What Cryptocurrencies Trading Should Learn From Wall St.
With Bitcoin prices down almost 70% and some altcoins faring worse, crypto space is doing surprisingly well. The number of wallets is increasing, there are new projects starting all over the world and while volume on the exchanges has tempered off, OTC trading is exploding.
The proverbial cat is out of the beg, cryptocurrencies are creating alternative business models, alternative payment options all over the world. Cryptocurrencies are forcing governments with their national currencies to compete for capital and transactions of their citizens. And that is a beautiful thing, to me, this is the real mission of cryptocurrencies, create alternatives, offer people all over the world options. In many places in the world, people have no political power, votes mean very little, but people vote everyday day with their capital, it is a lot easier to vote with the money in your pocket.
With that said, as the market expands, how will cryptocurrency trading evolve going forward? Is it different this time? How will crypto instruments trade as more and more participants join the market? The short answer is no it is not, cryptocurrencies are just another asset class, another market. Investors, traders are looking at it with the same set of tools. From the fundamental standpoint it is not easy to figure out what the fair market value of Bitcoin should be but from the technical analysis standpoint, traders are looking at the same charts, same candlesticks, moving average, etc., use the same order types to execute trades. To that end, the crypto market is just another financial market, another asset class, it will follow the evolution of every other electronic market — fees will be reduced, numerous exchanges will disappear (some will close doors, some will be bought out) institutional grade tools, pre and post-trade will be developed. Institutional trading will be decoupled from retail and participants are looking for credit and leverage so the market will provide it, institutional investors are looking for settlement with very limited and quantifiable counter-party risk, so institutional clearing solutions that exist in other markets will be adapted (look at CLS functionality as a model). Let’s break it down.
Transaction fees. Exchanges make money on volume, and when there are hoards of new participants joining the market, exchanges can charge whatever they want. But if there are 10 venues offering the same services and compete for the same customer, the only way to steal the market share is to reduce transaction fees. Once the first exchange would do that, others will follow. They have no choice, or else their volume will disappear. Before Binance opened its doors average fee was about 0.25%, it is no wonder Binance stole the market share from others by offering trading with 0.5% commission. Of course, another way to increase trading volume is to buy out your competitors. I think we will start seeing these transactions later this year. Look at how online stock brokers fared over the last 20 years. Does anyone even remember “full service” brokers, or those online brokers who used to be called “discount brokers”? Transaction fees went down about 10x over the last two decades. And now you can even trade for free. Crypto exchanges, will follow the same trajectory. Btw, as a side note, I have a hard time calling these trading houses exchanges. They really are very much like retail FX brokers. They hold your deposit, you trade on their platform, they provide leverage and credit and settle your transactions but you really have no idea if they take the other side of your trades, and what other market manipulations they engage in.
Credit and leverage — In traditional financial markets these concepts are related, you need credit to obtain leverage. professional traders need leverage to generate desired returns. To some extent volatility of the crypto market reduces the need for leverage and with current volatility trades can generate enough juice without much leverage to make it interesting. But volatility has been coming down and will continue to come down as more and more participants enter the market. So credit and leverage are needed. Currently, some exchanges started offering leverage or ability to short coins. Thus these venues are offering credit to some of their customers. Offering credit puts these exchanges at risk and since they also handle customer deposits (that is how they offer credit) they put all their customers at risk. None of the exchanges in the traditional finance offer credit and take this kind of risk. Crypto trading will move to use credit intermediaries, using the same model that exists on Wall St. thus reducing the risk of crypto exchanges but also reducing their revenue.
Clearing and settlement — This is probably the biggest change the crypto trading will see as it evolves to support institutional clients. From the Wall St. standpoint, both centralized and decentralized exchanges are bad options (see more on this below) and Wall St. has a very hard time using either model. Institutional investors first and for most are concerned with two things: Is my capital safe? And can I trade where I want to trade? Not surprisingly these questions have been addressed very well by traditional financial infrastructure. We don’t have to look much further than the Spot FX market to see how billions and trillions of dollars are traded every day on numerous venues with very little counter-party risk. Security of the client funds and settlement risk are addressed. The FX trading venues catering to the institutional investors all trade on credit. Credit is provided by the custodians or by the Prime Brokers, all major banks are offering the prime brokerage services.
Opening a PB account would be daunting for a small investor, google ISDA agreement and read one for fun, but for any institutional investor, a fund this is must have to operate properly. But once the PB account is established, to trade on a particular platform all a client would need to do is ask the PB say Citi to set up a trading account on that platform. The platform only knows that Citi asked to set up an account. with specified trading credit, i.e. 10 million USD. Many times, the platform may not even know who the actual customer trading is, it could be just a numbered account. Every time that account (Account A) trades the trade is reported by the platform to both counter-parties. So if Account A traded with an Account B and Account B has credit provided by Barclays. The Platform is sending the trade confirmation to Citibank that their Account A made a trade with Barclays and the Platform sends the trade confirmation to Barclays that their account B made a trade with Citi. That is it! Now banks book the trades to the client’s accounts and settle among themselves. There is more to it but this is the basic process. As a consequence of that structure, a fund could ask their PB to provide credit to trade on two platforms, so if it bought Euros on one platform and sold it on another, at the end of the day both trades will be reported to the prime broker and PB will see that the fund is flat and will credit or debit p&l into the account, no money or coins have to be sent around. That’s it. All the funds stay in one place, clients trade where they want to trade and all can go home every night knowing that all the trades were netted out and settled.
If a fund needs leverage the PB will provide it, trading platforms don’t even need to know if the fund has leverage or not, how the credit is secure is a different issue, it could be secured by some collateral or just on the strength of the balance sheet. It doesn’t matter to the trading venue or exchange. All they know is that Citibank guaranties the trading account, full stop. So you can see, that spot FX trading is way ahead of crypto “exchanges”, exchanges are decentralized, and settlement is also decentralized. Clients can trade anywhere and don’t have to worry about who is on the other side of that trade. Client’s only link is the prime broker and the PB lets the client trade anywhere where the PB’s credit is accepted. With that said, not all trading will move these credit-based institutional platforms, some retail trading will stay with existing exchanges, some exchanges will become regulated and therefore will offer more transparency and security to their clients, but exchanges that would want to cater to the institutional investors will have to change, will have to offer trading on credit and separate trading and custody.
So why are the current crypto trading solutions both centralized and decentralized are bad? In short neither can handle the volume, open to abuse and unsafe. Centralized exchanges have to deal with too much risk, both by holding customers deposits and by offering leverage. Decentralized exchanges fragment the order books, open to abuses such as order front-running, limited to trading the coins/tokens that the settlement smart contract could handle. And both don’t offer what institutional market participants are looking for: custody, credit, settlement, trade netting, etc.
To be fair, cryptocurrencies are not built for HFT and institutional trading, and existing exchanges do not help it. Recording trades in blocks where both first and last trades in the block are confirmed at the same time, slow forming consensus by independent nodes, all slow by design. It may be counter-intuitive but the immediate settlement of all the coin trades is detrimental to institutional settlement. Why should my buy transaction go through settlement when I know I will sell it back in 30 seconds or less? And if I do a few hundred trades a day can I just settle my net exposure before I go home???
Both centralized and decentralized exchanges are bad options, traditional Wall St. options are much better addressing the needs and concerns of institutional investors — there should be a separation between trading (aggregating orders, managing risk) and holding the assets. Traditional trading venues, exchanges handle order aggregation, order matching and manage trading risk. Independent clearing firms handle settlement and settlement is really just a utility, it is usually, rarely is a big money maker. Credit, leverage, product landing is provided by independent third parties, banks, brokers, etc.
And finally there are tons of services pre and post-trade professional traders are looking for: order averaging and allocation, TCA, tax reporting. All these services are needed and will be available in a short order.
Here’s my final thought — cryptocurrencies, blockchain are major innovations, it opens the door to new business models, tokenomics, new ways to deploy capital, but from the trading standpoint, it’s just another asset class. Show a Bitcoin chart to any professional trader and they see candlesticks and moving averages just like they would see with any other instrument. They are looking for the traditional trading tools, credit and platforms they use every day. Follow these traders and you will see the future of cryptocurrency trading.
Dan Raykhman, CEO of Fungible Network