James Cirrone

Michael Bodley

Cryptocurrency-focused prime brokerage sFOX is taking efforts to secure digital assets belonging to its clients as regulatory tensions build.&nbsp;



SFOX told Blockworks exclusively that it will insure clients’ assets up to $250,000 — without imposing fees — via its custody arm, sFOX Safe.&nbsp;



Industry prime brokerages typically offer custodial solutions for free or at discounted rates in an effort to maintain relationships with trading clients. And industry participants say there’s opportunities to capitalize on business development opportunities in the sector, especially given regulatory setbacks in the US for larger counterparts.&nbsp;



The firm’s offering is set to be made available to individuals who “choose to secure their entire portfolio in sFOX SAFE, use sFOX SAFE to safeguard client assets in their own digital asset business, or simply place $250,000 of digital assets in an account for protected custodial diversification,” the company said in a statement.&nbsp;



The company’s pitch falls in line with longstanding FDIC safeguards in the US that protect up to $250,000 of client assets held by registered entities, like banks.&nbsp;



Akbar Thobhani, the CEO and co-founder of <a href="https://blockworks.co/tag/sfox">sFOX</a>, told Blockworks that there’s a crypto-native twist on his company’s offering compared to what the <a href="https://blockworks.co/tag/fdic">FDIC</a> has historically provided.&nbsp;&nbsp;



“When you give money to a bank, the bank can lend that money out,” Thobhani said. “We&#8217;re not taking that money and lending it out. You get to decide when you want to lend it out, or what you want to do with it. We&#8217;re just holding that in bailment.”



<a href="https://blockworks.co/tag/sfox">SFOX</a> is not a bank. It is rather a culmination of crypto things: including a custody solution, coupled with a brokerage solution that allows clients to trade digital assets. Those clients include the likes of hedge funds, asset managers, high net worth individuals and family offices.&nbsp;



Thobhani told Blockworks that its custody and trading services are kept separate from one another.



Thobhani equated sFOX Safe’s business model to that of a valet. A valet drives off with your car and parks it somewhere safe, but they don’t own your car. In the analogy, the assets of sFOX’s customers are the car, and sFOX is the valet.&nbsp;



There’s also a separate insurance policy for the custody service underwritten by Lloyd&#8217;s of London. This insures customers’ assets up to $200 million to cover “the physical loss of private keys from various covered events,” sFOX told Blockworks.



SFOX Safe is offered through an sFOX affiliate, the SAFE Trust Company. That company is chartered by the Wyoming Division of Banking, an agency from a state known to be <a href="https://blockworks.co/news/these-5-crypto-friendly-us-states-show-initiative-on-tax-laws">friendly to crypto companies and investors</a>.&nbsp;



The current SEC hasn’t been quite as kind. With <a href="https://blockworks.co/news/gensler-house-financial-services-committee">Chair Gary Gensler himself stepping into the hot seat</a> Monday, Thobhani told Blockworks that he too wanted to see more regulatory clarity.



“The more clarity we have, the better products we can build and the more kinds of services we can offer to our customers within the confines of the regulation in the US,” Thobhani said.



Blockworks previously reported in August 2022 that the <a href="https://blockworks.co/news/crypto-traders-beware-irs-gets-greenlight-on-brokerage-inquiry">IRS targeted sFOX</a> with a John Doe summons — a tactic used to identify individuals who are potentially evading taxes. At the time, sFOX was forced to volunteer information about all customers who were US taxpayers and traded at least $20,000 in digital assets between 2016 and 2021.



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Crypto Prime Broker SFOX Protecting All Assets From Bankruptcy

<div id="highlights-block_633b685319176" class="highlights">
 <ul>
 <li>Large institutions use dark pools to access crypto markets without creating massive buy or sell walls in a public order book</li>
 <li>Dark pools help decrease price volatility but are not the &#8220;end solution&#8221;</li>
 </ul>
 
</div>



In 2021, crypto investors heralded market movers, such as MicroStrategy and Tesla, as champions of the bull market. They represented the tip of an institutional iceberg of increasing interest in digital assets.&nbsp;



While the spotlight may not be kind during a crypto winter, the bottom half of that iceberg is still there – all of which wouldn&#8217;t exist without dark pools. These sometimes controversial back door entrances into the crypto market serve the same function as dark pools in traditional markets – often moving markets in mysterious ways.



We met with sFOX, a <a href="https://www.sfox.com/" target="_blank" rel="noreferrer noopener">full-service crypto prime dealer</a>, to learn more about dark pools and their relationship to crypto markets.&nbsp;&nbsp;&nbsp;



<h3 class="wp-block-heading">What is a dark pool?</h3>



A dark pool allows oversized market players to trade large blocks of digital assets without the trade being visible to the broader public. Their origins in traditional markets go back several decades, enabled by SEC regulation, which allowed investors to trade securities off-exchange.



According to the <a href="https://www.sec.gov/news/statement/shedding-light-dark-pools" target="_blank" rel="noreferrer noopener">SEC</a>, dark pool trading accounts for 18% of trades in US equities. More<a href="https://www.nasdaq.com/articles/the-risk-and-reward-of-more-dark-pool-trading" target="_blank" rel="noreferrer noopener"> recent data</a> from Nasdaq puts it at 40%.



SFOX explains in their <a href="https://www.sfox.com/dark-pool-ebook/?utm_source=ps&amp;utm_medium=os&amp;utm_campaign=blockworks" target="_blank" rel="noreferrer noopener">new dark pool report</a> that the main point in difference with crypto dark pools is the settlement process and trade execution. All digital asset transactions eventually need to settle on the blockchain. Dark pools pass those transaction costs on to the clients. Trade execution differs in that crypto dark pools use a multiparty computation protocol (MPC) to break the trade into multiple orders. This approach maintains privacy and security for the client.&nbsp;



Their use has courted some controversy. On the one hand, the lack of transparency means that dark pool trades don&#8217;t move the market at the time of trading. However, upon disclosure to the regulator post-trade, the most significant trades tend to drive the market in a general direction.



<h3 class="wp-block-heading">Greater market participation</h3>



Dark pools played an instrumental role in the lead-up to the 2021 crypto market bull run. SFOX shared a report from <a href="https://www.finoa.io/blog/crypto-institutional-investors-custodian/">Finoa</a> to illustrate the impact of accelerated institutional interest:&nbsp;



<img loading="lazy" decoding="async" width="598" height="375" src="https://lh3.googleusercontent.com/L6MrgPWXoTccfYTzMnCmCMHP0BItqZY7-hxWZLnDlVfJ5D2CZU4qMeMmzLOXIYDh61YfV016Dy_yi3uRRZ6_af20ZQX7oWohYiQTmByRJ7E2Yg13j81Da4UDoUZoCfUkjADI7seWw8N06V3k-Tf0OEDB43bIuZJXc5tsNqt8tggsnWTFZJuPduraWg">



Source: <a href="https://www.finoa.io/blog/crypto-institutional-investors-custodian/">Finoa</a>



While 2021 initiated the first wave of institutional interest, we have yet to witness the second one. This lack of movement, in large part, is due to regulatory uncertainty and price volatility.&nbsp;&nbsp;



The larger Institutions, waiting on the sidelines, are slow moving and risk averse. They&#8217;re not going to enter a market until the rules of engagement are crystal clear. And these rules aren&#8217;t as simple as approving or banning particular digital assets. In our conversation with sFOX, they explained that these larger, more established players need complete compliance standards to ensure their ability to fulfill fiduciary obligations.&nbsp;



Since 2018, we have seen parts of the institutional-grade jigsaw being put in place — piece by piece. From digital asset custodians to prime brokers, lending, credit and risk management facilities. A jurisdictional battle between regulatory agencies may be one of the remaining items needing clarity.&nbsp;



<h3 class="wp-block-heading">Decreased volatility</h3>



In our conversation with sFOX, they listed price volatility and illiquidity as the second barrier to institutional buy-in. Crypto dark pools offer a necessary work-around, but they have their trade-offs. Because liquidity is fragmented across a 24-hour global market, many institutions have to go through intermediaries before executing a trade through the pool.&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;



Another option for an institution is to engage with digital assets infrastructure firms such as Fireblocks. They can provide the plumbing to access different liquidity pools, although the shortcoming with this approach is that it&#8217;s not seamless. There will be a need for the market player to have separate accounts with the various liquidity providers.



A senior representative at sFOX stated that their dark pool addresses this problem by routing the trade through a &#8216;single order.&#8217; This approach keeps the trade private while offering routing transparency to the market maker. Collaborating with a specialist and having one account to an aggregation of liquidity providers is likely to be a robust option for institutions in the future. Institutions will find better price discovery as more incorporate this aggregated liquidity model into crypto dark pools.



The representative clarified that dark pools are not the end solution to market volatility and fragmentation. As dark pools improve price discovery for larger trades, it will attract more institutional capital across the market. It has a &#8216;rising tide&#8217; effect on the industry, consequently improving price stability to a degree.&nbsp;



But he states that liquidity fragmentation will still need to be addressed. If price continues to fluctuate differently across markets, then arbitrageurs will take advantage and perpetuate the volatility. He believes that sFOX’s approach to <a href="https://www.sfox.com/trading-platform/" target="_blank" rel="noreferrer noopener">aggregating the liquidity</a> into a single order may offer the stability institutions want for increased participation.&nbsp;



<h3 class="wp-block-heading">A better outcome for institutions</h3>



The opportunity for limited market impact for an institution utilizing a dark pool essentially means that the entire order gets filled without the asset price increasing/decreasing disproportionately. In this way, the trade shouldn&#8217;t get front-run, and maker orders can occur without slippage.&nbsp;



In effect, it means the best trade execution for that institution. It also means the ability to execute trades at lower fees. Reduced reporting and disclosure requirements, the absence of exchange fees and fewer intermediaries make for significant savings.



<h3 class="wp-block-heading">Diminishing arbitrage returns</h3>



In considering all of the above, between an expansion of the digital asset market due in part to dark pools being made available (as a prerequisite to the entry of the institutions), the improved market liquidity and greater efficiencies still with an aggregated liquidity approach, arbitrage opportunities will diminish, especially in the case of less sophisticated investors.



Hedge funds will likely cannibalize any arbitrage opportunities that arise. Their quants will formulate algorithms as part of sophisticated trading strategies developed to mop up whatever remaining inefficiencies exist in the market at that stage.



Dark pools will likely make for a perennial point of controversy in crypto, just as they have done in TradFi. But increasing dark pool liquidity may invite the capital needed to calm the waters of an industry plagued with fear and uncertainty.



This content is sponsored by <a href="https://www.sfox.com" target="_blank" rel="noreferrer noopener">sFOX</a>.



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Start your day with top crypto insights from David Canellis and Katherine Ross. <a href="https://blockworks.co/newsletter/empire">Subscribe to the Empire newsletter</a>.



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How Dark Pools Quietly Influence Crypto Markets

Casey Wagner

<div id="highlights-block_62fbf3b0e4421" class="highlights">
 <ul>
 <li>IRS is after traders who may have concealed gains made via crypto brokerage SFOX</li>
 <li>A John Doe summons allows the IRS to collect information about unidentified taxpayers who may have evaded IRS payments</li>
 </ul>
 
</div>



The IRS is hot on the trail of any deep-pocketed investors who dodged cryptocurrency taxes pertaining to brokerage transactions.&nbsp;



A federal judge Tuesday authorized the IRS to issue a John Doe summons — a tool used to collect information about unknown taxpayers — to institutional crypto broker SFOX Tuesday.&nbsp;



SFOX will have to hand over information about all customers who were US taxpayers and traded at least $20,000 in digital assets between 2016 and 2021.



The judge has found “reasonable basis for believing that individuals conducting at least $20,000 in cryptocurrency transactions may have failed to comply with federal tax laws,” the Department of Justice said in a <a href="https://www.justice.gov/opa/pr/court-authorizes-service-john-doe-summons-seeking-identities-us-taxpayers-who-have-used-2" target="_blank" rel="noreferrer noopener">statement</a>. 



The IRS has been keen to crack down on crypto transactions, which are typically treated like stocks and subject to capital gains tax, in recent years. The agency has been particularly focused on monitoring staking activity and the non-fungible token (NFT) market.&nbsp;



The IRS has sought and been awarded John Doe summons for other crypto businesses, including <a href="https://cms.blockworks.co/tag/circle/" target="_blank" rel="noreferrer noopener">stablecoin USDC overseer Circle</a> in April 2021 and <a href="https://cms.blockworks.co/tag/kraken/" target="_blank" rel="noreferrer noopener">crypto exchange Kraken</a> one month later. 



“The John Doe summons remains a highly valuable enforcement tool that the U.S. government will use again and again to catch tax cheats and this is yet one more example of that,” IRS Commissioner Chuck Rettig said in a <a href="https://www.justice.gov/opa/pr/court-authorizes-service-john-doe-summons-seeking-identities-us-taxpayers-who-have-used-2" target="_blank" rel="noreferrer noopener">statement</a>. “I urge all taxpayers to come into compliance with their filing and reporting responsibilities and avoid compromising themselves in schemes that may ultimately go badly for them.”



It is up to the taxpayer to <a href="https://cms.blockworks.co/crypto-investors-low-on-funds-might-have-to-cash-out-to-pay-2021-tax-bill/" target="_blank" rel="noreferrer noopener">report their own gains</a> to the IRS, but exchanges hold key know-your-customer and trading information that regulators want. 



“Reporting is a huge problem right now, because exchanges are doing different things,” Shehan Chandrasekera, head of tax at Coin Tracker, told Blockworks ahead of the 2021 tax season. “If you take a look at centralized exchanges, they issue, I would say, four different types of tax forms, depending on how they interpret the existing tax codes, given the gray area, so people are very confused.”



Investors using decentralized exchanges or more than one exchange may have a particularly difficult time.



“Exchanges only have visibility into what’s happening inside that exchange,” Chandrasekera said. “But to figure out your taxes correctly, you need to connect all your wallets and exchanges and figure out that actual capital gain or loss.”



The IRS has not alleged any wrongdoing on SFOX’s part.



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Crypto Traders Beware: IRS Gets Greenlight on Brokerage Inquiry

Drew Mailen

To break down the mechanics of a crypto-liquidity crunch, we sat down with an institutional market expert, Chuck Lugay, head of execution services at sFOX. <a href="https://bit.ly/3AT2TMm" target="_blank" rel="noreferrer noopener">sFOX</a> is known by institutional investors for its deep order books — sourced from more than 30 top exchanges, OTCs and over 80 markets. Lugay brings more than 20 years of institutional experience and has lived through the significant market swings in the last two decades.&nbsp;



<h3 class="wp-block-heading">What is a crypto liquidity crunch, and how does it start?&nbsp;</h3>



The definition is simple. A crypto liquidity crunch is when platforms lack the liquid supply of cash reserves and 1:1 convertible stablecoins needed to meet demand all without collapsing market prices.



It&#8217;s a bank run.



And in the world of digitized assets, human behavior isn&#8217;t different. Like the 2007-08 real estate market crash, both follow a period of hyper-competitive yield chasing with little interest in risk-averse asset management. Those like Chuck Lugay have witnessed the same behavior across multiple industries.&nbsp;&nbsp;



&#8220;I lived through the market corrections in 2001. I lived through the real estate disaster in 2008. I think that if you haven&#8217;t had experiences like that within your professional career, you may leave yourself open to big issues like this,&#8221; Lugay said.&nbsp;



&#8220;There are no specific guaranteed red flags that give an indication of a liquidity crunch, but you need to prepare for the worst. It might come at the sacrifice of immediate returns of what you&#8217;re doing now. But I&#8217;d almost rather lose a small amount of money on a trade today, than lose half of my equity in the entire portfolio because I didn&#8217;t practice good hedging strategies. Multiple players in the space right now will not make it because they did not hedge themselves correctly,&#8221; Lugay said.&nbsp;



<h3 class="wp-block-heading">How the liquidity mechanics differ&nbsp;</h3>



While human behavior remains consistent across industries, the mechanics of a crypto liquidity crunch function differently. In crypto, very few on-ramps allow institutions to transfer large amounts of capital in and out of the market. Think of it as a new city with many highrises but not enough highways in and out. Crypto platforms developed solutions akin to an above-ground rail to alleviate congestion within the market. They either tokenized assets by holding a 1:1 equivalent value in cash or used algorithmically governed monetary policy to maintain a 1:1 peg. Like above-ground rails, these solutions help transfer liquidity within the system but do not offer an easy way out. They still need exchanges or stablecoin bank redemptions to exit completely.&nbsp;&nbsp;&nbsp;



Terra/Luna&#8217;s UST was an example of a 1:1 algorithmic stablecoin that crumbled from poor architecture. Before its collapse, funds and exchanges used it as a critical source of liquidity. But when it started to depeg, some of the biggest market makers could not move fast enough to meet liquidity demands. And in a world of automated and decentralized smart contracts, prices collapsed to zero in hours. Funds with UST on their balance sheet suffered the consequences. And now, multiple crypto lending platforms are facing bankruptcy and liquidation.&nbsp;



To say this is a big deal may be an understatement. In a recent <a href="https://cms.blockworks.co/webinars/crypto-state-of-the-union-trading-risk-management/" target="_blank" rel="noreferrer noopener">webinar on crypto&#8217;s state of the union</a>, Chuck had this to say about today&#8217;s market compared to previous bitcoin cycles:



&#8220;I think the biggest difference in this cycle is the credit fall out. We had a liquidity situation in 2017, but I don&#8217;t think you had the systemic problem that you are seeing today. We are in uncharted territory.&#8221;&nbsp;



Sourcing the proper liquidity from on-ramps and exchanges is key to navigating and preparing for a market-wide crunch. Chuck explains that institutions choose sFOX over individual exchanges because it does not limit order book access to one or two specific liquidity providers. Instead, sFOX has bundled and aggregated over 30 liquidity providers on one platform.&nbsp;



<h3 class="wp-block-heading">How aggregated liquidity providers can help during a liquidity crunch&nbsp;</h3>



Say one exchange in <a href="https://bit.ly/3chzn8F" target="_blank" rel="noreferrer noopener">sFOX&#8217;s aggregated liquidity</a> is over-exposed to a collapsed stablecoin. Chuck points out that institutional-level investors can maintain a degree of protection through the more than 30 additional liquidity providers. sFOX makes access easy because all the activity is taken care of in-house. This includes treasury management and establishing relationships — saving investors time and resources.&nbsp;



He even argues that when an institution wants to exit during a liquidity crunch, institutions can avoid some of the typical price slippage that occurs on exchanges. They achieve this efficiency through smart order routers and specific algorithmic order types.&nbsp;



<h3 class="wp-block-heading">In conclusion&nbsp;</h3>



There is no way to see a massive downturn in any specific token, so institutional investors must ensure they are thoroughly hedged. First and foremost, liquidity crunches often start with large downside market movements. In addition to environmental factors, market downturns can happen when portfolio managers, hedge funds, and institutional investors are not practicing good risk management.&nbsp;



Aggregated liquidity providers like sFOX can offer deeper pools of liquidity by drawing on more than 30 top exchange sources, including the industry&#8217;s OTC trading desks, as well as over 80 markets. 



This content is sponsored by <a href="https://www.sfox.com/" target="_blank" rel="noreferrer noopener">sFOX</a>.



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Start your day with top crypto insights from David Canellis and Katherine Ross. <a href="https://blockworks.co/newsletter/empire">Subscribe to the Empire newsletter</a>.



Explore the growing intersection between crypto, macroeconomics, policy and finance with Ben Strack, Casey Wagner and Felix Jauvin. <a href="https://blockworks.co/newsletter/onthemargin">Subscribe to the Forward Guidance newsletter</a>.



Get alpha directly in your inbox with the <a href="https://blockworks.co/newsletter/research">0xResearch newsletter</a> — market highlights, charts, degen trade ideas, governance updates, and more.



The Lightspeed newsletter is all things Solana, in your inbox, every day. <a href="https://blockworks.co/newsletter/lightspeed">Subscribe to daily Solana news</a> from Jack Kubinec and Jeff Albus.