Crypto at a Crossroads: Adopting FX Market Structure or Forging its Own Path?
As the crypto market reaches a crossroads for its future development, the industry and regulators need to decide whether to fully adopt traditional financial market structures to increase stability and attract institutional investment, or maintain crypto's decentralized ethos at the risk of impeding mainstream and institutional adoption.
October 02, 2023 - While it is clear that crypto trading would benefit from structural change, it might be over-simplistic to suggest that it should simply adopt exactly the same framework as the FX OTC interdealer market.
The divergence in the approach to regulation between Europe and the US, coupled with the fallout from the collapse of crypto trading platform FTX, has rattled many crypto market participants. Regulatory uncertainty in the US has seen a number of firms shut up shop in the country to focus their business in perhaps more crypto-friendly jurisdictions such as Dubai and Singapore. In March this year, Bittrex closed its US operation with one of the Founders, Richie Lai, saying on X, “Regulatory requirements are often unclear and enforced without appropriate discussion or input, resulting in an uneven competitive landscape. In the end, we made great strides toward accomplishing our goal of maturing the crypto space. However, operating in the U.S, is no longer feasible and Bill, Rami and I will focus on helping Bittrex Global succeed outside the US.”
According to the IMF, clear policies need to be established to protect investors and prevent abuse. One move that would reduce conflicts of interest is the separation of custody and trading, effectively institutionalising the structure of the crypto market. Traditional financial market infrastructure benefits from the compounding effects of both operational procedures and regulation that have been developed over time in response to market failures. The concept of segregating trading and custody is one of these key features.
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Lars Holst, CEO and Founder of GCEX, a digital assets brokerage and tech provider, agrees that the crypto market would benefit from the separation of custody and trading, “It does not feel right that the exchange or the broker wants to do self-custody as well. I do believe that the benefits of separating custody and trading far outweigh the potential drawbacks for 3 important reasons: reduced conflict of interest, enhanced security and greater transparency.” |
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“The crypto asset market would benefit greatly from embracing this model to provide traditional market participants with a structure that gives them confidence,” says Tom Flanagan, Digital Assets - digital assets head of platform trading at liquidity and data solutions specialist TP ICAP. “This segregated model has been proven to mitigate conflicts of interest - and the single point of failure risk - that arise from co-mingling asset custody with trading.” |
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Using a third party custodial solution requires a degree of trust, but there are benefits for convenience and for many it will be more secure, adds Christo de Wit, South Africa country manager at cryptocurrency platform Luno. “However, it is important that customers understand how centralised custody and self-custody work, the risks and benefits associated with both, and what is right for them,” he says. |
On the question of how having a centralised settlement utility would impact on the stability of the crypto market, de Wit observes that there could be pros and cons. “It would enhance efficiency, mitigate counterparty risk, and streamline settlement processes,” he says. “However, it would also pose systemic risk and counterparty dependency.”
Lars Holst from GCEX also sees the benefits of centralised settlement, but also the risks, “The introduction of a centralized settlement utility in the crypto market has the potential to significantly impact its stability, both positively and negatively. If structured correctly it could increase the stability but if we entrust the wrong players, then it could have catastrophic consequences and could erode trust in the market.”
Another element of FX market structure that crypto could benefit from is replicating the transparency and liquidity analytics accessible within wholesale FX venues. Most crypto venues are anonymous in nature with a lack of information detailing the type of flow and the market participants involved. Statistics such as fill rates and round-trip time - along with more advanced analytics such as pre/post trade mark-outs - are staples within institutional FX.
These all provide clients with greater information on the types of liquidity their firm is dealing against in an anonymous market place and whether it is beneficial flow to them and their franchise.
“Concepts such as the global code of conduct are another example of an initiative which helps to level the playing field and provide a layer of transparency for how all institutional market participants should interact”
- Tom Flanagan, TP ICAP
“Concepts such as the global code of conduct are another example of an initiative which helps to level the playing field and provide a layer of transparency for how all institutional market participants should interact,” says Tom Flanagan from TP ICAP. “Wider adoption of these practices would help to breed confidence and bring in a wider array of clients.”
Lars Holst shares this view. “As a regulated provider we welcome oversight and transparency. I feel we can only allow regulated players to operate in the market, so we know who we are dealing with to add transparency and reduce counterparty risk. We essentially need to make sure all providers are fit and proper and approved so can trade and operate with confidence. Isn't it time that we ensured all providers are approved, fit, and proper? Is it not the right moment to fill the market with confidence for secure crypto trading? By replicating these elements from the spot FX market infrastructure, the crypto market can attract institutional investors, ultimately fostering a more robust and trustworthy crypto ecosystem.”
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With increased institutional adoption, it will be important for service providers to separate offerings such as liquidity provisioning, prime brokerage, lending-borrowing, and exchange services as well as custody agrees Ayal Jedeikin, CEO and founder of execution-only, non-custodial trading platform Cypator. “Offerings need to be offered in a non-conflicting and independent fashion,” he says. “Hence it will be a natural transition for institutional digital markets to move to an OTC-style of trading model, cleared either bilaterally or through a central clearer. Top centralised exchanges are spinning off OTC desks to cater to institutional clients. This business is non-custodial in nature and settled post-trade, reducing counterparty risk significantly.”
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The convergence with FX markets will be strong as the basis of the market is very similar observes Thomas Restout, CEO EMEA at crypto-native liquidity provider B2C2. “It is a fragmented market, geographically and by exchange numbers, with fungible assets,” he says. “It will be OTC driven as exchanges become harder to trade on. It also has a very large volume of transactions and microtransactions that will increase with payment use cases.” |
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While crypto will use capital market models for addressing market structure, issues such as separating custody from market making and capital allocation services, David Wells, CEO at cryptocurrency exchange Enclave Markets says the infrastructure used to run these systems will be crypto native and much more efficient and stable than what exists in traditional financial markets, which currently rely on technology and codebases that are decades old and in many ways obsolete. |
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In addition, the crypto market is still relatively immature and many regulators have failed to determine what asset class it should be compared with.
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There are already some similarities between the crypto and FX markets, such as the decentralised nature of trading and the ability of each asset class to be used for traditional purchases, observes Patrick Bärtschi, head of business development at crypto trading platform Bittrex Global. “However, I think it ultimately depends on whether crypto will be considered a security or a commodity, or whether it will be regulated as a whole new asset class,” he adds. “Once we have clarity on that, we may have more insight on what structures it might be able to adopt.” |
Though similarly decentralised and prone to volatility, the crypto ecosystem is highly transparent relative to OTC markets through the constant production of on-chain data. Coupled with crypto’s fast transaction times, it is clear that any attempt to force these markets into a pre-existing mould would only diminish these features and potentially weaken the space.
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That is the view of Rich Evans, managing director institutional sales, prime liquidity at cryptocurrency exchange CEX.IO. “These distinctions help explain why the crypto ecosystem is not beholden to the same constraints as an OTC market and as such, it would behoove institutional entities to consider how they can best accommodate the environmental conditions of digital asset investing,” he concludes. “In fact, there is an argument to be made that crypto markets present a technologically advanced alternative to these established systems.”
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Paul Golden is a freelance finance writer covering foreign exchange, treasury and wealth management since the early 2000s. His work appears in a variety of online publications. |