On today’s episode, guest host Chris Solarz speaks with Tim McCourt, the Global Head of Equity Index and Alternative Investment Products at CME Group, James Koutolas, CEO of Typhon Capital Management, and Roy Niederhoffer, President of R.G. Niederhoffer Capital Management. Our guests today are at the forefront of cryptocurrency investment and their views give insight on where it is headed, from public acceptance to their integration in managed futures. Listen in to today’s episode to learn what makes cryptocurrency unique in human history, the long-term effects of investment, and the new developments that change how we invest them.

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In This Episode, You’ll Learn:

• What makes Bitcoin so unique among the history of currencies
• The differences between Ethereum and Bitcoin
• What challenges CME faced in creating a futures on something virtual
• How interest in cryptocurrency has changed over the last couple of years
• Why the guests disagree about the public long-term interest in cryptocurrency
• The historical precedent for the benefits of futures in the economy
• How the various kinds of traders make their financial system work so well
• The trading strategies around cryptocurrency and how it has evolved

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And you can get a free copy of my latest book “The Many Flavors of Trend Following” here.

Learn more about the Trend Barometer here.

Send your questions to info@toptradersunplugged.com

And please share this episode with a like-minded friend and leave an honest Rating & Review on iTunes or Spotify so more people can discover the podcast.

Learn more about James Koutolas and Typhon Capital Management

Learn more about Tim McCourt and CME Group

Learn more about Roy Niederhoffer and R.G. Niederhoffer Capital Management

Copyright © 2023 – CMC AG – All Rights Reserved

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Niels

Welcome back to another edition of Top Traders Round Table, a podcast series on managed futures. My name is Niels Kaastrup-Larsen and I'm delighted to welcome you to today's conversation with industry leaders and pioneers in managed futures brought to you by CME Group.

Your guest host today is Chris Solarz, Managing Director of Global Macro Hedge Fund Strategies at Cliffwater, and he is joined by some very interesting guests to discuss the current state of the crypto space. So, without further ado, here is Chris.

Chris

My name is Chris Solarz and I'm going to be your guest host today. Today's show is focused on all things crypto. Now, to paraphrase Mark Twain, the rumors of the death of cryptocurrencies have been greatly exaggerated. Today I have a panel of three great crypto enthusiasts, here to share their expertise. I have Tim McCourt, of the CME Group; Roy Niederhoffer of R. G. Niederhoffer Capital Management; and James Koutoulas of Tyfund Capital Management.

What we're going to talk about today is, first, a high-level introduction to crypto. We're going to address the pros and cons. We're also going to talk about the investability of cryptocurrencies, how you can access this market. We're going to talk about the three hundred plus crypto hedge funds including those based on CME listed futures. Finally, we're going to talk about the inevitable institutionalization of crypto as an asset class.

Before we get started I'm going to have my panelists introduce themselves. Tim, hello, how are you doing?

Tim

Great, thanks Chris, thanks for having me here today.

Chris

Can you please give us a little background on what we're doing here at the CME?

Tim

Chris

Great, well thank you, Tim. Tim told me that he's a huge Bruce Springsteen fan. His very first concert, in second grade, was to see Bruce Springsteen. He loves the boss so much he moved his family back out to New Jersey just recently.

Tim

That's right. I grew up on Long Island, but my first concert was when my parents took me to see Bruce Springsteen over at the Meadowlands, our giant stadium. Now, moving recently to New Jersey, I feel like I'll ever be conflicted when answering the question of whom do I prefer, Bruce Springsteen or Billy Joel, only time will tell.

Chris

Time will tell.

James, happy to have you on the podcast as well.

James

Thanks for having me, Chris.

Chris

Sure, can you give us a little background on yourself?

James

Sure, I'm the CO of Typhun Capital Management. We're a deconstructed hedge fund with several futures strategies in metals, crypto (of course). We also run a digital assets fund. I'm a securities lawyer and also an advisor to Basis, an algorithmic stable quant.

Chris

Great, James went to undergrad in Florida, Law School in Chicago, and now spends his time in New York City running his business. He still..

James

Part of my time in New York City.

Chris

Part of your time, sorry. The interesting thing is that you still play competitive ice hockey, even after two knee surgeries, and you keep a full set of hockey gear in all three places: Miami, Chicago, and New York for easy access.

James

You've got to be ready when the puck drops.

Chris

That's right, good stuff.

Last but not least, Roy Niederhoffer. Roy, thanks for being here on the podcast.

Roy

Thank you, Chris.

Chris

Roy

Sure, well, we were futures traders from the very beginning. Our strategy is very short-term, ranging from minutes to five or ten days, in all the major asset classes. I guess, what we've been known for is the fact that our funds are negatively correlated to stocks and bonds, so they're meant to be protective as well as an absolute return vehicle.

Chris

Almost a crypto denominated share class.

Roy

Exactly, exactly.

Chris

Maybe ten years ago we saw a few gold-denominated share classes and, now, I think this is the very first crypto denominated share class.

Roy

Right, we're actually still dollar denominated, but the thought was that the fund would hold a core of crypto rather than a core of dollars.

Chris

Yeah, synthetically. Well, very good.

James

Talk about Billy Joel?

Chris

Yeah, we certainly can.

James

They'll enjoy that.

Chris

Good, big picture here, I would love to start out and talk about cryptocurrency at the highest level. We have a lot of crypto enthusiasts here. Maybe we can start with you, Roy. Can you talk about your current view of crypto? Is crypto here to stay?

Roy

I'm extremely bullish on cryptocurrency. I would say I'm agnostic more so on blockchain than crypto. I think crypto is the killer app for blockchain.

The reason that I'm so bullish on crypto is that it is the first fixed supply asset that has ever existed, in human history, with all the characteristics of money, but without the vice of over creation, which has happened one hundred percent of the time in human history, in every type of government-issued currency except, in this case, we don't have that possibility. We know there will be a fixed supply of bitcoin, a fixed supply of coins in general.

What makes it different is that for the first time you can use that crypto and monetize it and do something else with it while keeping your exposure. In the same way that you can invest in yen and buy Japanese stocks, invest in China, get the currency exposure and also invest in Chinese companies or Chinese bonds, you can do the same in crypto.

You can lend your crypto. You can, in our case, trade futures with it. Our thought that this combination of fixed supply and the ability to get a non-devaluing rate of return makes it a unique and brand new investment vehicle. I think as people realize that the dollar has depreciated 99.95% in the last one hundred and twenty years, in real terms, you start to see that you can get the same return in crypto without that possibility. It's going to be very, very attractive for institutions and we're going to see massive appreciation from here.

Chris

Thank you. Maybe we can stay at the very, very top, James, and can you help us just differentiate between the different styles of crypto. Roy is talking about, perhaps, bitcoin, but there's also the different protocols like Ethereum and there's also different out coins like the ICO as we see. I think those are, perhaps, the three big buckets. Could you just tell us, for the listeners who are still new to crypto, what it means to invest in these different styles of coins?

James

Sure, you have coins like bitcoin that has digital historic value. Ethereum is really designed around our concept of smart contracts where you can have algorithmic functions whose networking power is paid for with the currency surrounding that. Then you have tokens that look to mimic VC investments by the ICO market which is the most regulatory indices of the three.

Chris

Exactly, Tim, can you tell us a little about how you got into crypto and about what you're doing with crypto here at the CME? I know that just recently, I guess less than a year ago, you launched futures on bitcoin.

Tim

Just for those who aren't aware, the bitcoin reference rate is a once-a-day rate that is published where it is derived from bitcoin dollar spot transactions between 3:00 PM and 4:00 PM, London time, from four constituent exchanges; Bitstamp, itBit, Coinbase and Kraken. In that one-hour observation window it's partitioned into twelve equally weighted five-minute samples wherein each sample we take the volume rated median price of the bitcoin dollar spot transactions and then straight-line average them over those twelve samples.

So, we've seen very strong growth in our bitcoin future month over month. We're pleased with it. Then, in this past May, we also expanded our pricing product, or the index products, to include Ether U.S. dollar or we also have an Ether U.S. dollar reference rate and real-time index and that one is based on spot transactions from Bitstamp and Kraken.

Chris

So, perhaps we can expect a bit Ether futures in the near term future?

Tim

Yeah, we don't really have plans right now for an Ether futures product. Our focus right now is just on the pricing index. Just like with the bitcoin futures, any future product development with respect to futures contracts, at CME, will be deployed and designed in response to customer demand. We're certainly listening to customers, but right now bitcoin futures is keeping us pretty busy.

Chris

In the launch, what were the challenges constructing a futures index on something that is virtual, something that doesn't exist, something that is digital, as opposed to a lot of the commodities which are asset-backed, a lot of the equity indices that have real assets backing them.

Tim

I think, in terms of the future design and the contract specs, our job was made a little bit easier by the homework that went into creating the bitcoin reference rate, to start. That reference rate was designed such that the methodology would be transparent, it would be observable, it would be discrete, it has an oversight committee, it has an index administrator, it has a calculation agent.

The fact that we designed that index, and we then effectively wrapped the futures around it a year later, there weren't so many product-specific challenges with that design because it is financially settled. It has a multiplier of five bitcoin.

So, I think the challenge wasn't so much around the design. It was making sure that, as we brought this product to market, we implement all the proper risk controls and credit controls and clearing protocols to give people a confidence and safety to transact in something as new as bitcoin. That is one reason why we went with the financially settled is that it made it that a little bit easier for customers, and we've seen customers continue to adopt it over the last year.

Chris

It seems like one of the more safe ways for institutions to play crypto is through the bitcoin futures. One of the biggest risks to investing in crypto yourself is that you, physically, own it. You have risk for hacking, etc. Thank you and congratulations for that.

Just, can you give us some background on the trading volume and how it compares to some of the other mature contracts that are trading?

Tim

Sure, so what's interesting to watch is that we're doing about thirty-five hundred contracts per day as of yesterday through October, month end. That has grown steadily. When we look at the first month we were doing a little over a thousand contracts, so it has increased month over month.

The most volume we had was back in April where we did, I think, about eleven thousand three hundred bitcoin futures in one day. Then, in July and August we were doing between five and six thousand bitcoin futures per day. But, to put that in perspective, since we have a five bitcoin multiplier, we're talking about doing between twenty-five and thirty thousand bitcoin equivalent per day in our futures contract for the months of July and August. That makes it one of the largest U.S. based risk transfer platforms for bitcoin.

Chris

Right, so, over these past two years, since I've been following crypto and crypto hedge funds, what's really interesting is that if you overlaid a chart of crypto interest over the price of bitcoin you'd have an R2 of close to 1. Interestingly, now that we're back to the price of six thousand bitcoin, after the peak of nearly twenty thousand there seems to be much less interest in crypto as there was when we were running up past through six thousand. There's much less of an interest from the investment community.

James

I disagree with that. I think the interest is still overwhelming. I don't necessarily think of the price of bitcoin is, like you said, the true parameter of interest. If you look at the VC world, raises are still happening. Like the brain drain, people are leaving traditional hedge funds, for example, to go run companies like this. My partners in Basis, they left D. E. Shaw, they left Google Analytics to start crypto and have been incredibly successful.

The amount of VC money going into the space is just accelerating. The amount of institutional partners: Fidelity, Northern, Trust, getting in this space, all of that is accelerating. I think it's important to keep the perspective.

There has been, I believe it's been a seventy percent drop, or drawdowns, in bitcoin in the ten years that it has been around. It's incredibly volatile.

But to me this looks like things are consolidating here and it's really, as I said earlier, this thing is going much, much, higher. I think, as you alluded to earlier as well, once we have custody solutions in place, things like SOC 2 compliant, custodians that are SCC register RIAs get involved and comply with the custody rule, I think that's going to be a big driver of cryptocurrency prices.

Roy

I think another key factor, when one looks at volumes and transactions, is that, as with, say, S&P futures trading, when there's a lot of volatility you've got a lot more transactions, you've got a lot of people able to high-frequency trade. So, volume goes way up with volatility.

I think that if we look at October, you guys probably had a great month in your futures contract. I see a smile there, yes, I think the answer is certainly. But, that doesn't mean that there are fewer people interested in the stock market, today, then there was when volume was a quarter of what it was last year when it was the quietest month ever in the S&P. So, I think we have to separate out those two factors.

I agree with you, James, that there is still the core interest. People are still, every day, coming out with great new products and every crypto and blockchaining. Everyone wants to talk about it as much as they did last year and much less than the year before. I think transaction volume and total trading volume is one measure, but we have to look deeper to really see whether it's just a volatility factor or is it a fundamental loss of interest.

Chris

Well, can we talk about the bubble that happened? Because, if the core interest is inconsistent or increasing, certainly the speculative interest was very, very interested and fell off there. Can we talk about the bubble and what happened in the build-up and the selloff?

James

Yeah, and there's a great chart on the internet that shows the price of bitcoin over time. I wish there was video here so that I could draw with my finger, but basically there has been many exponential moves in bitcoin, and then drawdowns as well (as we just alluded to). It is volatile, right? Things have moved, but every time it has gone considerably higher.

Roy

I think that there's also a bit of perspective that one needs to have if you think about, in percent, the appreciation of bitcoin, so far, probably has something like a billion percent. It's ten to the ninth, I think that might be the number. So, it went up a billion percent and dropped thirty and people think it's over. It dropped sixty and people think it's absolutely over.

I like to tell the story of how we all know a great example of how speculators reduce volatility. It's actually in the Bible, where Joseph, in Egypt, got a great tip about the grain market and he made the same trade that the pork belly traders used to. There was a big surplus, so he bought it up, and kept it, and seven years later he sold it back out again.

So, what did he do to the price? He increased the price when things were low price, and reduced the price when there was a shortage. I think that's what people will use the futures for, as everything matures in the derivatives world, and you can sell volatility, it means that you can get more pliant and more safe for investors.

As a general rule, when people say, "Well Roy, what about custody, what about that it's too volatile, I'm too afraid of it, I don't know anything about it," all of these things are the reasons that the price of cryptos is as low as they are. Those create the opportunity. It's too volatile, yes, or it would be taxed. It's hard to custody? That's right, or it would be ten times more valuable. So, every one of these reasons is absolutely true, now, but we know that as speculators come in it's going to get more liquid and that will make it more valuable, and for every one of the reasons that I'm sure we'll talk about today. It's important to realize that this represents the opportunity, in my view.

Tim

Yeah, I think that when you look to the futures market, we're talking about the S&P and NASDAQ and things like that, it's undeniable that when you look at the near twenty-four hour access of CME futures and liquidity pools that are offered, there are always going to be different customer personas or motivating factors for why people are trading. But, it's not all speculative.

You have hedgers. You have speculators. You have people who are investing in long-term views. So, it's really when you get these types of personas together that it makes that risk transfer more efficient and it increases the velocity of the trading, and it gives them multiple paths to express their views or to manage their risk.

To Roy's point, if someone was only beholding to a spot market, it could potentially exacerbate or cause different market structural reactions in terms of if someone is wanting to either liquidate or to put on new positions. So, you really look at the interrelated aspect of the underlying market with the futures market, and they're highly symbiotic.

That's something that we've also seen start to develop for bitcoin futures as well. When we look at the personas of the customers, or the segmentation, we do have your "natural hedgers." We have miners in the contract. We have those firms that have accumulated open market positions through spot transactions, but then we also have people who are using futures because it's on a regulated exchange and they want to use it as an access point in lieu of the spot market. Then you have the opportunistic people who are looking to trade or deploy strategies around the price movements, and it's the confluence of these types of personas that lead to efficient discover.

So, we're very proud of the fact that, if we look at from June onwards, the bitcoin futures have been up about five contracts up a side under two ticks. So, when you break it down, in terms of your risk management needs for bitcoin, the fact that you can come to CME and transact the equivalent of twenty-five bitcoins for less than fifty dollars, that's an immensely powerful risk management tool.

Chris

So this was interesting, you broke out the segmentation of the users of bitcoin futures. The first one seems the most obvious, to me, the miners are mining bitcoin, they want to sell it to lock in their profit, so they probably would be a natural sell. You've got the people who want to, as an access product, who don't want to take the risk of any counterparty risk or any hacking risk, they would probably be natural longs, or maybe short, depending on their view. Then you have a lot of the prop trading firms that are opportunistically trading it, both long and short, depending on the price moves, right?

Tim

That's correct. I think that's a fair assessment. Sometimes it's always hard to quantify or pinpoint the exact motivation, but I would say, in general, that thesis would hold true. I think the one thing that we're also seeing, which is interesting, is that when you look at some of these proprietary trading firms, they're also very active in the underlying digital market or the spot market. So, we're also seeing some of them, not necessarily always selling or always hedging, but they're also providing liquidity, and they're looking to move between both sides of the market as they trade around inventory.

You also see some of the advent of things like loaning bitcoin or trying to facilitate short selling and things like that. So, I think that it's not always necessarily long or short, I think people will change their position, or change the role that they're playing in the market even if they have a more natural de facto starting position. It is something that I would characterize as fluent, depending on what is going on in the market even for some of the people who might be, as you refer to, natural sellers. They're not necessarily always sellers or always buyers, etc.

Roy

I think there's one more group of people that we need to think about. Just as a lot of ETFs and institutions use S&P futures as an access point to just buy and hold, we're going to see this futures contract as an entry to the space for institutions. If they do want to hedge their exposure to overprinting of the U.S. dollar (which I think this is a possibility we all have to think about as we try to meet the two hundred trillion dollars of unfunded liabilities for Social Security, Medicare, and Medicaid) institutions may think, "I can get three or five percent in my bitcoin holdings with no risk of that. How am I going to get access to that? Maybe I should put a couple of percent." We're already seeing that. We're seeing Harvard, Yale, Stanford, UNC, all investing now in blockchain, in crypto. So this is just the beginning. I think the futures contract, as with the S&P futures and all other futures as well, represents, for speculators and for long-term holders, a great way to get in the market.

Tim

Yeah, for sure. I think if we look back to last Friday on the October expiration of the bitcoin future, I believe... I forget what the exact number was, but about twenty percent of the open interest was also brought into expiration. So, the people have been rolling the contracts prior to that, month to month. They typically have been doing it in an outright fashion, trading the front month versus the second month, not necessarily using the Globex listed spread for all of their roll activity. But, people have been rolling it.

You are seeing this long-term view, but I also think that, as people are getting more comfortable holding the contract until expiration and having that go into that bitcoin reference rate or the BRR final fixing for the settlement at maturity. I think you're going to see people get more comfortable holding it as well. That was something that we saw in October with I lot of people, or more people than usual bringing the contract to expiration.

Chris

Well, this is the perfect segue into trading strategies, here. In fifteen years of evaluating hedge fund trading strategies I found it very interesting, probably about a year and a half ago, I started to see bitcoin arbitrage funds come out, or cryptocurrency arbitrage funds come out.

Just to put it in perspective, for years I have been talking about fixed income arb and vol arb and statistical arbitrage, and, truly, when I understood what these funds were doing with cryptocurrency arb, it was the first time that I really thought that this was pure arbitrage. There's no investment risk. In fact, all of the other arbitrages should be called relative value because they've almost reinvented the strategy.

There are probably two hundred exchanges around the world, cryptocurrency exchanges. Many of these are really small cell site brokerage firms. They have a lot of credit risk. But, what's happening is people are actually buying low and selling high, simultaneously making markets between these exchanges. They've been doing it for many, many years. I find this very interesting.

When Roy talks about the buy and hold story, when he talks about that, that's really the beta of the market and, if we talk about five to ten years, probably cryptocurrencies and bitcoin will all be much more valuable, but that's a really simple story. That's the buy and hold. Today we have alpha, and alpha is ephemeral, because as more market participants come in, the spreads you can make on these trades are quite small.

James, can you tell us a little about this, about the alpha you're seeing today with respect to crypto derivatives?

James

Sure, so there's definitely alpha in the crypto arb trade. It's one that we are not comfortable doing customer money in. Like Roy says, there's a reason arbs exist, there's a reason that bitcoin is lower now. When doing the cross exchange arb you can't really effectively short on the U.S. platforms, which means that you have got to go to the Asian platforms (I won't say exchanges because they're not regulated exchanges like CME).

But, the Asian platforms, you've got a lot of counterparty risk there. Look at all the concerns with Tether. You can't really trust those. I don't feel comfortable putting customer money there from a proprietary trading strategy, though, there are absolutely arb opportunities.

So, what we've done on the futures, and we were live in about thirty minutes of the futures contracts going live, is use algorithms that were very effective in other volatile commodities - things like oil and gold to trade cryptos and trade crypto futures. We've been at a two sharpe ratio there, on the futures, which has been fantastic, and then on the long-biased fund we allocate to the futures strategy. We hedge with futures, but we do take long positions with digital assets, and we do that on U.S. only exchanges.

Chris

What do you mean by a futures strategy? Can you explain that in a little more detail?

James

Yeah, so structurally we offer a registered CTA vantage account strategy that uses crypto futures, so it's fully quantitative. I can't get into the methodology too much, but there are momentum components, there's mean reversion components. It's short-term in nature.

Chris

One interesting thing I've seen is crypto CTAs, trend followers that have emerged. There are just a few of them, and they're the classic story of a CTA or a trend follower is to be diversified across, perhaps, a hundred different futures contracts. You're trading equities. You're trading currencies. You're trading bonds. You're trading a little bit of everything. Through that diversification, you are able to capture the momentum premia, and it has worked over time.

What's interesting, though, whereas everyone has added the bitcoin futures as the one hundred and first contract, a few have now come out and are just selling that one contract. Amazingly, year to date (because it's only been live for less than a year), they're outperforming these diversified funds. It's a small timeframe, but perhaps it speaks to the fact that the participants and the underlying fear and greed of the bitcoin futures are not institutional in nature and haven't been overcrowded the way that a lot of the CTAs are historically competing with other CTAs and it's very, very crowded.

Roy

I would definitely agree with that. We find, when we apply our short-term strategies that have been traded on all the other markets, to crypto, we do find a lot of alpha there. Of course, you also have much higher trading costs.

On the trend following side, it's very, very challenging. It's particularly challenging on the machine learning side because you're dealing with markets that have had a billion percent appreciation which you've chosen, retrospectively, to trade because they've had that appreciation.

So, I like to give this example. A trend follower says, "You know what, we're going to try our futures strategy in equities." So, they say, "OK, we're going to test our strategy on the hundred largest equities." Well, low and behold this thing works great and you start trading equities, and the thing just fails. What did you do wrong? Well, you retrospectively chose one hundred largest stocks which didn't all begin as the hundred largest stocks. So you have a huge upward trend bias, and of course, buy and hold works, and trend following on the long side works, but even trend following bi-directionally will have that huge bias.

Now, if you take bitcoin, your machine learning strategy, whatever trend following strategy that you use, is going to work. You will never be able to sell the high in bitcoin on a retrospective basis using the data.

So, you have to be very, very careful and I think the shorter-term areas, as I'm thinking you probably determined as well, have a little bit less of that potential for bias. I think that perhaps we're going to see the same thing happen in bitcoin that has occurred in equities where when "buy the dip" stops working a lot of damage can occur and a lot of funds can lose money at the same time.

I think a possibility that we all need to think about is, what happens if bitcoin just stays at six thousand for a few years. I'm really bullish five to ten years out, but it might get pretty boring for a while. What do you do if your investment is in a fund, that's relying on crypto appreciation?

So, I'm really happy to see James and others, there are a few, who are doing real trading strategies that are not necessarily just dependant on arb existing, which of course it exists for a reason, as you correctly pointed out. I think that's something we have to think about. Of course, the downside is something that's also possible. I think if you're in the space, you're a believer and you're well aware that you're buying something that is up a billion percent.

Tim

One thing that's interesting to add, and these are some of the conversations that we have with market participants, is when we're talking here, we're talking about the advent of crypto advent only buy-side firms and CTAs and really, I think, redefining what the "institutional investor" is. In crypto, you can't always apply that similar logic or that legacy logic of identifying some of these shops.

One of the things that the futures do provide is that when people are looking to deploy these familiar or tried and tested strategies from other parts of their portfolio or other parts of the ecosystem that they're familiar with, it works at CME because it's on glowbacks, it's a common technology protocol. People can deploy similar tactics because it's on the same platform.

When you look at some of the underlying digital space or some of the spot platforms that are out there, there are institutional accounts that they're trading, but I think the question is, is it institutional flow, is it institutionalized in the same way that you're finding in the futures space?

It's still a little be elementary in the way that orders are sent, and I think we're waiting for the advent of more complex orders or more complex algos being deployed on some of the spot markets or digital platforms. On the futures side I think that is one of the attractive things - people can deploy those strategies that worked. In other words, that have been tried and tested and now they are just applying it to another future at CMA as opposed to going through the machinations of trying to connect, for the first time, with some of these platforms, or work through the trials and tribulations as digital spot transaction platforms and ecosystems are coming online to more complex order types.