Today I contrast the two main ways that market participants can trade Bitcoin (BTC) against dollars (USD) for immediate delivery, also known as the spot market.
The spot market for BTC/USD can be broadly divided into two types:
- Exchanges, such as Coinbase, Bitstamp, Kraken, or Itbit.
- Over-the-counter (OTC) institutional brokers, such as Jump Trading, FTX, Cumberland, Galaxy Digital, or Genesis Trading.
I will explain the workflows for both of them and also offer some predictions for how these markets will continue to evolve. My point of view is as a large trader seeking to execute as a taker.
The workflow for an exchange client begins once she decides she wants to buy or sell Bitcoin.
If she wants to buy bitcoin with USD, she starts by initiating a bank transfer to send fiat from her bank to the bank of the exchange she has selected to use. In some countries, this may involve physically going to a bank branch and filling out telegraphic transfer forms. In other countries, this can be done online. Depending on the method, it may take anywhere from a few hours to a few days.
If she wants to sell bitcoin for USD, she starts by initiating a coin transfer from a place where she controls the BTC. This may be her own hardware wallet or it could be a custodial solution. Controlling the keys herself would make this a near-instant affair, but she still needs to wait for confirmations to occur on the Bitcoin blockchain before the coins are credited in her exchange account. Some other causes of delay:
- If the coins are in deep cold storage, she may have to travel to various physical locations to obtain the private key.
- If they are secured via a multi-signature setup, she may need to wait for other individuals to sign off.
- When transferring from a custodian, then there may even be a long mandatory hold period intended to protect her from fraud or theft.
Once the funds are on the exchange, she then executes the market orders corresponding to the trades she wants to do. The price may have moved significantly against her trade in the period between when she decided to trade and the moment she was actually able to click the button. This uncertainty and time-delay is a user struggle and contrasts sharply with the user experience she would have become accustomed to in equities trading. Because a stock brokerage account exists in the traditional financial system of non-bearer assets, the user has never had to worry about loss of funds if she leaves them on the exchange. Furthermore, the channels to move fiat from her bank to her exchange are much faster and smoother, without any random delays due to compliance.
When an institutional OTC client decides to trade, she pings her OTC brokers and is shown a two-sided quote for the size that she wants to deal. Because she has signed legal agreements with her brokers and her brokers have vetted her and trust her to fulfill her financial obligations, there is virtually no latency between intention to deal and ability to deal. She can ask her top three brokers for a quote in anywhere from 25 to 2,500 BTC and choose the best price. Once the price is agreed, she has a period of time to be able to send instructions to the necessary custodians to move her coins or to her bank to move her fiat. The funds may even come from several sources staggered through time.
Of course, the OTC brokers need to dedicate some balance sheet to be able to quote on a post-trade settlement basis for her. This capital needs to be sitting on call awaiting client demand. Nonetheless, they are compensated for this encumbrance via the optionality which they gain from sitting in the middle of this flow.
For instance, they may decide to not actually hedge her trade in the real market. If the client wants to sell but one of the brokers is bullish himself, he may quote a better bid and then just warehouse the risk. If he’s right, by waiting for the market to move up substantially before selling, he achieves zero market impact on his own view while being able to satisfy his client. Even for a risk-averse broker, if the broker knows they have an opposite-way client looking to trade in a few minutes, they can refrain from paying exchange fees on hedging and wait for their flows to net off instead.
In addition, OTC brokers can access both leveraged and non-leveraged sources of BTC liquidity, so depending on the market conditions, they are able to make significantly more than just the bid ask spread on any given transaction. For instance, if perpetual swaps are cheap, then they can buy those instead of buying spot itself when hedging for a client.
For the client, she of course benefits from this as well as the broker can quote tighter spreads versus if she had just deposited onto a single exchange. Moreover, the broker likely qualifies for a much better commission tier than she herself does. If she only trades once a month, she would certainly receive a much better all-in price from an OTC broker than from a spot exchange.
Trusted vs Trustless
In the early days of Bitcoin trading, whales preferred to trade on exchanges vs OTC brokers because that’s where the liquidity and trust was. There were frequently one thousand BTC buy walls and sell walls that traders would watch for clues as to future market direction. Meanwhile, there were few OTC brokers reputable and professional enough to handle an eclectic mix of clients.
Today, whales rarely send all their coins/fiat to a single exchange. With the presence of vast liquidity on derivatives exchanges such as Bitmex and Deribit as well as indications of interest in the OTC market, these whales would be doing themselves a huge disservice by signalling their interest on a single venue while being unable to access the liquidity on others. They risk not only failing to lock in their desired price but also leaking their intentions to the rest of the world.
Indeed, exchanges requiring larger traders to fully fund their spot transactions will continue to shepherd volumes toward OTC brokers who give clients the flexibility they demand. It is thus no surprise that many exchanges have rushed to hedge their existing exchange-trading business lines by offering their own OTC services. After Kraken bought Circle OTC, every large spot exchange now also offers OTC trading as well, with various levels of overall success.
While the risk that OTC brokers take on by extending credit in this way may appear to be highly trust-based and seemingly run counter to the “decentralize all the things” values of cryptocurrencies, the reality is that this has been the structure of human finance since our ape days.
It will always be a lower-friction, higher throughput, more private, and more bespoke experience to deal bilaterally. If you think about a supplier and a distributor managing a long-term business relationship, or a frequent client and his favorite restaurant, the importance of the local and the interpersonal becomes apparent. Bilateral negotiation as the lifeblood of business efficiency is a fact that transcends any industry, so any trustless method of transacting can be immediately made cheaper and better by adding trust.
Trust enables the broker to cater to their clients’ specific needs and it also enables the client to bestow on the broker highly secretive information. This cannot be replicated or improved upon by decentralization–in fact, it is its very antithesis. I predict that OTC trading as a ratio versus on-exchange spot trading will continue to grow and that possibly some firms will emerge that manage to scale the OTC trading experience to a broader market client base. The challenge is to provide a high level of customer service, manage the cost of KYC, and still deliver an all-in price that adds value. In other words, in the world of spot trading, expect the scaling of trust as opposed to the scaling of trustlessness. Trustless decentralized trading protocols may ultimately prove useful for web3 use cases, but they will almost certainly struggle to compete for high volume spot transactions.
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