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There are a couple of things that I have often found funny about crypto companies.
One is that they basically operate exactly the same ‘pretend to be investment platform’ model that Robinhood pioneered in the US and which has since been adopted by companies like Trading 212, eToro, and XTB.
The difference is that, whereas those companies claim to be stockbrokers and then cross sell CFDs, crypto companies say they are a place to buy bitcoin and then switch you over into perpetual futures. If you look at Bybit’s marketing tactics on their website and know that the founder worked at XM for seven years, you can see he learned from the best.
The other point is that a lot of crypto companies are described as exchanges when that isn’t really what they are. This has been apparent for years and I am regularly amazed that it seems to just be accepted with a kind of ‘meh’ and shrug of the shoulders.
Imagine if the London Stock Exchange started marketing itself as a place to trade stocks, then onboarded you as a client, and was responsible for custody of your assets. This would be weird and yet in crypto world it’s completely normal. The team at crypto ECN Crossover Markets captured this well in a post on their website published last year.
“[Crypto exchanges] have no members – instead, they have customers,” they wrote. “They are not matching engines – instead of connecting buyers and sellers at a mutually agreeable price, they hold their clients’ assets and trade on their behalf. To be blunt, these ‘exchanges’ are not exchanges at all – they are brokers, with some custodial functions thrown in for good measure.”
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That crypto companies can get away with this stuff is a great example of the power of marketing. For whatever reason, crypto has managed to make itself into something more relatable and ‘tech-y ’. The result is they can do exactly the same stuff as ‘tradfi’ and no one cares.
The structure of a perpetual future is another example of this. It is very similar to a CFD. It is also not new. In Hong Kong, the Chinese Gold and Silver Exchange has – for over a century – let traders open positions and defer physical delivery perpetually. A trader’s account is debited or credited overnight, depending on whether there is an excess of buyers or sellers. Perpetual futures took this exact structure but gave it a different name and made it sound cool, so everyone thinks it’s new and innovative.
Another area which brings to mind that Biblical line “what has been will be again” is the existing central limit order book (CLOB) model. All major crypto exchanges currently operate using a CLOB.
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We looked at this topic before a bit when we spoke to Konstantin Shulga, the CEO of crypto ECN Finery Markets, but it came to mind again earlier this month, after Binance said it had suspended a market maker for non-specified market abuse.
The basic problems with the CLOB for institutions mirror those that we had in the equity markets. Basically you cannot execute large size orders and, assuming such a ‘thing’ exists in crypto, there is information leakage.
For retail, the problem is more about getting ripped off by other, more sophisticated market participants.
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“The CLOB issue isn’t isolated to Binance; it’s a systemic problem across crypto exchanges using the Central Limit Order Book model,” Ilies Larbi, the Founder and CEO of ‘No CLOB’ crypto trading platform Ouinex, told me.
“Mixing institutional and retail orders in the same book leads to inherent unfairness. Additionally, while major exchanges are obtaining MiCA permissions in Europe, enforcing market abuse policies will be challenging due to the fundamental flaws of this model.”
The Binance market maker debacle is one sign of this. If you look at what is happening with a lot of new coins being listed on Binance and other exchanges, they pop after they start trading, then immediately crash.
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“In crypto the projects issuing coins often pay market makers, who get a large inventory of coins at prices below market value, to ensure liquidity,” said Finery Markets’ Shulga.
“Without proper oversight, this arrangement can lead to conflicts of interest, with both parties having a vested interest in artificially inflating coin prices to make a profit. This means so-called “pump and dump” schemes simply mirror age-old manipulation strategies. Essentially, market makers create a false sense of genuine trading interest in certain coins. Once the hype catches on, they sell off their holdings to retail investors who are driven by FOMO.”
As Shulga alluded to, a lot of these problems have existed for ages in futures or equities markets. The difference is that in crypto there seems to be minimal oversight or regulation on how market makers are supposed to behave.
For example, the LSE’s rulebook is (currently) 106 pages long. Binance has four bullet points…
If you look back at futures trading in the late 2000s and early 2010s, it was similarly (and arguably still is) Wild West. That was part of the reason laws banning spoofing were introduced in 2013 by the CFTC.
Right now, on most crypto exchanges, it just doesn’t seem like it would be that hard to engage in spoofing or wash trading. Indeed, there isn’t much clarity on who is actually making a market on the exchange. Would you be that surprised if most exchanges, bar perhaps Coinbase, were operating one?
Then you have the potential for a conflict of interest, which also exists on other exchanges, outside of crypto. If market makers are paying exchanges lots of fees, they have little incentive to stop them from doing what they’re doing. Prior reporting from Bloomberg has suggested there is indeed a ‘cosy’ relationship between crypto exchanges and their market makers.
To be fair to Binance, the fact they suspended the market maker and took the profit they’d generated is a sign they are cognisant this is a problem. Plus you have to keep in mind that, even if other asset classes have gone through a process of structural change before, crypto is still pretty new, so it’s not that surprising its exchange architecture remains undeveloped.
Finally, with regards to pump and dumps, a lot of new coins just seem….really dumb? And if you actually look at forums or discussions about them, a lot of the time people don’t seem annoyed they got rug pulled. Instead they’re mad they weren’t the one pulling the rug!
Nonetheless, it will be interesting to see if pressure to stop this kind of activity grows. If you look at the CFD industry, ‘no dealing desk’ marketing became completely standard because people don’t like the idea they are trading against their broker.
In equity markets, the creation of dark pools was initially so that ‘uninformed’ market participants could trade, often in larger size, without having to worry that they would get wrecked by ‘informed’ market participants. That there are now an increasing number of crypto ECNs suggests that a similar development may be taking place in the digital assets industry.
What may also happen for retail is that we end up with a situation not too dissimilar to what exists in retail equity markets. If you look at the LSE, for example, you have a quote-driven system, where orders are mainly (from what I understand) executed against market makers in the retail service provider (‘RSP’) network. A similar system exists in the US where brokers sell order flow to wholesale market makers.
Of course, it’s worth noting that all these systems exist in other markets alongside one another. There is never a ‘one size fits all’ model and the options out there reflect the varying needs and demands of different market participants. For example, if you are an individual, long-term investor buying some Apple stock to hold for 10 years, you probably don’t care that much if you got arb’d for $0.05 by a market maker. If you are day trading futures contracts then you do.
The same dynamics exist in crypto. Consequently it’s fair to assume we’ll see the same mix of trading venues and market infrastructure develop as time goes by.
