There is money to be made, but only if genuine on-chain demand materialises and significant operational hurdles can be cleared
By Toby Lawes
If 24/7 liquidity and the instant settlement of everything is an unstoppable train, market-making firms will be essential for greasing the wheels. But whether tokenised real-world assets (RWA) and ETFs represent an attractive spot to put their precious trading capital to work is a question being asked across liquidity provider C-suites. For some, like Amsterdam-based Flow Traders, tokenisation represents a new frontier. Volatility and inefficiencies will present plentiful arbitrage opportunities for skilled players. For others, concerns remain that genuine appetite for on-chain exposure and out-of-hours trading will materialise.
“We live and die on volumes and volatility,” explained Jake Ostrovskis, head of OTC trading at Wintermute, a historically crypto-native market-making firm that has backed some early token projects. “For now they remain niche products, but we do we see a world where tokenised equities and by extension ETFs become more and more interesting. It is something we are watching very, very closely,” he said.
Secondary market trading for tokenised assets and funds is still in its infancy. Aside from a small handful of ETFs that have been tokenised, most blockchain-based funds operate similarly to mutual funds: once-a-day liquidity and once-a-day pricing. Leading tokenised equities issued by xStocks and Dinari’s dShares, for example, enjoy some secondary market volumes, but the leading way is on-chain precious metals, where trading volumes amount to a few billion per day.
As for the underlying assets themselves, the trading of tokenised products is intermediated by market making firms. These liquidity providers charge bid-ask spreads for each trade they facilitate – quotes are often given in stablecoins – but can also profit from arbitrage opportunities and even short-term directional bets.
Amsterdam-based Flow Traders, which started life in 2004 as an ETF market maker, has been one of the most vocal proponents of the tokenisation opportunity, with CEO Thomas Spitz describing it as the ‘next ETP moment’ on the firm’s Q4 results call. Flow Traders is supporting early liquidity for Dinari’s token project and recently announced a 24/7 over-the-counter (OTC) offering for tokenised money market funds, equities, and commodities – a bet on genuine institutional demand to trade and hedge exposure both overnight and on the weekend.
“As a market maker, you want to see as much flow as possible. And we do see tokenised assets taking off,” said Flow Traders co-head of trading Marc Jansen in a recent interview with The InterSection. “I look at tokenised products as a new asset class. You get the same exposure but with some attractive add-ons like 24/7 trading, programmability, interoperability and the ability to fractionalise. They are getting bigger and bigger,” he said.
The early days of cryptocurrency trading – also a 24/7 market – were famously fertile ground for market makers. Significant mispricings between exchanges and low levels of competition created arbitrage opportunities aplenty and wide latitude for steep bid-ask spreads. For Roger Bayston, head of digital assets at Franklin Templeton and architect of the firm’s blockchain-based investment platform Benji, tokenisation represents a “massive opportunity” for market makers.
“There’s a lot of volatility in these markets and that’s how these firms make money. If there’s big uptake and enough fungibility across the space, then it’s potentially lucrative business.” Bayston said Franklin Templeton was engaging with several liquidity providers to establish secondary-market functionality for its tokenised money market funds (MMFs) – something Flow Traders has since said it will provide as part of its new OTC offering.
Another asset manager eyeing 24/7 liquidity for its tokenised MMFs is WisdomTree. The New York-based firm recently announced round-the-clock trading and instant settlement for the WisdomTree Treasury Money Market Digital Fund (WTGXX) – the first example of such a capability within the US regulatory perimeter. To facilitate that liquidity, a WisdomTree subsidiary will offer bilateral trading by holding a large inventory on hand, but the firm hopes to attract additional liquidity providers over time.
This model is one that WisdomTree is plotting to extend beyond money funds. “We want to see other exposures become available and tradable on chain and are actively exploring tokenised ETFs,” said Will Peck, head of digital assets at Franklin Templeton. “We view that as the next evolution.” On the appeal of tokenised asset trading for market makers, Peck felt there would be arbitrage opportunities for market makers but stressed that there must be genuine demand from customers to trade them.
Whether that demand will materialise is tokenisation’s trillion-dollar question, but it is not there yet. In fact, issuers of tokenised assets are incentivising market makers to show prices at appealing spreads for their products – not dissimilar to the contractual market maker model that is widely used within ETFs. xStocks, for example, the largest issuer of 1:1-backed tokenised equities and ETFs, uses retainer models and negative-swap rebates to entice market makers to provide volume.
The firms providing liquidity in tokenised assets to-date largely fall into one of two camps: crypto native market makers like Wintermute and GSR or proprietary trading firms like Jane Street, Flow Traders and Cumberland, the latter a subsidiary of DRW. Conspicuously missing are the large investment banks, but several, including Goldman Sachs, are starting to build out tokenisation desks, a person familiar with the plans told The InterSection. The prop trading firms believe they are best placed to win in this new world. “If markets go towards 24/7, we already have sophisticated pricing models for closed markets from trading ETFs, so we can roll them out on the crypto rails we are already comfortable with given our crypto trading,” said Flow Traders’ Jansen.
He added that while “the crypto native firms are comfortable on crypto rails, they are a bit behind on the even more complex more traditional finance rails” – an assertion disputed by one specialist crypto market making firm The InterSection spoke to. “Right now, it makes no sense to market make a bond on crypto rails because you need to pre-fund it. For a specific bond, you can count the number of trades each day on one hand – the economics just don’t make sense,” explained Flow Traders’ Jansen whose firm’s new OTC facility is designed to help clear this hurdle.
Another problem is that settlement in tokenised markets remains largely bilateral – at least outside of individual exchanges – increasing operational complexity for market makers and limiting the netting benefits enjoyed within centrally cleared systems. As a result, market makers often need to fund positions on a gross rather than net basis, increasing balance sheet usage and funding costs – a pain point that will be reflected in wider spreads.
And although progress is being made on this front, prime broking on crypto rails also remains limited. This impairs market makers' ability to take on leverage to provide quotes, meaning they are required to use more of their own balance sheet. Instruments tracking the same assets but with greater capital efficiency like perpetual futures – ‘perps’ – have seen a real surge of interest in recent months, perhaps a reflection of this difficulty. But where market makers will really be tested is on the weekends. With traditional markets shut, they will be unable to create and redeem tokens by trading the underlying, will be unable tap pre and post market venues as they can on weekdays, and will find it difficult or impossible to source proxies and hedges.
“There’s very little trading over the weekend because there is no real way to hedge and therefore traders are having to warehouse large amounts of risk,” said Wintermute’s Ostrovskis. “Spreads will have to be measurably wider to account for that.” But thin trading will lead to large dislocations – and that brings significant opportunities for market makers. “It is common for us that when a market is closed on a Monday we need to price not just over the weekend but from Friday evening until the next Tuesday. There are a lot of similarities from our ETF trading we can reuse,” said Flow Traders Jansen.
Toby Lawes is a writer over at www.etfstream.com. He came from a fund management role at Ruffer LLP where he worked on the multi-asset, global macro strategy. He holds an undergraduate degree in Economics from the University of Edinburgh and a postgraduate degree in Financial History from the University of Cambridge. Toby is a CFA charterholder.
