If You Can’t Beat Em, Join Em???

With the announcement that Bittrex has joined Kraken, Coinbase, itBit and other exchanges by offering an OTC trading desk, it seems that most exchanges have decided that OTC trading is their best chance to grow their business. This comes amidst a backdrop of OTC desks out-competing the exchanges for market share, particularly for large traders, according to many published reports.

To achieve a dominant market share, however, the exchanges must earn the trust of investors in the fundamental fairness of the market. Public order books that facilitate price discovery should have a unique and important place in establishing that trust. Unfortunately, the current fragmented exchange landscape is hard for many investors to navigate . Large investors have issues with the lack of credit lines at exchanges (while OTC desks provide them) and the difficulty of moving assets between them, partially due to artificial barriers created by the exchanges themselves. These barriers, stem from the individualistic culture of cypherpunk and Silicon Valley that gave rise to crypto.

It is quite ironic, but the crypto community should learn about cooperation from Wall Street, which, despite a public perception of embodying unfettered, “bare knuckle” capitalism, has a culture of cooperative endeavors. Unlike Silicon Valley, which tends to operate on the principle of one of my favorite movies, The Highlander (“There can be only ONE”), Wall Street is based on shared business practices. Whether it was the original “members only” exchange (NYSE), the largest self regulatory members organization (FINRA), widespread adoption of multi-broker trading platforms or the FIX protocol that facilitated that, or standards for derivatives documentation accepted by all, cooperation is entrenched. Crypto exchanges, for the most part, however, refuse to cooperate with each other, making it hard for clients to navigate the fragmented marketplace. Individual exchanges should work together to promote best execution, manipulation surveillance, credit lines & clearing, all of which would help mainstream investors gain needed trust in the system.

Getting back to the examples cited in the opening, those exchanges that are trying to compete with OTC markets face two divergent paths:

1. Exchanges could attempt to compete with the OTC market by offering such services directly, on their own, or
2. Exchanges could strengthen online price discovery by cooperation. This could entail setting up or empowering intermediaries with electronic agent functionality with smart order routing and pan-exchange algorithmic trading that focuses on best execution.

Path 1: Establish Independent OTC Desks Without Cooperating with Exchange Competitors

There are three problems with this “lone wolf” OTC Desk approach. First, there are inherent differences between exchanges and trading desks. Each occupies a particular niche within the ecosystem of the market. Exchanges, OTC market makers, proprietary trading desks and agency brokers all have important roles, but there are reasons why they are separate businesses in most asset classes. Second, single exchange OTC desks lack connectivity to other exchanges. This hobbles the capabilities of such desks, meaning they are unlikely to perform well vis a vis independent desks. Third, the establishment of OTC desks risks harming confidence in the neutrality of exchanges, damaging the integrity of those markets. Each of these will be discussed in turn.

The primary function of exchanges is to provide price discovery, via accessible public order books. Investors enter orders to exchanges, where those orders can interact, match and execute continuously. This function requires that exchanges be neutral with regard to their clients, so that all participants are confident that the market is fair. Client information beyond what is displayed in the order book must remain confidential, while access to order data and the matching engine should be managed according to well understood rules. The exchange itself should have no vested interest in the movement of the asset prices they trade, in order to ensure these conditions.

OTC desks, however, are quite different. They provide immediate liquidity to their clients, using their own capital and trading inventory, or, sometimes, by finding another client to match against. OTC desks are the very opposite of neutral, as, in most cases, they profit by trading against their clients. This is not a bad thing, as OTC market makers provide necessary liquidity for clients that need it, but it is important to understand the distinction. While, in some markets, particularly where regulations govern order handling, clients trust market makers with their orders, in most cases, there is significant distrust. Market makers provide accessible quotes, sometimes on their own dedicated trading platforms. They also trade directly on exchanges, quite often being the most active traders on the exchanges. What they rarely do, however, is provide a neutral platform for handling orders and when they do, those systems are walled off from the market making function.

The best way to understand this is was from a conversation I had with the head of electronic trading at a major investment bank that also, as most do, offers OTC trading. We were discussing the importance of third party verification of the (equity market) execution quality they provided to clients and I commented that his pristine reputation should have made verification less important. With a smile, he turned to me and said: “Thanks for the compliment, but (considering my firm’s business) my pristine reputation means that the buy side only thinks I am half full of shit..”

The upshot is that, in equity markets as an example, the majority of trading takes place on the public order books of exchanges, while OTC desks are an important supplemental method, used when the liquidity on exchanges is insufficient for client’s immediate needs. Much of the trading on exchange, however, is done via pan-exchange algorithmic methods and smart routing. It is exceptionally rare that any serious trader utilizes a single exchange for all their trading and it is likely that they would be judged to be failing their best execution obligations if they did so.

In crypto, however, much exchange trading is done via single exchange interfaces, despite the obvious fact that, quite often, the exchange of choice does not have the best price. People justify this by pointing to the fact that crypto exchanges provide custodial functions for their clients which make it hard to trade across platforms. There is some truth to this, but it is certainly possible to manage multiple exchange wallets and trade across them with systems like that provided by CoinRoutes.

The second problem with the exchange OTC strategy is access to other exchanges. In order to have a truly competitive trading desk, that desk needs access to as much liquidity as possible, yet getting such access will require allowing their competitors the same thing. This gets back to the cultural issue described above. The bottom line is that today’s leading exchanges face a crossroads: if they insist on going it alone, they risk losing what they have, if their peers and new entrants establish a working ecosystem without them.

The third, and perhaps most important issue is that the exchange OTC desks could undermine confidence in the exchange itself, rendering such an initiative counterproductive. This could occur if there was a perception that the exchange OTC desk has access to more information or has superior access to trading on their own exchange than anyone else. Here is a simple example:

The public data feed of the exchange shows 100 Bitcoin was sold by a single order, but nothing else about the seller was publicly known.

The Exchange OTC desk had access to wallet information and, therefore, knew that the seller had transferred 5000 Bitcoin to their exchange wallet earlier that day and had already sold a few hundred Bitcoin before the most recent order.

That desk would have inside information that there was over 4500 Bitcoin likely to be sold in the short term, which is a large advantage.

There are other examples, of course, including faster connection abilities, potential for preferential priority within the exchange, etc. The point is that, in the absence of third party verification, it is hard to build trust in such an environment.

Path 2: Establish Inter-Exchange Cooperation

This path starts with a willingness of the top exchanges to work together and establish ground-rules for that interaction. In addition to agreement on standards for trade surveillance and allowing accounts for agents of competing exchanges, it would include cooperation on self-regulation. In such a world, exchanges would still compete on market structure, order types and pricing, and product offerings for different product niches.

In this world, exchanges could also establish OTC desks, but would, more likely establish or work with agency oriented intermediaries, both electronic and high touch. Exchanges could offer algorithmic trading solutions that might prioritize their own books, but do not ignore their competitors prices. Their goal would be to attract as much order flow as possible to their displayed order books, rather than trade everything on an opaque, OTC basis. In this path, even if exchanges create OTC desks, cooperation would bolster the effort, as it would ensure more available liquidity.

It is also worth noting that the “clock is ticking.” In addition to the potential for regulators to insist on a more modern market structure directly, there are implications to the current flawed market structure. Chief among them, is the fact that the SEC has expressed their dissatisfaction with the lack of broad price discovery and potential for manipulation by rejecting all of the Bitcoin ETF applications to date. In addition, new entrants joining the fray seem to understand concepts such as best execution and likely won’t hesitate to embrace them. The leadership of the incumbent exchanges should consider this. After all, by their own admission, they are losing the battle for “institutional” wallets to OTC trading already, these new threats are emerging to their existing business. In our opinion, the leading exchanges would be better served by working with solution providers such as CoinRoutes (which can facilitate cooperation via consolidated data and pan-exchange trading algorithms) than by a lone wolf strategy. Only time will tell what path they choose.