Institutional investors and high-net-worth individuals (HNI) typically use over-the-counter (OTC) trading when they want to buy or sell a large amount of cryptocurrency. That’s because while 99% of people who want to buy or sell cryptocurrency can do it directly on an exchange, placing an extremely large order on an exchange can be a costly enterprise. Say that you’re an institutional investor trying to buy $1 million worth of Bitcoin, or that you’re a cryptocurrency start-up that’s trying to sell $1 million worth of Bitcoin raised through ICO. If you try to place such a large buy or sell order on a cryptocurrency exchange, the order can move the entire market up or down — and lose you a fortune.
Large market orders typically go deep into the order book, leading to poor price execution.
In the example above, a 100 BTC sell will eat up the buy side of the order book, from $13,036 all the way down to $12,936 and farther below. After the large order is fully executed, the price will be considerably lower than $13,000 per BTC. The party that wants to sell a large quantity of Bitcoin will need to lower its price. Avoiding scenarios like these is the main reason why investors will trade OTC. Instead of placing a trade on a regular exchange, OTC trading is done directly between two parties. An OTC broker either supplies the trade with liquidity, or finds someone willing to take the other end of the trade. Because this happens outside of the regular market, the volume is hidden and isn’t registered by an exchange. There are two main types of OTC venues:
- An inter-dealer broker, a firm that acts as an intermediary to match a buyer and seller. An inter-dealer broker will normally advertise a fixed fee to both counterparties for their match-making services.
- A principal OTC trading company, a firm that will act as the direct counterparty and take on the trading risk. Principal OTC trading firms will charge the same as an inter-dealer broker or more, based on market demand and how well they can manage their risk. For example, if you ask to buy 100 BTC, they will look at the available liquidity in the market to calculate how quickly they could hedge themselves and add an additional spread to safely cover their risk.
While this sounds good in principle, crypto OTC trading is really opaque. On an exchange, you can see all the buy-and-sell orders in the order book. When you’re trading OTC, you don’t necessarily know what the market looks like or how big a spread an OTC broker is charging. Trading OTC provides anonymity and price stability, but it isn’t necessarily cheap. If you go into OTC trading blindly, you can end up getting played even worse than you would if you sold on an exchange. If you don’t know how the game is played, OTC brokers can and will profit off you. In this article, we’ll shed some light on the games traders play and equip you with strategies to minimize trading costs and market manipulation.
Avoid these Mistakes when Trading OTC
By placing a large order on an exchange, you’re showing your cards to the market, and the market will usually react and take advantage of you. The same goes for OTC trading. While OTC trades are hidden from the market, you can unwittingly expose your hand to brokers and they can use that information to their advantage. Trading is a zero-sum game. The worse the rate an OTC broker can give you, the more money they make. There are a number of strategies an OTC broker can employ to skew your view of the market and profit from you. Say that you want to sell 1,000 bitcoin and that the current exchange price for bitcoin is $10,000.
You call several brokers on the phone for pricing and give them the details of your trade:
- Broker 1: $9750 per BTC
- Broker 2: $9700 per BTC
- Broker 3: $9650 per BTC
By the time you call the first dealer back on the phone, the market has moved down and he’s decreased the price he’s willing to pay to $9720 per BTC. For the trade, you’re paying a hefty $280,000 above the exchange price! Armed with the amount, time, and size of your trade in advance, the OTC brokers you spoke to may have done any number of things to profit from your trade. Knowing that the trade would move the market, they could front-run and adjust their own Bitcoin holdings. They could have manipulated the order book to skew your view of the market and agree to a poor rate. They could have shared the details of your trade with counterparties in their network. They could even do all of the above at the same time. Let’s do a deep dive into the most common mistakes people make when trading OTC. We’ll explain how OTC traders profit from these mistakes, and what you can do instead.
Mistake #1: You Shopped Around
When trying to execute an OTC trade, people commonly believe that the best way to find a good deal is to shop around by calling multiple brokers on the phone and ask around for rates. That way they can go with the cheapest option. The problem is that the more people you tell about your trade, the more likely it is that they’ll use that information against you. For example, say that one of the brokers you called was an inter-dealer broker. After you call them for the quote, they’ll talk to people they know to find a counterparty for the trade. Now the network knows there’s a highly motivated seller. The counterparties can remove their buy orders from the market, making the price of Bitcoin appear lower, so they can secure a more favorable rate. The key is to avoid shopping around for rates. While you might think shopping around helps you find the best deal, you end up showing your hand and brokers can turn that information against you. What to do instead: Don’t shop around for rates. Call no more than one or two OTC brokers, and only when you’re ready to execute the trade.
Mistake #2: You Showed Your Hand
Even if you only call a single broker on the phone with the details of your trade, that gives them enough information to front-run the market and manipulate the price. Say that you call an individual broker and say that you want to sell 1,000 BTC in one day. You’ve just shown your hand to the market, and that information can be used against you. The moment you hang up the phone, the broker rushes to sell some of their own Bitcoin. If you do go with that broker, they can simply buy their Bitcoin back from you at a lower rate. Even if you go with a different broker, since your 1,000 BTC trade will move the market down, the broker you called can simply buy Bitcoin back from the market at a cheaper price. Either way, the broker gets the upper hand because you’ve spilled the beans around your trade. What to do instead: When you call an OTC broker on the phone, ask them to provide both buy and sell rates for 1,000 BTC, 500 BTC, and 100 BTC. That way, you’re getting the broker to show their hand instead of exposing your own. You can look at the spread between the buy-and-sell rates to estimate the broker’s profit margins.
Mistake #3: You were Predictable
Another common mistake people make with OTC is behaving predictably. Brokers can exploit patterns of behavior to their advantage. Let’s say that every time you want to make an OTC trade, you call the same couple of brokers on the phone and ask for a rate. You do this each week over the course of a month. OTC brokers aren’t stupid. They’re taking notes on how you behave and they’ll know that when you call, you’re talking to other brokers and looking for the most competitive rate. To lock in your business, an OTC broker might give you a really attractive window price for your trade the first time that you call. After you’ve spoken to other brokers, you’ll go back because the first broker gave you the most competitive rate. That’s when they stick you with the real rate, which needless to say, is substantially higher. Since this broker gave the best rate initially, you’re more likely to execute your trade with him even if the final rate is higher. What to do instead: Don’t be predictable with your OTC trades. If an OTC broker gives you a rate that sounds too good to be true, it probably is. Call their bluff and ask them to lock in that rate for you.
Mistake #4: You Bought or Sold the Full Amount
If you’re trying to buy or sell 1,000 BTC OTC, don’t make the mistake of trying to stuff the full amount into a single trade. The rate that you get for selling 10 BTC will be much better than the rate you get for selling 10,000 BTC. With a large trade, there’s always the risk that the market will move and that the price will slip. OTC brokers price this risk into the rate that they give you. For a sell order of 10,000 BTC at a price of $10,000 per BTC, a 10% upward movement in the price can cost millions. To adjust for this risk, a broker will go very deep into the order book to supply you with an unfavorable rate. What to do instead: Don’t buy or sell the full amount of crypto in a single OTC trade. Split your order into several smaller trades of 10 BTC each.
Mistake#5: OTC Trading in a Slow Market
Just because an OTC broker provides you with a price guarantee, that doesn’t mean that your trade is completely protected from market movements. Another common mistake when OTC trading is trying to place trades in a slow market.
The chart above shows a sharp dip in 24-hour volume for Bitcoin on Christmas Day, 2016
Let’s say that you want to make an OTC trade on Christmas Day. Because it’s a holiday, there will be a lot less activity on the market and lower volume than almost any other day of the year. To execute your trade, an OTC broker will have to go much deeper into the order book than in a normal market, leading to a poorer rate. What to do instead: Make sure that there’s a decent level of activity in the market before placing an OTC trade.
Mistake #6: OTC Trading in a Volatile Market
Similarly, another common mistake people make is OTC trading in a volatile market with high fluctuations in price. In theory, the market is stronger during periods of high volatility because there’s a higher level of activity. But remember that OTC brokers charge a risk premium when they price a trade. If the market is volatile, it’s harder to know the price a trade will execute as, and OTC traders will charge a higher risk premium accordingly. What to do instead: Avoid OTC trading when the market is highly volatile. Wait for prices to stabilize before trying to execute your trade.
Play Your Cards Close to the Chest
While OTC helps you shield your investment interest from the market, you can’t completely hide that interest, because you’re dealing with a middleman who’s active in the market. When you trade OTC, you need to account for the explicit fees that you pay the broker along with the implicit fees you’ll eat by sharing information with an active market participant. Minimize the information you share to minimize your exposure to manipulation.
Above all, remember the three cardinal rules of trading OTC:
- In general, don’t be predictable.
- Don’t share the exact time you want to trade, or the full quantity.
- Shop only when you’re ready to trade and we recommend talking to no more than 1–2 brokers.
Finally, there are a number of tools available on the market that are making it easier for traders to buy and sell crypto OTC on their own. In an upcoming post, we’ll teach you how. Stay tuned!
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