Although the influence of retail investors in the Bitcoin trading market is gradually expanding, huge amounts of funds and professional investment technology determine that institutions will still be the masters of any financial market.
Original title: “Dismantling the Bitcoin Transaction Ecology: What are the institutions and what are they doing? 》
Author: Deep Chain Finance
When Bitcoin was first born, institutions were not too cold. But beginning in 2020, the interest of institutions has grown stronger.
The main reason behind this is that under the epidemic, the central bank represented by the United States implemented an overly loose money printing policy, which caused severe market shocks.
In response to the interest of institutions, Arcane Research, a research institution under the Norwegian cryptocurrency investment company Arcane Crypto, made a special research report.
It turns out that the institutions basically agree that despite the current regulatory and other issues, they are still very confident in the future and believe that institutions will occupy the core position of the Bitcoin market.
The question of the survey is: In the next three years, which two parts will account for the main part of the cryptocurrency trading volume? The feedback from institutions, from highest to lowest, is: asset management/funds, banks, brokers, retail accounts, and non-financial companies. Source: Arcane Research Report
This research report, entitled “Bitcoin Ecological Transaction System and Infrastructure of Emerging Institutions”, summarizes in detail the changes that have occurred in the Bitcoin ecosystem after the institution entered the market.
What are the market makers and brokers? How many types of exchanges are there? Why do bankers need custody?
Deep Chain Finance compiled and reorganized this research report, trying to help readers clarify the roles and functions of different institutions in the Bitcoin transaction ecosystem, and take everyone to a deeper understanding of the institutional ecological map of Bitcoin transactions.
Traders can be divided into four categories
Before deeply analyzing the Bitcoin ecosystem, let’s take a look at the types of users in the market who directly participate in transactions.
Most people are individual investors, which can be divided into two categories:
Small fishes
Refers to small retail customers, who usually exchange cryptocurrencies such as domestic fiat currency and Bitcoin for exchange transactions. They mainly take on the role of “Taker” and are not particularly concerned about the spread between transactions and transaction fees. This is the “little fish”.
Bigger fishes
The same is a retail investor, some people are special, very sensitive to prices, and deliberately seek trading platforms with low spreads and fees. They usually have accounts in different exchanges and their daily transactions are very active. This is the “big fish”. There is fierce competition among exchanges around these “big fish,” and high marketing expenses. Institutional investors are also divided into two categories according to whether they belong to the crypto-finance or the traditional financial sector:
Crypto whales
The “whales” we usually hear are such institutional investors rooted in cryptocurrencies. What they seek is the best liquidity and the lowest latency, shuttle between different platforms, and are very willing to “lead” the market direction, with cryptocurrency as the number one asset. They will not only trade on their own, but also commission brokers to operate; they are both active on exchanges and on the OTC platform; in addition, they will use encrypted native derivatives trading platforms to perform more complex and professional operations.
Whale in suits
Another type of institutional investors come from the traditional financial industry and are subject to more restrictions. In addition to cryptocurrencies, they have also invested in many different types of assets, so they are more inclined to choose platforms that they are familiar with in order to meet stringent regulatory requirements. Of course, they also have high requirements for low latency and strong technology.
They will appear on highly liquid platforms that are fully compliant, such as LMAX Digital Exchange, Chicago Mercantile Exchange (CME), and even Coinbase.
These two types of institutional players operate similarly when trading Bitcoin. The biggest difference is reflected in the strategy they choose when entering the exchange due to technical and compliance requirements.
What role does the institution play
The biggest highlight of Arcane’s research report is the Bitcoin ecological map, which elaborates on the respective roles and functions of custodians, lenders, banks, exchanges, and investors in this ecosystem.
Bitcoin transaction ecology diagram designed by Arcane
Participants in this ecosystem are connected to each other, and a company may assume several different roles. For example, Coinbase acts as both an exchange and a custody. Retail-oriented exchanges will also seek liquidity from institutions, and some traditional payment tools will also obtain liquidity from brokers to support cryptocurrency trading functions. Banks sometimes provide custody services. The following describes the roles of the eight types of participants in turn.
Market maker/liquidity provider
The soul of the financial market is liquidity, which gives the market maker/liquidity provider (market maker/liquidity provider) a special mission.
Without market makers, the cryptocurrency market will experience an avalanche like the stock market. The plunge in 2017 caused a flash crash on Coinbase, which also compensated investors for millions of dollars.
Since the transaction price is formed by each exchange separately, the arbitrage space of cryptocurrency is larger and it is more prone to confusion. The purpose of market makers is to create order in disorder and fill the order book through artificial buying and selling, thereby stabilizing market sentiment.
In the early days of the industry, the number of pending orders in the order book was very small, which resulted in large fluctuations in price changes for each transaction.
After 2016, this problem has been significantly improved, mainly reflected in the trend of narrowing bid-ask spreads.
Take Binance as an example. Two years ago, a $10 million transaction would cause price fluctuations of 5% to 8%.
Today, this spread has fallen below 1%, which means that transactions are more secure.
In the above figure, the 8% peak in March 2020 is due to the new crown epidemic sweeping the world. Many investors want to withdraw funds as soon as possible to bail out, resulting in insufficient liquidity. In contrast, this year’s “big drop” is not so terrible, and it is actually normal in terms of liquidity.
Currently the most important market makers are: Jump, HedgeTech, Alameda Research, Galaxy Digital, B2C2 and Woorton.
Brokers and OTC counters
The most efficient market makers generally cooperate with OTC (over-the-counter) counters to minimize slippage when completing large-scale transactions.
The so-called slippage means that after the order book is submitted on the exchange, due to the difference in the quantity of each order between the long and the short, the final transaction may eat up multiple orders at one time, resulting in a large deviation between the final transaction price and the initial pending order price The phenomenon.
In order to avoid paying additional transaction costs, market makers generally lock in prices through over-the-counter transactions, so as to complete target orders more quickly.
A survey by Citibank shows that 90% of cryptocurrency OTC transactions are done in the form of electronic APIs, which is much higher than the traditional financial market. The improvement of infrastructure has made the slippage of Bitcoin transactions worth tens of millions of dollars on OTC controlled from 50 to 200 basis points (0.5%-2%) in 2017 to 5-10 basis points (0.05%-0.1%) ).
The main clients of OTC are hedge funds and index funds. At present, most of the major institutions that provide OTC services are from quantitative investment backgrounds, such as Jump, B2C2, Alamada Research, and Genesis.
However, with the entry of non-financial companies such as Tesla and MicroStrategy into Bitcoin this year, the main source structure of the OTC platform has also changed.
In Q4 last year, non-financial companies only accounted for 0.5% of Genesis’s customer base. In Q1 this year, this proportion soared to 25%.
Institutions not only hope to quickly complete large transactions with the lowest slippage, but also hope to make this process more convenient, which gave birth to the role of brokerage.
Brokers are intermediaries, completing a series of complex investment processes such as executing transactions, custody, clearing and settlement on behalf of clients. The Block once pointed out that this kind of business originated from the prime brokerage (PB) service of traditional finance, which is specifically aimed at institutional clients. The degree of innovation and difficulty is very high. At present, the Chinese mainland securities market does not have a deep understanding of it.
The brokerage business is still a new product in the cryptocurrency industry, and the biggest challenge facing it is clearing and settlement and deep capital market support. In these aspects, it lags far behind the traditional financial market.
Another big problem is that the existing brokerage business is too fragmented. The winners in the future will inevitably be the super players who can realize the “one-stop” concept of transaction acceleration, leverage extension, asset custody, capital introduction, and trading strategy in the spot derivatives market.
Traditional bank
Crypto-friendly banks are usually overlooked as a type of role, but they provide large institutions with access to the legal currency of gold. The most famous is Silvergate.
Founded in 1988, this bank has entered the cryptocurrency field since 2013 and quickly transformed into a special bank with crypto companies as its main service targets. Today, it has more than 900 institutional clients. By the end of last year, corporate deposits had exceeded US$3.7 billion, of which more than half came from 77 different cryptocurrency exchanges.
Silvergate is proud of its self-built payment network SEN (Silvergate Exchange Network). Through SEN, institutional users can complete fiat currency transfers and transactions without interruption throughout the year. In Q1 this year, the transaction volume of fiat currency processed by SEN was as high as US$166.5 billion, a year-on-year increase of 857%.
Of course, Silvergate’s business is not limited to banks. Its CEO Alan Lane said that the SEN network will be further monetized in the future, the main means is to promote digital asset lending and custody services.
Another well-known bank is Signature Bank, which is also a traditional bank that focuses on cryptocurrency corporate business. This is the first bank backed by the Federal Deposit Insurance (FDIC) of the United States, and it has obtained a financial license from New York State, which is safe and compliant. Reassuring. In the past two years, Signet has successively integrated with Fireblocks and the stable currency TUSD protocol.
Not only these traditional “banks” are engaged in banking business, but also some cryptocurrency native institutions. Kraken, a veteran cryptocurrency exchange, successfully applied for a Wyoming bank license-Special Purpose Depository Institution License (SPDI) last year.
This means that the inflow and outflow of funds on the Kraken Exchange is more convenient. It can not only operate the exchange business, but also provide banking services such as deposits and withdrawals, and is fully compliant.
Fintech company
Compared with B-side payment tools, C-side payment tools are more familiar to the public. The fintech companies in the Bitcoin ecosystem have four pillars-Cash App, PayPal, Robinhood, and Revolut. The common point is that they started as payment tools and then gradually developed transaction functions.
The first entry was Cash App, which was named Square Cash when it was founded in 2015. The Square company behind it was founded by Twitter CEO Jack Dorsey. Cash App is one of the most popular financial apps in the United States. As of March of this year, there are 36 million active users. Even Microstrategy boss Michael Thaler admitted that he also bought Bitcoin on Cash App.
Not only can you use Bitcoin to pay and transfer money on the Cash App, you can also use Bitcoin as an asset for transactions. In Q1 this year, Bitcoin sales on Cash App exceeded $5.5 billion.
PayPal has obtained the New York State Bitcoin license, so every Bitcoin sold to customers must be backed by actual Bitcoin reserves. It is Paxos that provides liquidity behind it.
In the past two years, PayPal has moved frequently. Last October, PayPal opened the cryptocurrency transaction function. In April this year, Venmo, its payment company, opened up cryptocurrency transactions. In early July, it also raised the upper limit of U.S. compliance users to purchase cryptocurrency from US$20,000 to US$100,000.
On July 29, in the Q2 investor conference call, the CEO of PayPal revealed that the development of a super application wallet has been basically completed, with high-yield storage, fast deposits and other related functions. Robinhood (Robin Hood) is also a very popular trading platform this year, and has been criticized by the US securities regulatory authorities for being too gamified. In fact, Robinhood itself is not an exchange. After customers issue trading instructions, the platform buys and sells cryptocurrency assets on different exchanges on their behalf.
Robinhood has repeatedly been exposed to “some problems in cryptocurrency trading” at critical moments, especially when the price of Dogecoin rises, trading will be suspended, causing market dissatisfaction.
On July 29, Robinhood went public on the Nasdaq under the HOOD code name. Its IPO did not go smoothly, its valuation was held down by hesitant investors, and it was caught in a compliance dispute with regulators. On the first day of listing, the stock price failed to exceed the issue price, and finally broke 8.4% after the shock.
Robinhood’s first-day stock price change graph, source: Nasdaq Stock Exchange official website
Compared with the products of other technology companies, the biggest difference between Cash App is that you can freely deposit and withdraw cryptocurrencies. On the Cash App, users can refer Bitcoin to other wallets at any time. Neither PayPal nor Robinhood have this feature, and Revolut, which focuses on low handling fees and low opponent risk advantages, also only tests this feature for high-end users.
According to the latest version of the official website (June 30, 2021) cryptocurrency terms of service, the cryptocurrency on PayPal is more like an investment tool-the cryptocurrency deposit and withdrawal function has not yet been opened, and users are not allowed to send cryptocurrency to the accounts of relatives and friends Or in your own third-party wallet, you can’t even buy things directly with cryptocurrency. Moreover, this service is only for US users.
Of course, at the Consensus conference held by Coindesk this year, the person in charge of PayPal also stated that the deposit and withdrawal functions are already being developed.
In addition to the advantages of deposit and withdrawal, Cash App owns 8,027 bitcoins. When Arcane released a research report, it estimated that the market value of these bitcoins was about 500 million U.S. dollars, and the holding cost was about 220 million U.S. dollars.
In fact, this first-mover advantage of Cash App is also inseparable from founder Jack Dorsey’s sentiment towards Bitcoin. Not long ago, at The â‚¿ Word conference, Jack also praised the Bitcoin agreement as beautiful, hoping to use Bitcoin to promote human peace.
In summary, Square’s leading position in the Bitcoin ecosystem will continue for some time.
Exchange
There are many ways to divide exchanges, and the most important criterion is customer positioning. All transactions are only for retail users, such as Bybit, BitMEX; some are only for institutional users, such as LMAX, CME Group; most are two-way, such as Binance, Huobi, FTX, Coinbase, Gemini, etc.
Retail exchange
The C-end exchange must find ways to attract and retain new customers. Since there are many exchanges and low customer loyalty, these exchanges must strengthen research and development and often engage in activities such as listing coins.
Since most of the customers are retail, they are not very sensitive to the cost of placing orders, so the handling fees that retail-level exchanges can charge are actually higher than institutional-level exchanges.
The core competitiveness (USP) of retail-level exchanges is simple operation, user-friendly UI interface, and various marketing activities. Correspondingly, marketing costs are also very high. If there are too few listing activities, customers will not be retained.
For retail investors, the biggest annoyance for C-side exchanges is that the user base is too large, so when the market fluctuates sharply, they are likely to encounter server downtime.
Institutional Exchange
Conversely, for organizations, downtime is absolutely unbearable. Institutional users have many common prerequisites for entering the exchange: professional operation interface, huge throughput capacity, no downtime, credit line, and operation compliance.
Therefore, the technical requirements of institutional-level exchanges are extremely high. Under extremely volatile market conditions, 100% real-time transactions must also be guaranteed, and the depth of liquidity is indispensable. The dual requirements of compliance and technology make the platform development of institutional-level exchanges far more difficult than retail-level exchanges.
Retail-level exchanges seek innovation, and institutional-level exchanges seek stability.
In addition, according to different trading products, the exchanges in the ecosystem can also be divided into spot exchanges and derivatives exchanges.
Spot exchange
Due to the rise of compliant exchanges, more and more users have chosen to directly exchange between legal currency and cryptocurrency. But so far, the vast majority of transactions have been completed through stablecoins.
Even Binance, the world’s largest trading volume, only started trading in fiat currencies in 2019. For a long time before, Binance only supported currency transactions.
Among the mainstream exchanges, the highest volume of fiat currency trading is Coinbase, followed by LMAX Digital, Bitfinex, Bitstamp, and Kraken.
All in all, with the continuous advancement of the construction of cryptocurrency compliance and the continuous improvement of supervision, the shift from currency trading to legal currency trading is a long-term inevitable trend.
Derivatives Exchange
The trading volume of Bitcoin derivatives has surpassed the spot. The role of the derivatives market in the process of Bitcoin price discovery is even more critical.
Bitcoin’s monthly spot and derivative trading volume comparison chart since July 2019. Green is a spot, and black is a derivative product. Source: CryptoCompare
There are two types of derivatives exchanges:
The first category is offshore, unregulated derivatives exchanges. The KYC (Know Your Customers) of this type of exchange is usually not very strict. Anyone, rich or poor, whether it is a white or a wealthy whale, can experience margin trading. The minimum margin ratio is only 1%.
The second category is compliant derivatives exchanges that accept strict supervision. Clients are all certified investors, and each contract must invest at least 5 bitcoins, and the margin ratio is as high as 40%.
The advantages of offshore exchanges are easy registration and low deposit restrictions. Even a small amount of funds can be experienced. As a result, it has attracted the participation of many retail investors around the world, and the transaction volume is very large. The main representatives are Binance and Bybit. Binance alone undertook 35% of derivatives trading volume.
Of course, the disadvantages of offshore exchanges are also obvious: due to few restrictions, retail investors cannot withstand the temptation, and often use high leverage, which multiplies the risk by many times. Liquidation has become commonplace, just like opening Pandora’s box.
The regulatory authorities have obviously been eyeing these offshore exchanges a long time ago and do not want them to become “outside the law.”
The U.S. Commodity Futures Trading Commission (CFTC) and the Department of Justice (DOJ) accused BitMEX of illegally operating a derivatives platform and providing trading services to U.S. citizens in October 2020. Exchanges such as Binance and FTX also expressed their views in July this year. The maximum leverage ratio was reduced from 100 times to 20 times, and it was emphasized that leveraged trading is not the mainstream of the cryptocurrency ecology.
Compliant exchanges solve the problem of offshore exchanges, but they also bring the disadvantage of narrow coverage. It is difficult for ordinary people to access their Bitcoin futures products.
The largest compliant derivatives exchange is the Chicago Mercantile Exchange (CME). They settle futures in cash and have trading time restrictions. They are only open for trading from 5 pm on Sunday to 4 pm on Friday, and 4 pm every day. After that, the market was closed for one hour.
In contrast, Bitcoin spot is tradable at any time 7×24, and the liquidity is significantly stronger than CME Group’s Bitcoin futures. In December 2017, the Chicago Board Options Exchange (CBOE) also announced the launch of Bitcoin futures, but it completely withdrew after June 2019. At present, the largest exchange of the second category is CME Group.
CME Group’s major liquidity providers include Akuna Capital, B2C2, BlockFi, Cumberland, Galaxy Digital, Genesis, NYDIG, etc.
Overall, the biggest contributor to the derivatives market is still offshore exchanges. In the process of Bitcoin price discovery, offshore derivatives exchanges play the most important role.
After all, the belief in the cryptocurrency industry is that everyone has the right to trade freely, and as long as they are willing to take risks, they should not be blocked. Freedom includes responsibility: using 1% of margin to participate in leveraged transactions is the freedom of users, but at the same time they must be prepared to pay the price of response.
Other investment tools
Grayscale Fund and its competing ETF are also important members of the ecosystem. Investing in this type of fund can enjoy tax incentives.
In the past year and a half, they have developed very rapidly, absorbing 800,000 bitcoins in total.
Grayscale and ETF are taking different routes. The same fund, Grayscale is closed-end, traded on the U.S. OTCQX exchange, and only qualified investors can participate. In the primary market, you can enter the gray level of gold, you can use bitcoin in kind, or fiat currency in cash. Fund shares can be transferred on the secondary market, but due to the lack of a redemption mechanism, the price of gray funds and the market price of Bitcoin often appear at a discount or premium.
ETF is a special fund between open and closed. It can be listed on the exchange or freely redeemed. The flexible and convenient process makes the ETF tracking price and the bitcoin market price have a small gap.
Due to the demand for redemption, Bitcoin ETFs must set aside reasonable liquidity channels to ensure the balance of Bitcoin holdings on a regular basis. Therefore, Bitcoin funds and brokers and OTC counters also maintain close contact to complete the smooth exchange between cash and Bitcoin.
Canada is relatively open on Bitcoin and Ethereum ETFs, while US institutions are not so lucky. Many institutions have submitted applications to the US SEC, including Fidelity, NYDIG, Galaxy Digital, Skybridge Fund, VanEck, Valkyrie, Wisdom Trust, etc., but the SEC has not passed any ETF so far, and most of the recent responses have been “delayed responses.”
Hosting
Trezor and Ledger were the first to provide hardware wallet services, where users can use small USB devices to store their own cryptocurrency. Later, Casa appeared, providing high-end membership services such as multi-signature restoration of Bitcoin access and multiple hardware remote backups to avoid disasters caused by the loss of a single private key.
The exchange is also providing custody services for important customers. For example, Coinbase has established an independent entity, Coinbase Custody, whose assets are isolated from the exchange, and specifically accepts users’ entrusted custody of cryptocurrencies. Gemini subsequently followed up and spent US$200 million to insure the cryptocurrency under custody, claiming to be “the custodian with the widest insurance coverage in the world”.
As one of the world’s most prestigious institutions, Fidelity began researching blockchain technology as early as 2014, and established a digital asset subsidiary Fidelity Digital Assets in 2018, and launched a custody solution a year later. The specific performance has never been made public, but the CEO confidently stated that this business has achieved “unbelievable success.”
Traditional trust service providers also want to share the pie. The Bank of New York Mellon (BNY Mellon), with assets under custody of more than US$41 trillion, announced in February this year that it was preparing to launch its custody service in the second half of the year. In the abandoned military bunker; secure multi-party computing (MPC) mathematical model; hardware security component (HSM), add an expansion card to the computer to be responsible for encryption and decryption operations.
An abandoned military bunker in Switzerland converted into a cold storage base for Bitcoin
In addition to Bank of New York Mellon, Standard Chartered Bank, Northern Trust Bank, JP Morgan Chase, Goldman Sachs, and Citigroup have also deployed digital asset custody services.
The largest customers of the custody business are cryptocurrency exchanges, such as Binance, Coinbase Pro, Gemini, FTX, B2C2, Galaxy Digital, Genesis. In addition, there is also demand for OTC counters, market makers, lending companies, and payment processing companies.
Borrow
Credmark data shows that in Q1 of this year, the size of the cryptocurrency lending market has reached 29 billion U.S. dollars.
Lending can revitalize the liquidity of the Bitcoin transaction ecosystem. The same is leveraged trading. Institutions prefer to find lending companies instead of exchanges because the automatic clearing of exchanges is too frequent.
The main customers of the Bitcoin lending market are market makers.
The main providers are Genesis and BlockFi. Genesis only serves institutional customers, while BlockFi also serves individual customers. In addition, traditional institutions are also developing different kinds of lending services. As a traditional bank, Silvergate has cooperated with Fidelity to provide institutions with US dollar legal currency funds loans through the SEN payment network. The bitcoin pledged by customers during this process is kept separately by Fidelity.
What factors are most important to institutions
Through communicating with banks, funds, asset management companies, high-frequency trading systems, and proprietary trading companies in the ecosystem, Arcane summarized the mentality characteristics of institutions investing in Bitcoin, which are mainly reflected in three aspects:
Choosing a trading platform: Reliability is the most important
The three most important factors are: first, reliable technology, 100% normal operation, no downtime is allowed; second, deep liquidity; third, low latency, and the transaction situation is clear.
In addition, the following factors will be considered: preferential handling fees; transaction compliance, good reputation, and currency security; deposit and withdrawal operations can be performed through API; stable currency is allowed; intraday leveraged financing transactions are provided; legal currency channels are provided.
Choosing the hosting party: safety first
The study found that nearly half of the institutions directly chose the trading platform for custody. In addition, the three most common custody schemes are: offline, institution-level, multi-signature custody; traditional custody professional institutions; and masterless wallets.
As for the factors to be considered when choosing, there is no doubt that security ranks first, followed by accessibility, convenience, and the ability to associate with exchanges.
Choosing infrastructure: communicating the reality of finance
The improvement of infrastructure is a prerequisite for institutions to hold and invest in Bitcoin. Most of the interviewed institutions believe that the infrastructure that needs to be strengthened most is mainly reflected in the connection with the bank and the credit system.
Specifically, banks, funds, and asset management institutions are most eager to upgrade banking and credit infrastructure, brokers are most eager to upgrade banking infrastructure, ordinary companies want to strengthen banking and compliance services, and proprietary trading companies and high-frequency trading companies are most eager Hope to strengthen the construction of the credit system.
Bitcoin’s “new era”
Recently, some people have always felt very optimistic that financial market behavior has entered a new era driven by institutions to retail investors, Internet celebrities, and traffic.
Indeed, the influence of retail investors and online news continues to expand.
In the “Game Post” movement, retail investors used Reddit to agitate social media sentiments and convince Wall Street institutions that were short on Game Post stocks to yield.
This also makes the retail investors in the currency circle excited, wanting to imitate the success of the game station. The Dogecoin army is particularly prominent, claiming to do something on April 20 this year to make Dogecoin rush to $1.
But in the end, their rhetoric still ended in failure, and Dogecoin returned from the $0.4 level to the $0.3 mark that day.
In the final analysis, huge amounts of funds and professional investment technology determine that institutions will still be the masters of any financial market, and their role must not be ignored.
A healthy trading ecology is bound to be mutually beneficial and win-win for individual investors and institutional investors. Without the participation of any party, it is not enough to become an “ecology.”
The new era of Bitcoin is both institutional and retail.
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