Recently there has been substantial growth in cryptoasset marketplaces and product offerings. The marketplace is complex and comprises of the traditional stock market, foreign exchange and the cryptoasset market. As outlined in Diagram 1, this blog post provides details on both crypto-only and fiat-supporting markets. We also explore trading venues, such as centralised and decentralised exchanges and the over-the-counter (OTC) markets.
Cryptoasset-only marketplaces allow users to trade one cryptoasset for another to gain diversification within the cryptoasset complex. Currently, there are over 210 exchanges with cryptoasset trading offers. However, over 95% of the total daily trading volume is processed by the top 50 exchanges, all of which are centralised exchanges (CEXs).
Centralised Exchanges (CEXs)
Most cryptoasset exchanges are centralised and privately owned, whilst some are registered in a specific jurisdiction, such as Binance and Huobi.
A cryptoasset exchange is mainly composed of order placement, order cancellation and order matching functions. For CEXs, the exchange architecture relies upon third-party service providers. This however, can lead to single point failure. For instance, the purchase and sale of cryptoasset between members of an exchange does not involve the transfer of ownership of the asset too. Therefore, users of the CEXs are actually operating within virtual accounts on the exchange, which have ultimate ownership of the cryptoasset. In other words, the trades on CEXs are done on an IOU basis e.g. a debt instrument. The users of the CEXs do not receive their funds until they explicitly withdraw their funds from the exchange. Many CEXs were not prepared for the influx of users they received, and as a result, they are vulnerable to major system failures and cybersecurity risk.
Decentralised Exchanges (DEXs)
On the other hand, decentralised exchanges (DEXs) aim to broadcast each part of the transactions to a decentralised network such that no centralised third-party server is needed in the trading system. DEXs’ architecture has no central controlling server and does not rely on third-party services to store user funds. Through an automated process on blockchain, peer-to-peer transactions are stored in their personal wallets. DEXs provide greater confidentiality and reduce the risk of server inaccessibility and single point of failure.
A number of DEXs are hybrids of CEXs and DEXs, which allow for fast access to centralised gateways. This type of architectural design includes on-chain operations that do not require significant network capacities, such as settlement. However, the order books can be established through off-chain trade entry, using the centralised gateways. Another type of DEXs is based on Ethereum smart contracts or the mechanics of multi-sig signatures, providing high security for cryptoasset transactions. However, such DEXs suffer from slow transaction speed and are not efficient cryptoasset marketplaces.
In summary, DEXs facilitate value flow and align with the decentralised values espoused by the blockchain community. However, DEXs suffer from slow transaction speed and are not yet efficient digital asset marketplaces.
Fiat-supporting marketplaces are governed by rules and regulations based on jurisdiction and the type of services each exchange offers, which result in a different market structure and ecosystem. The majority of trading volumes on fiat-supporting marketplaces represents continuous on-off ramp fiat money flow from the cryptoasset ecosystem to the incumbent financial system and the real economy All cryptoasset exchanges suffer from regulatory uncertainty and this is especially true for fiat-supporting marketplaces. As the regulatory framework solidifies and provides investors with protection, such marketplaces will grow.
Spot: Exchange-traded spot products are the largest segment of the ‘on-off ramp’ or ‘fiat-to-crypto’ segment by trading volume, which is much smaller than the cryptoasset-only spot trading volume. Currently, no ‘fiats-supporting’ DEXs exist due to KYC and AML considerations .
Futures: Futures contracts enable investors to take short positions. Bitcoin futures contracts started trading on CME and the Chicago Board Options Exchange on 10th December 2017. These products allow investors to hedge or speculate on bitcoin prices without actually transacting in the cryptocurrency.
Futures contracts rely on a robust and representative underlying instrument that the contract will be priced against. However, there is no centralised price or exchange for Bitcoin. The CME and CBOE chose different methods for calculating the underlying price for their futures contracts. The CME bitcoin futures contract employs a Bitcoin Reference Rate (BRR), which is calculated and published by Crypto Facilities Ltd. (CF). The CBOE chose to reference an end-of-day auction rate published by Gemini, a prominent cryptocurrency marketplace.
CME set the required margin level at 35% of notional value for Bitcoin contracts, whilst CBOE set the required margin level at 40%. CME Bitcoin futures contract size is 5 Bitcoins per contract whereas it is 1 Bitcoin for CBOE Bitcoin futures contract. The larger contract size for Bitcoin futures instruments allows institutional traders to trade and risk manage positions efficiently in OTC markets.
Over-the-Counter (OTC) Market
Spot: The cryptoasset market is fragmented and competing exchanges exacerbate the liquidity profile of products traded on an exchange. For institutional traders seeking anonymity and liquidity for large block trades, the bilateral OTC market has emerged as a feasible trading venue to minimise slippage and market impact.
Given the significant counterparty and credit risk associated with the bilateral nature of OTC transactions, the OTC marketplace is slowly embracing regulation as a way to build trust and create a healthy and fair environment. As the cryptocurrency market matures, we expect OTC trades to dominate volumes on exchanges due to the emergence of diverse derivatives products for institutional trading and hedging. Taking the
Non-Deliverable Forward (NDF): NDF instrument has existed in emerging market foreign exchange rate with capital controls for decades. Taking the design of emerging market foreign exchange NDFs, TeraExchange was the first regulated marketplace to offer U.S. Dollar settled Bitcoin forwards. Bitcoin, in this case, is analogous to the emerging market foreign exchange rate.
Market foreign exchange NDFs, TeraExchange was the first regulated marketplace to offer U.S. Dollar settled Bitcoin forwards. Bitcoin, in this case, is analogous to the emerging market foreign exchange rate.
The notional amount of the Bitcoin NDF is never exchanged. The only exchange of cash is the difference between the Bitcoin forward price at trade date and the prevailing Tera Bitcoin Price Index (‘Index Price’) on the valuation date.
Contract for Difference (CFD): CFD products are prohibited for U.S. residents and citizens, but permissible in other jurisdictions, such as the European Union. Through CFDs, traders can participate in the price movements of Bitcoin without actually owning the underlying asset; in this case, Bitcoin. When trading the CFDs, traders select whether they want to take a long or short position. Traders who purchase a ‘long’ CFD profit if the price of the corresponding cryptoasset increases. Traders who purchase a ‘short’ CFD profit if the price of the corresponding investment decreases. All purchases and sales of CFDs are subject to a bid-ask spread paid to the broker who acts as the counterparty on every CFD trade.
All CFD brokers offer some form of leverage up to 20x on Bitcoin vs. the US dollar. To trade a CFD, a trader needs to post initial and maintenance margin to fund the account. The lower the margin, the higher the leverage (i.e. 10% margin requirement leads to 10x leverage). Initial Margin (IM) is the amount to fund before initiating a long or short position. The Maintenance Margin (MM) is the minimum amount of margin that traders must have against the portfolio. If the account breaches margin requirement, the broker can close out the open positions and liquidate the account.
Options: An OTC derivatives market for cryptocurrency has been developing over the last few years. For example, LedgerX , a SEF and Derivatives Clearing Organization (DCO), has an options product that is similar to FX options. It allows a purchaser the right, but not the obligation, to purchase (in the case of a call option) or sell (in the case of a put option) Bitcoin at the price specified (‘strike price’) in the options contract at the expiration date. Traders who choose to write call options or put options will have the obligation to sell (in the case of a call option) or purchase (in the case of a put option) Bitcoin at the price specified in the contract at the expiration date.
However, LedgerX bitcoin options contracts are fully collateralised USD-priced European options, which are capital inefficient. Before accepting a contract for clearing, it requires traders to provide collateral to cover the maximum potential loss of the contract as well as pass a pre-trade credit check to ensure that the participant’s collateral is sufficient. For a call options seller, the trader must deliver the full quantity of deliverable Bitcoin underlying the call option to LedgerX prior to entering the order. If the call is exercised, the trader’s Bitcoin collateral is used to satisfy delivery. For a put options seller, the trader must deliver the full USD strike price underlying the put option to LedgerX prior to entering the order. If the put is exercised, the trader’s USD collateral is used to satisfy delivery.
As more and more institutions operating across the capital markets grapple with the implications of cryptoassets, the fees and regulatory uncertainty remain a concern for traders as cryptoasset marketplaces continue to broaden the range of fiat currencies to support.
The evolution of a cryptoasset ecosystem has been a source of opportunity and obstacles and, looking back over recent years, there are lessons to be learnt. It is widely considered that products that straddle the worlds of cryptoassets and regulated derivatives exchanges are forthcoming. Indeed, the capital market for cryptoassets will continue to grow as market participants start to build institutional quality infrastructure to meet investor needs for a healthy and safe ecosystem.
 Michel Rauchs, Apolline Blandin, Kristina Klein, Gina Pieters, Martino Recanatini, and Bryan Zhang, “Global Cryptoasset Benchmarking Study,” Cambridge Centre for Alternative Finance, 2018