As the entrance of institutional players into the crypto space continues to draw nigh, the market for a murky off-exchange form of trading known as over-the-counter is becoming an increasingly critical lynchpin to the cryptocurrency ecosystem.
While most people looking to buy or sell cryptocurrency can do so through standard exchanges, large institutional investors and high-net worth individuals who transact in large volumes of bitcoin must look to the relatively uncharted world of OTC markets to execute these trades.
Because cryptocurrency exchanges typically lack the technological infrastructure and the liquidity required to execute large block orders, big buyers and sellers are effectively forced to find one another by venturing into Skype chatrooms hosted by proprietary trading firms like Cumberland, private messaging platforms like Telegram and even public forums like LinkedIn.
“The big deals have to go OTC. A lot of the exchanges limit the order size, so you have to break up your orders, and that’s just fatal,” explained Monica Summerville, director of fintech research at Tabb Group, a U.K.-based market research firm.
Breaking up a large sell order of, say, 1,000 bitcoins, could send an adverse signal to the market and trigger what’s known as slippage – whereby the price of a trade at execution is different than the expected price.
The appeal of OTC for traders, miners and the like, is that it provides a much-needed offramp from crypto into fiat – necessitated by the fact that most of the largest crypto exchanges don’t deal in fiat currency.
“We prefer to hedge into fiat when we want to liquidate. Others go into (stablecoins), but there’s a lot of shadiness out there, so we prefer not to diversify,” said one trader, adding that simply transferring assets to a fiat-compatible exchange isn’t always a ready solution either:
“A lot of exchanges use banking services in different countries and geographies that aren’t necessarily respected. Just because you can get fiat into an exchange doesn’t necessarily mean you can get it out.”
These markets have grown significantly more popular and competitive over the last 12 months, according to participants, as more sophisticated investors and traders enter the space. Many of these players have begun trading through brokers like Octagon Strategy, Genesis Trading, Circle, though the exact size and scope of this market remains difficult to quantify.
A report earlier this year produced by the Tabb Group estimated daily bitcoin OTC volumes at $12B globally. Summerville reckons that this figure is two to three times larger than the daily average traded across standard crypto exchanges globally, though this is comparison is difficult to quantify because the volume figures reported by exchanges can be of questionable veracity:
“There is nobody checking the volumes that are being reported, and there are suspicions that exchanges are doing various things to increase their volumes that would not be legal for a normal regulated exchange.”
Still, estimates of the actual size of the bitcoin OTC market vary widely. Lucas Nuzzi, director of technology at Digital Asset Research, pegs the total daily volume at around $250M.
“This is very different from other figures we see out there,” he said. “Our estimation is based on things we can see and people we interact with that are actively participating in those markets.”
Institutional Stumbling Block?
While an influx of new institutional money into crypto has been a topic of endless discussion and speculation over the last 12 months, the lack of exchange infrastructure has pushed many of the players brave enough to venture in to the OTC realms.
“Structurally, for a lot of institutional investors, OTC is really the only way they can trade the most liquid assets,” said Nuzzi.
However, a general murkiness and lack of sophistication in OTC markets hasn’t created an environment that institutionals can be fully comfortable participating in.
Somewhat paradoxically, crypto OTC trading requires a heavy degree of trust when cashing out into fiat is the end objective.
“Currently, some parts of the cryptocurrency industry are organizing six figure trades over Skype and Telegram – very similar to how old-school Wall Street brokers and traders would call clients to bring buyers and sellers together,” explained Frank Wagner, founding partner of INVAO – an artificial intelligence-enabled investment vehicle for crypto assets.
“Clearly, this can’t be the most secure and effective way to execute these trades and may be a reason that many institutional investors are deterred from getting involved.”
In particular, crypto OTC trading brings with it several unique forms of counterparty risk. One aspect is that, because of anti-money laundering rules, many financial institutions are still averse to the idea of processing large wire transfers directly related to cryptocurrency transactions. This means that even if a trade is agreed upon by both parties, there is no guarantee that the fiat transfer will actually execute.
A crypto for fiat exchange is also asymmetrical in the sense that the coin transfer happens much faster (sometimes by several hours) than the wire transfer.
“When you execute a trade with an OTC broker, after the trade you need to deliver the currency to the broker. Until the broker delivers you the BTC/ETH or the Fiat you have a risk that for example he will default before he delivers your tokens or funds,” said Daniel Peled, co-founder of Orbs, a hybrid public blockchain project that is engaged in OTC trading, adding:
“Basically there is counterparty risk that the other side might not be solvent since it doesn’t happen in real time, so you need to trust them to wire you the money.”
Gene Grant, CEO of VRBEX – a crypto and security token exchange, explained that as transaction sizes grow larger, the process becomes more complex and a heightened layer of counterparty risk is added due to the high stakes.
“The large transaction market is fairly small, and the players are deeply distrustful,” he said.
Still others contend that more robust regulation, custodial solutions and surveillance tools are needed to give mainstream investors the confidence needed to wade more aggressively into crypto OTC.
“OTC is regulated similarly to other traditional trading ecosystems, but the industry is still missing the monitoring tools for enforcement,” said Peled, adding:
“Therefore, the fear that certain parties are sharing knowledge and front running is a real concern for traders.”
Solutions on the Horizon
But despite the downturn crypto markets have experienced since the beginning of the year, there are numerous onramps being built with the goal of bringing more sophisticated infrastructure to OTC markets.
A sure sign of maturation is last week’s announcement that Fidelity, the world’s fifth-largest asset manager, is entering the world of storing and trading crypto – to be sourced from OTC markets – for institutional investors.
Indeed, building software systems for crypto that can replicate the settlement, clearing and risk management systems to which traditional investors are accustomed is becoming big business.
“Even though the market has disappointed a lot of people, the infrastructure wasn’t sacrificed and you still have a lot of things being built,” explained Nuzzi. “There are dozens of software providers that are tackling this need by OTC traders.”
For example, OTCXN is building a multi-custodian network that seeks to address the lack of a clearing and settlement mechanism that can connect liquidity providers and exchanges with minimal counterparty and settlement risk.
“What we have created is an institutional-grade Layer 2 network, like Lightning Network, except that it operates across all crypto assets and at institutional scale and capacity,” said Rosario Ingargiola, CEO of OTCXN.
“You simply cannot scale the crypto markets to institutional levels without removing public ledger transactions from the real-time trading critical path,” he continued, explaining that his platform will facilitate OTC trades between counterparties to be settled and cleared in less than a second.
OTCXN recently announced partnerships with Kingdom Trust and Prime Trust, which are both registered as qualified custodians with the Securities and Exchange Commission, to custody the crypto assets that are traded on its platform.
Another solution making headway in this realm is Caspian, which recently raised nearly $20M in an initial coin offering with the goal of providing sophisticated traders and investors with better tools, such as a single user interface that connects to major exchanges. In early October, Caspian partnered with B2C2 – the crypto market maker – to better serve the liquidity needs of large OTC traders.
But while there may be a Cambrian explosion of new platforms devoted to helping institutional traders manage risk coming onto the scene, Nuzzi of DAR argues that the market for duplicating legacy trading tools will likely end up a niche one:
“A lot of them will fail only just because there’s this infrastructure being developed that already exists in traditional financial markets.”
Based Blockchain Network