New trading mechanisms start to blur the line between exchange and OTC trading as challenges surround delivery-versus-payment (DvP) mechanisms.
The volatility of digital assets and cryptocurrencies is a given, but adding more complexity and risk in terms of market structure will only further impede participation by a broader set of institutional investors. A closer look at the custody and OTC models being utilized and the challenges surrounding delivery-versus-payment (DvP) mechanisms reveals that as the crypto market evolves, so, too, are solutions to address the thorniest issues.
The centralized exchange model is the dominant approach for trading digital assets and cryptocurrencies in public blockchains because it solves the limitation of numerous blockchain protocols relating to trading speed and settlement fees. (Mining fees are per transaction rather than the traded value.) However, this poses significant issues for the market in that parties to a trade are exposed to the security of the crypto exchange during the transaction process. As a result, there is growing skepticism about the relevance of the centralized exchange model, and most institutional participants are utilizing OTC mechanisms to facilitate trading and settlement of crypto assets.
The reasons for institutional investors to trade OTC versus on exchange are often similar across assets, but they tend to be reinforced in the crypto-world:
A number of crypto startups admit that the centralized model of crypto-exchanges was a necessary first step to develop the market, but that the next evolution will come from decentralized exchanges. While this type of venue currently represents trivial volumes, it is gaining significant attention and might represent the next evolution and/or addition in the cryptocurrency exchange landscape. For example, Binance, which operates a centralized pure crypto exchange, last summer unveiled a demo of its decentralized exchange (DEX) platform. But even within the decentralized exchange space, some differences arise. One needs to think of them as P2P platforms. On one hand, you have semi-decentralized venues that aggregate orders into a centralized order book (think Napster), but in which settlement is decentralized. On the other hand, there are fully decentralized platforms, like Gnutella, in which the user reconstructs the order book on its interface by aggregating orders available in the network and where queries are distributed by all the other nodes on the network. These new trading mechanisms would certainly blur the line between exchange and OTC trading.
This blog is the first in a three-part series, authored by Tom Casteleyn, Global Head of Custody Product Management BNY Mellon Asset Servicing and Lucien Foster, Head of Digital Partnerships, exploring the market structure. Parts 2 and 3 explore emerging trends, the evolution of digital assets and technological play.
1 Average Median standard deviation of daily returns of BTC/USD pairs across crypto-exchanges: Bit-x, Bitfinex, cex.io, Coinbase, exmo, Gemini, Kraken
The views expressed herein are those of the authors only and may not reflect the views of BNY Mellon. This does not constitute Asset Servicing advice, or any other business or legal advice, and it should not be relied upon as such.
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