As an increasing number of professional traders enter the digital asset space, they may find it tempting to view the markets through a traditional lens. However, cryptocurrency markets have many fundamental differences, having emerged as a fast-growing, unregulated, and technologically evolving sector. In many respects, the principles of decentralization and open finance are at odds with existing regulations and how institutions are used to operating. One feature of the cryptocurrency markets is the high degree of liquidity fragmentation, which comes with a unique set of challenges – and some opportunities.
Crypto market and exchanges: a large and complex industry
The structure of trading venues is the first and most obvious difference between digital assets and traditional markets. Unlike the traditional markets, which are governed by jurisdictional regulations, the crypto markets comprise a large group of international exchanges like Bitstamp, Kraken, and Coinbase in competition with one another. Local firms such as Bitcoin Suisse and Crypto Finance act as brokers.
The markets are so fragmented that even if the largest five exchanges globally were to merge, the new entity would still only command around 40% of the overall trading volume.
Furthermore, as a significant volume of digital asset trading is conducted through OTC desks, it’s difficult to know exactly what proportion of the total circulating supply of any given asset is changing hands through exchanges.
To make matters more complex, decentralized exchanges are also rising in popularity. Uniswap, one of the biggest and most-used DEX’s, has seen total locked-in assets increase by five times in six months, from $1.3 billion in December to $8 billion in May, according to the tracking website DeFi Pulse.
Security tokens: regulatory progress will be key
The phrase “digital assets” also includes tokenized assets, which have been slated for years by industry watchers as a key catalyst for growth in the long term.
Security tokens come in a number of different forms. For instance, equity tokens represent shares, debt-based tokens represent instruments like bonds or mortgages, and asset-based tokens represent the right to fractional ownership of an underlying asset.
Regulation has been a key stumbling block so far. Security tokens were regulated in the same way as conventional securities, mandating the creation of a range of separate, licensed legal entities such as a securities depository and clearing system. These measures ensure improved protection for investors but also made it extremely complex for industry operators to obtain a trading license.
These barriers to the creation of regulated security token exchanges have hampered the growth of the secondary markets. Although the security token liquidity has improved over recent years, the regulatory and trading infrastructure remains underdeveloped. In some cases, issuance platforms offer a secondary market for trading tokens but there is a general lack of liquidity, and volumes are light.
There are positive signs of regulatory progress. In Switzerland, the DLT Act will enter into law in August 2021, greatly simplifying the process of establishing regulated security token venues.
The European Commission now seems set to follow suit, with the DLT Pilot Regime announced last September.
As regulations come to accommodate the specific features of trading digital assets, barriers to creating new trading facilities will be lowered. While this may improve the overall depth of liquidity, it would result in further market fragmentation. Large crypto exchanges may find themselves in competition with specialized security token trading venues on a regional or territorial level.
Overcoming the challenges of fragmentation
What does all this mean for traders? A fragmented market offers opportunities across different trading venues, large and small, global and local, centralized and decentralized. Therefore, the main challenge is ensuring that traders can find the best sources of available liquidity while mitigating the risks of fragmentation, which requires innovative solutions.
Fees and slippage are a key risk, as the spread of liquidity over multiple venues means larger orders involve engaging with multiple exchanges, brokers, or OTC desks to get filled. Fees can vary significantly between venues. Relatively shallow liquidity on any given venue means that large trades are highly conspicuous, introducing the additional risk of frontrunning.
An automated execution management system enables traders to connect to an array of venues using execution algorithms to split and randomize orders. This can be combined with a smart order routing (SOR) strategy, which automatically sends orders to the venues offering the best price and depth of liquidity. The net result is an efficient way to trade while minimizing the risks of slippage and front running.
Another point to highlight is that the digital asset space lacks a common communications standard. In the traditional asset market, FIX is used by all major venues. However, liquidity providers in the digital asset sector use a range of different APIs to exchange data based on systems like REST and WebSocket. No common rules exist, so the way a certain action is executed on two different exchanges is likely to differ.
As a result, establishing and maintaining reliable connectivity with a range of venues can be a complex technical challenge. Technology vendors can handle these issues, providing connectivity over a standard FIX connection to a wide range of venues.
Off-chain settlement to manage counterparty risks
In a nascent market where choosing reliable partners is a challenge, counterparty risk is real. Institutions need to strike a balance here. To ensure best execution and meet clients’ needs, they need access to as many liquidity venues as possible, but this increases the burden of vetting to mitigate counterparty risk.
In addition, cryptocurrency exchanges generally require traders to open an account and provide credit upfront to pre-fund any transactions. Some exchanges will offer credit lines to larger traders, but this generally occurs on a case-by-case basis.
Therefore, to have access to a wide range of liquidity, a trader would need to open accounts with each exchange and keep each one topped up with credit. It’s not hard to see why these requirements act as a systemic bottleneck that increases counterparty risk, impedes best execution, and, ironically, introduces the tedious task of managing multiple wallets.
To overcome these challenges, there’s increasing demand from institutional players for digital asset platforms that allow off-chain settlement. An intermediary settlement network sits between the financial institution and various trading venues, outsourcing off-chain settlement to a trusted partner and thus eliminating counterparty risk. The trader can store all funds in a secure, multi-currency, multi-address, self-custodial wallet only needs to fund each settlement prior to execution.
Are there opportunities in fragmentation?
While the challenges of fragmentation are extensive, it also creates opportunities. One example is that it allows traders to take advantage of “crossed spreads,” which occur when order books from different venues do not align. When this occurs, the best bid on one venue is higher than the best ask on another, resulting in crossed markets. You can effectively sell an asset for a higher price than that at which you bought it.
<INSERT IMAGE AlgoTrader Data Aggregated Order Book Crossed markets chart from original article>
The graph above shows a real-world example of the aggregated order book from separate venues. Below a quantity of 1.3BTC, bid prices exceed ask prices. This type of market anomaly shows that there are significant benefits in automating connectivity to a wide range of trading venues, allowing traders to capture opportunities when they arise.
Fragmentation and the quest for liquidity also offer other opportunities not found in traditional markets. For example, it’s possible to earn yields by contributing liquidity to a decentralized exchange or a lending protocol such as Compound. There are also now centralized lending services available offering similar yield-earning features.
Although the situation continues to evolve, it’s fair to say that the structure of the digital asset markets is starting to emerge more clearly. One thing seems inevitable – the ongoing technological innovation that characterizes the space, combined with the direction of regulation, means that fragmentation is likely to remain a feature. While this comes with its own challenges and opportunities, a more dynamic secondary trading ecosystem is now emerging that will help to offset the challenges of fragmentation while creating more new opportunities.