Goldman Sachs and Morgan Stanley, after their clients pestered them long enough, recently released two widely read reports on where the Bitcoin price is headed. Even though both banks believe the current rally is a bubble, it is very positive that so many clients demanded research on the cryptocurrency.
If there is that much pent up demand, the next question for executives is whether or not the industry is big enough yet to support one or more full time employees market making and trading Bitcoin and other digital currencies. The following is a thought experiment on the cost benefit analysis for starting a digital currency trading desk for a bulge bracket bank.
Before a young man or woman begins blowing up your capital, the resources needed to get them started run close to a million dollars alone. Market data feeds like Bloomberg and Reuters can run in the tens of thousands of dollars per month. As an example, while I was an ETF trader at Deutsche Bank, my market data costs were $50,000 per month.
The next and bigger cost center is the number of support staff needed. Compliance, middle office, back office, and IT personnel are needed to help a trader effectively perform his or her duties.
The final and most important asset a trader needs is capital. From the bank’s perspective, this capital has a cost. Investors in investment and commercial banks demand a certain return on equity (ROE) for their investment. Goldman Sachs is the most profitable bank by a country mile, mainly because its management actually has a clue about how to use capital effectively.
Over the past 5 years Goldman averaged an ROE of 10%. I will use this as the benchmark for the following calculations.
The trader himself needs to get paid. Given the risk involved in trading Bitcoin, a bank would assign a mid-career trader to the desk. Assume this person’s annual total compensation is $500,000. For an equities’ banker this might be the MD’s take home pay, but for a good FICC trader it is average.
Trading Bitcoin requires a trading desk to have accounts on the leading Bitcoin exchanges. Exchanges, as we know, get hacked repeatedly. Insurance in the Bitcoin space, for good reason, does not exist. The desk needs to assign a probability of default on the exchange. Using the Bitfinex haircut as an example, let’s assume the yearly probability of default is 35%.
Trader Support: $1 million
Trader Pay: $500 thousand
Default Risk: 35%
The next consideration is how much capital to allocate to this trading operation. Even if the desk is able to achieve the ROE, making just a few million dollars won’t be worth the hassle. The approval for a Bitcoin trading desk would need to come from the CEO. Lloyd Blankfein doesn’t get out of bed for less than $10 million of profit. Let’s assume that the bank, at a minimum, must be able to deploy $100 million.
Given that 35% of the capital deployed will be spirited away, the returns must be achieved on $65 million. In order to make $1.5 million (Cost) + $10 million (Required ROE), the desk must make 17.70%.
A 17.70% annual return is very achievable. I routinely speak about arbitrage opportunities that yield in excess of 50% per annum. However, you cannot put $65 million into any trades I describe without tremendous market impact.
The trading desk will not have a mandate to just punt Bitcoin or Altcoins. They will search for pricing discrepancies between exchanges, or between spot and its derivative. When massive directional bets are removed as a strategy, it is very hard to put that much size into arbitrage trades.
With a market cap close to $100 billion, the entire crypto space is worth evaluating for a trading desk. However, the market still cannot support the volume needed for a trading desk to meet its hurdle rate.
When the top 5 most liquid Bitcoin / USD exchanges trade in excess of $1 billion per day on average, then we will see the first bank sponsored Bitcoin trading desks emerge. Given that yesterday $500 million was traded by the top 5 exchanges, we are not far away.