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OPINION: Institutional Trading Could Kill Crypto Exchanges

Can crypto exchanges survive the expected deluge of institutional investment? Today, that bet is even money.

Satoshi Nakamoto never intended to graft bitcoin onto the existing international financial markets. It was meant to operate in parallel and be an uncorrelated alternative.

The crypto markets began, like most typical markets, as over-the-counter transactions between individual investors before crypto exchanges began popping up like mushrooms to facilitate easier trading. Once that happened, it began piquing the interest of institutional investors.

However, what it takes to support retail investors and institutional investors regarding services and support is quite different.

Individual investors have shown over the past few years that they are happy to invest without a standard instrument taxonomy, third-party custody, reference data, transaction cost analysis, and smart order routers, which are non-negotiables for institutional investors.

Does it make sense for digital-exchange operators to chase the institutional cryptocurrency market and make the necessary investment to replicate the business model of self-regulatory organizations?

It doesn’t. Digital exchanges currently make their money from their sizable trading commissions while giving away their market data, which is a mirror image of the SROs.

Even if exchanges did make the necessary investments to meet the requirements of institutional investors, they might be waiting a long time to cash those institutional trading commissions.

Institutional trading, by its nature, is OTC trading. Buy-side traders want to keep their order flow off the displayed markets as much as possible to avoid moving the market against them.

All buy-side traders need is a reference price and size to use as a benchmark for their trade negotiations, which the digital exchanges already give away for free, before registering their trades in the appropriate distributed ledger.

Trading digital securities, on the other hand, presents its own issues. Regulation D or Regulation A securities are illiquid instruments at best and do not fare well on limit order books.

If digital exchange operators wanted to pursue the digital securities market, they would need to develop matching methodologies that are similar to those in the interdealer markets.

In this case, exchanges could generate revenue from its market data and trading fees as well as a host of tangential services, such as developing and issuing the digital securities.

All the digital exchange operators would be doing is adopting the same business plans of private securities trading but swapping out the middle and back office for a token-based infrastructure.