Crypto exchanges are stepping up their game to lure high-speed traders like Virtu and Citadel
- The cryptocurrency market is known for a profusion of cryptocurrency exchange venues.
- To compete for business from large trading firms, some crypto exchanges are building out their infrastructures to look like traditional equities exchanges.
- Exchanges such as Gemini and Coinbase have begun supporting block trading.
- Some crypto exchanges are rolling out new liquidity programs and considering co-location and other market structure developments, according to executives.
Crypto exchanges are trying to step up their game to lure the fastest traders on Wall Street.
These exchanges, which helped shepherd the nascent market for digital currencies through 2017's boom, have been adding customers and making money hand-over-fist. Bloomberg estimates crypto exchanges bring in $3 million a day in fees. Still, many have failed to attract large institutional investors to the platform, relying for now on small time traders for liquidity.
In order to draw in big traders, exchanges across the space are beefing up their capabilities and rolling out new products to attract liquidity.
"How do we get Virtu, Citadel Securities, DRW, Susquehanna to make markets?" said Larry Tabb, founder of consultancy Tabb Group, said in an email to Business Insider. "Those are the things they're thinking about. It's going to be a combination of incentives, order types, connectivity, co-location, and pricing."
Block Trades
The exchange business is a volumes game with more volumes equaling more profit. Attracting large traders or investors is one way to boost volumes. But most customers of this profile have opted to trade in over-the-counter markets, rather than on retail exchanges.
That's because big trades on a crypto exchange can impact the broader price in the market, said Michael Moro, chief executive of Genesis Trading, an OTC trader and market making firm in the crypto space. Moro told Business Insider that most of his accounts would never trade on an exchange.
"As better as these exchanges have kind of gotten, 95% of what I do is OTC," Moro said. "I don't touch the exchanges for liquidity at all, but that's because OTC markets are far more efficient, especially for size."
To compete for larger orders in the crypto markets, a number of exchanges have started to offer block trades, which are executed off an exchange main order book as to not move the market in a direction against the trader.
Gemini, the cryptocurrency exchange founded by the Winklevoss twins, started allowing customers to buy and sell large quantities of crypto in April. Coinbase has also started supporting block trades as well. That could lure large traders to their venues, according to CoinRoutes chief executive Dave Weisberger.
"I think that there is a clear need for more tools available for block trading in Bitcoin and other crypto assets, so companies that fill that need will be rewarded," Weisberger said in an interview.
Liquidity programs
Crypto exchanges have also been flirting with different incentive programs, which provide discounts to certain market makers for adding liquidity to a venue.
The idea of providing incentive to liquidity providers is not new to trading. IEX, the upstart stock exchange, recently unveiled such a program that offers discounts on trading fees across a number of securities trading on its venue. The New York Stock Exchange and Nasdaq offer rebates to brokers to incentivize them to send their order to their exchange.
The point of a market maker is to ensure immediacy of execution, even if there isn't natural interest in the market. With incentives, you are more likely to attract traditional market makers to the fold, executives from market making firms told Business Insider.
"It could draw in those who have only been involved in a lower capacity," one trading executive said.
The lack of liquidity in crypto is one reason behind its neck-breaking volatility.
"There's less liquidity in the marketplace than people might think," the executive added. "This last run-down can show you. People selling because of Tax Day drove this market to the ground."
In the US, dollar to crypto transactions are in the couple hundred millions of dollars a day, according to research by crypto firm MithrilX.
Currently GDAX, Coinbase's cryptocurrency exchange, does not charge liquidity providers for placing orders on the exchange. And it is currently looking into adding new liquidity incentive programs, according to a job advertisement for a head of market structure. Gemini provides incentive for some market makers trading in its auctions.
Circle, the fintech firm that recently acquired crypto exchange Poloniex, is also looking into new incentive programs for market makers, the company's chief executive office Jeremy Allaire told Business Insider in an interview.
"We inherited a fee structure and are obviously looking closely at that to make sure it is in line with what participants expect," Allaire said. "I think there will be multiple models and experiments tried across venues."
What else can be done?
Outside liquidity incentive programs, cryptocurrency exchanges are also looking into supporting co-location capabilities, which would allow high-frequency traders to house their servers in the same building as exchange matching engines.
The practice, which was highlighted in the hit Michael Lewis book "Flash Boys," has been controversial on Wall Street, since it provides traders with faster access to information.
"I would imagine in the upcoming year that we will see exchanges develop co-location capabilities, and it will be something of a common occurrence," Miha Gcrar, head of business development at Bitstamp, said.
Coinbase is considering co-location as well, a source told Business Insider.
To be sure, at this time, co-location isn't a "core necessity" for trading firms, Gcrar said.
What they want to see in the crypto exchange market, for the most part, according to market insiders, is outside of their control or will require years to come to fruition.
For instance, the lack of a proper prime broker is keeping Virtu Financial, the high-speed trading firm from entering the market. Here's chief executive Douglas Cifu:
We are a market maker in the Cboe and the CME futures products around [cryptocurrency], I guess they're bitcoin futures right now. We do not currently make markets in any of the [cryptocurrency] markets primarily because of our concerns round risk management. In other words our MO has always been to trade in transparent and regulated exchanges with centralized clearing or clearing though a prime broker in cash, if you will, bitcoin and other [cryptocurrencies] that is currently not available.
A prime broker would allow traders to trade across venues simultaneously without maintaining a balance on a single exchange. A prime broker would put their own funds into a crypto exchange and then extend their customers credit to trade in and out.
There also isn't a major clearing firm in crypto to act as an intermediary between banks. As a result, small banks such as Silvergate and Signature act as quasi clearing houses.
"You can only have instant clearing if your counterparty is using the same banks, " Jonathan Benassaya, CEO of MithrilX, said. "The bank is becoming the clearing house."
Still, even if these things were to come to fruition, it may not be enough for some large traders. As Genesis' Moro put it: "You could poke holes in everything the exchanges are doing for not being of institutional quality."