by Dave Weisberger
Crypto-assets, at their core, provide a method for trusted value exchanges between parties that have no direct knowledge of each other, paving the way for decentralized systems. The concept that decentralized, but connected systems could be THE answer to many economic problems is broadly understood. Unfortunately, there are firms in the crypto world that only pay lip service to this concept, choosing instead to promote their own vertically integrated business models. In the financial market for crypto assets, this could become a serious problem, as there is a strong need for interconnections and common standards. Such interconnectedness is required for the evolution of a true “Open Financial System,” which will require cooperation between key nodes in that system.
It is, therefore, quite ironic that a market such as equities, which features centralized clearing and a bureaucratic regulatory regime, is actually a better example of decentralized trading than crypto markets, due to the interconnections between exchanges, agents, and traders in equities. In equities, the concept of consolidated market data is ubiquitous globally, as is smart order routing that compares prices across markets. No single exchange considers itself the market, as there is a general recognition that the market is a complex ecosystem. Even the NYSE, as iconic as it is, is one of many exchanges that trades the same “inventory” as other exchanges. Investors have benefited from this competition as it has enabled bid offer spreads and trading fees to have decreased significantly, while liquidity has improved dramatically from the days when markets operated independently. It has also meant that investors can choose to trade on one market, but be safe in the assumption that they never buy or sell at prices that are significantly inferior to where they can trade on other markets. This, however, is not the case in crypto.
Almost every day, there are situations where one or more markets trade out of line with other markets trading crypto assets. Sometimes, these price differences can be extreme, meaning that the investor buying on a single platform could pay dramatically more than they should have. As an example, a little over a week ago, the following incident occurred in Bitcoin trading in US dollars, where buyers on one exchange aggressively bid up the price of Bitcoin, while other markets continued to offer it at much lower prices:
If we zoom in, we can see that the best bid on one exchange rose over a 10 minute period to a maximum of $7550 per Bitcoin, while all of the other exchanges were offering Bitcoin at roughly $6720.
While this incident was extreme, it highlights a reason that investors should be aware of the prices on all available markets, particularly when buying or selling large quantities of coin. It also highlights a reason why exchanges themselves should have access to a consolidated data feed and either implement routing or establish “guard rails” that prevent the execution of orders at prices that are wildly out of line with other markets.
That said, the real issue, is not the isolated instances of significant price dislocation that occur in crypto-trading. The issue is that a marketplace that features individual, disconnected markets without ubiquitous “fair value” pricing, is prone to such dislocations and is extremely hard for clients to evaluate. You see, all investors should want to know what it costs to trade, and a key component of the answer to that question is the ability to measure how good each execution was. This is why SEC has made this point repeatedly in its rejection of Bitcoin ETF proposals.
One example of a product that delivers “fair value” pricing is what we offer at CoinRoutes. Our Patent Pending Consolidated Best Bid & Offer products can be filtered to include orders of certain sizes as well as exchanges that are accessible to investors in particular geographies. This allows traders to know precisely where and when to route orders and also to establish benchmark prices to use for measuring the quality of trades. Whether it is CoinRoutes or another vendor, however, it is important for the maturation of the crypto market for such products to become generally available. As alluded to in the opening of this note, however, there is at least one exchange which restricts the ability to broadly distribute consolidated data. In that case, the exchange blocks redistribution of their pricing data from being used to create benchmarks for best execution or for determining “fair value.” Note that it is not an issue of economics, since it would be perfectly reasonable, if exchanges wanted to charge users of their data, to do so, as long as their pricing was available to all users at similar terms. The issue is simply that there are players in the crypto market who want to protect their currently dominant franchise, at the expense of the overall market and, in some situations, their own clients.
In a certain sense, the libertarian and free market ethos that permeates crypto is the issue, as there are many crypto projects that promote ungoverned “peer to peer” trading and the ability to escape from central government surveillance. The problem in this case is that free market economics only work when freely competing suppliers and freely competing consumers can interact without restriction. The idea, which I strongly believe to be true, is that such unconstrained interaction will result in optimal prices that best satisfy the marginal utility of all participants. For this to work, however, both consumers and producers need to be informed about the state of the market and be able to switch between alternatives freely. The world is awash in examples where barriers in either information or the ability to switch causes economic hardship, ranging from shortages of basic necessities in countries with price controls to the runaway cost of medical care due to a complete lack of price transparency.
We have also seen many examples on the positive side of the ledger, however. One that is particularly germain to this note is the massive efficiencies driven by the ability to compare prices of goods and services enabled by internet technology. Travel, books, music, and consumer goods of all kinds, along with services ranging from graphic design to software development have become cheaper and more accessible to consumers and businesses. In all these cases, private industry solutions were developed to provide the necessary connectivity and information, and providers that refused to participate were ultimately forced to do so by their clients or, in rare cases, by government anti-monopoly rules. While I assume that crypto markets will ultimately all accede to uniform sharing of information, it would be best for the market to do so quickly, in order to help avoid the potential for excessive regulation.
Over-zealous, prescriptive regulation is a serious threat to crypto markets worldwide as most jurisdictions have rules which don’t apply or (worse) would make crypto-assets almost impossible to issue and trade. This is a serious risk as regulators in the largest economies have historically been focused on protecting retail investors and crypto, unlike equity and bond markets, is dominated by retail investors. It is, therefore, crucial that the industry proceeds with emerging self-regulatory efforts and facilitates (instead of blocking) free market solutions that promote best execution as well as fair and orderly markets.