cryptoassets must do so via an exchange.

As brokers and advisors should advise their clients, there are a number of factors to consider before investing in cryptoassets, and that certainly holds true for trying to get cryptoasset exposure through means such as these aforementioned futures contracts, trusts, cryptocurrency-related equities or exchange-traded funds. All of the pros and cons of each investment option should be considered before making an investment.

Clients choose to work with a financial advisor for a variety of reasons, one of those undoubtedly being their expertise on markets and recent developments within the investment ecosystem. That’s why it’s critical financial advisors be aware of how cryptoassets are purchased, sold, settled and custodied, as well as who is holding the keys. That way, when their clients raise concerns or questions about cryptoassets, advisors can feel confident in providing knowledgeable guidance in the same manner they would other investment advice.

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