Original title: “Crypto Market Structure 3.0”
Original author: Arjun Balaji translation: 0x13
In the early 2010s, the crypto market consisted of a small number of retail-oriented small brokers. In the past ten years, the market has grown to a daily trading volume of more than $15 billion, spanning the spot, derivatives and on-chain markets. Today, BTC is among the most liquid assets in the world.
The weirdness of crypto assets creates a novel market. The crypto market is open 24 hours. Users all over the world can obtain fully realizable assets. The public blockchain allows the frictionless transfer of cryptocurrencies and fiat currencies within minutes. Individuals can keep their assets as safe as a bank. Unlike the New York Stock Exchange or Nasdaq, retail investors can trade directly on the largest crypto exchanges without the need for intermediaries.
Even with these advantages, the structure of the crypto market is opaque and not understood due to the global dispersion, rapid change and diversity of participants.
This article outlines two major evolutions in the crypto market in the past ten years and sets out a vision for future possibilities.
Market structure 1.0: 2010 to 2017
The germination of the crypto market began with p2p transactions through Bitcointalk and IRC. In July 2010, with the launch of Mt.Gox, the first real market structure appeared. In the next five years, many early exchanges have launched legal currency on-chain services for individuals.
Due to the start-up period of Bitcoin, it is a challenge to obtain stable banking channels, which led to the rise of stable coins such as Tether. As the adoption rate increased, over-the-counter (OTC) counters began to provide services to a few early institutional companies. There is no mature market maker, and liquidity is very poor. The price difference between cross-border and cross-site is usually measured in single-digit percentages.
The influx of new market participants in December 2017 overwhelmed the exchange every day, marking the end of an era. It is not worth reflecting on this past era. Thanks to the early builders, they are the ones who made us here.
Market structure 2.0: 2018 to present
Since December 2017, the crypto market has developed to a 2.0 iteration, from a market designed for individuals to a market that institutions can enter. During this period, the trading volume of derivatives increased by more than 25 times, while the bid-ask spread dropped by 10 times. The market has matured from a manual, expensive, BTC-denominated market to a fully electronic, cheap, and stable currency-denominated market.
The main drivers of this transformation are:
(1) The liquidity of derivatives is eclipsed by the spot.
Since 2017, the center of cryptocurrency liquidity has shifted from the spot market to derivatives. In 2017, the trading volume of crypto derivatives lags behind the spot trading volume, but now the trading volume is 3-5 times the spot trading volume, exceeding 10 billion US dollars per day. With the increase in double-sided liquidity, the volatility of Bitcoin has dropped significantly. The current 60d volatility is 2-4%, 4-8% in 2017-18, and more than 7-10% in 2013-14. Today’s derivatives landscape is diversified, including US regulated markets (CME, Bakkt), global participants (FTX, Deribit), and products from international spot exchanges (Binance, Huobi, OKEx).
(2) The electronic execution of over-the-counter transactions.
Since 2017, the over-the-counter transaction spread has been compressed by an order of magnitude, from 50-200bp to 5-10bp for today’s 8-digit BTC transaction. In 2017, over-the-counter transactions were mainly conducted through voice and chat. Today, it is completely electronic, led by quantitative trading companies such as Jump, B2C2, Amber, and Alameda Research. Customers do not need to start Skype, but can directly connect to the platform hosted by the market maker to stream quotations and execute transactions via API.
(3) The emergence of lending.
In 2017, the credit of cryptocurrencies was almost zero. Today, trading companies can obtain more than $2 billion in BTC and stable currency loans, and the service desk also intermediaries retail (BlockFi, Celsius, Blockchain.com) and institutional (Genesis) borrowers. The lending market reduces the capital cost of market makers, which is beneficial to institutional clients with small spreads and retail users with single-digit yields.
(4) Stable coins are used as encrypted financial reserve assets.
In 2017, almost all mainstream trading pairs of crypto assets were priced in BTC. This leads to significant price imbalances and liquidity evaporating during periods of high volatility. Today, almost all of the top 30 crypto assets, the most liquid trading pairs are priced in stable currencies. Stablecoins have replaced BTC as the reserve asset of the crypto market, as reflected in the 10-fold increase in the total number of stablecoins issued in January 2018 (US$2 billion to US$20 billion).
(5) Institutional services and products.
In 2017, institutions can only enter the market through retail channels. Today, institutions can work for dozens of qualified custodians, new entrants in the electronic execution and lending market, such as Tagomi, Fireblocks and Anchorage, in addition to incumbents such as Coinbase and Genesis/BitGo. ECNs like Paradigm.co have improved the block transaction workflow, and professional venues like LMAX Digital are now leading the global BTC: U.S. dollar liquidity.
Market Structure 3.0: From 2020 to?
We are in the early stages of the next structural evolution, from 2.0 to 3.0.
In the mature period, the iteration of market structure 3.0 will (1) fundamentally improve capital efficiency, and (2) connect the centralized market and the emerging decentralized financial (DeFi) market.
(1) Capital efficiency
Due to the fragmented market and the lack of industry-wide credit evaluation, the capital efficiency of encrypted transactions is still very low.
Nowadays, exchanges have very high requirements for margin, and companies cannot conduct cross margin, that is, use the margin paid by a broker or place to mortgage positions in other places. This forces the company to provide almost all of its trading activities with all funds, and makes transaction settlement subject to many large confirmations. In a highly unstable environment, when the congestion on the chain is the most severe, full financing is particularly laborious.
Due to these inefficiencies, perpetual swaps have become the main source of short-term funds, “coming for incremental capital efficiency and staying for 20 times leverage.” Relying on the perpetual contract market as the pillar of market funds is very undesirable: the layered liquidation in March 2020, BitMEX alone caused a nominal liquidation of more than 1.6 billion US dollars, most of which should be in a more efficient market It can be avoided.
Credit creation and shortening the transaction life cycle can promote the improvement of capital efficiency. Credit creation allows companies to obtain purchasing power of more than one dollar per dollar. Shortening the transaction life cycle means that the same dollar can be turned over more times, increasing the liquidity per dollar.
We will see some specific ways to create credit and shorten the transaction life cycle.
Dedicated major brokerage companies and large exchanges have the most robust balance sheets in the crypto sector, allowing them to directly provide large amounts of credit. Indirectly, PBs like Coinbase enable customers to make deposits across sites, while cold storage accelerates the transaction life cycle by moving transfers off-chain.
Clearing of encrypted native derivatives. In the traditional market, exchange-traded derivatives are cleared by the central clearing house, which is responsible for maintaining the ledger for margin calculation. In the past few years, companies like Zero Hash and ErisX have tried to port this model directly to the encryption field. In addition, methods like X-Margin can also achieve this encryption native by doing encrypted collateral proof on the chain.
A formal repurchase market. The 2-4T/day repurchase market allows institutions to borrow cash on a safe short-term basis. Encryption already has an informal repurchase market, through perpetual swap financing, and over-the-counter repurchase (50 million/day) with double-post settlement. A formal institutional repurchase market can realize considerable short-term borrowing without being exposed to perp sites.
Lower on-chain confirmation threshold. An excellent understanding of public blockchain settlement guarantees promotes faster deposit times between known parties. Fireblocks’ digital asset transfer network settles more than $25 billion per month on the chain, and allows members to choose “instant” deposits. All transfers initiated by Fireblocks are signed by SGX and ensure that an (unconfirmed) transaction is the only signed transaction for a given UTXO. These guarantees allow exchanges like FTX to accept deposits from other Fireblocks users once the transaction enters the mempool.
(2) Gradual integration of CeFi and DeFi
Decentralized finance (DeFi) first appeared at the end of 2017 and developed in parallel with market structure 2.0. As the structural importance of DeFi continues to increase, CeFi and DeFi will tend to converge because they overlap in market participants, liquidity pools, and product user experience.
Even in its 1.0 iteration, DeFi has begun to subvert “CeFi.” Give some examples.
Liquidity is first established on AMMs: In 2017-18, establishing liquidity in a new asset requires cooperation with exchanges and market makers. With the realization of permissionless listing of AMMs, passive retail LPs ca created market depth before professional LPs had no inventory. The world’s major crypto exchanges used to be the starting point for liquidity and are now the rising star of the long tail.
Optimal execution requires interaction on the chain. AMMs like Curve now hold nearly $1 billion in stablecoins. The direct implication is that brokers that cannot obtain on-chain liquidity have a direct disadvantage compared to brokers that can obtain on-chain liquidity. This transition is happening very quickly; the impact of AMMs on centralized liquidity has already become apparent in March 2020. For many MMs, this is already a real mandatory feature, added to DeFi.
Encrypted native cross margin. DeFi’s margin positions have been tokenized from the very beginning, in the form of Uniswap LP shares, Compound cTokens and Synthetix synthesizers. The DeFi margin tokens are fully collateralized and can be called on the chain. When used in combination, transparent remortgage can be achieved (for example, using Uniswap LP shares as Maker CDP collateral). Although FTX has taken the lead in launching a tokenized margin on a centralized venue, the design has just opened up.
DeFi’s frictionless user experience: DeFi’s user experience is better than CeFi in many aspects. Critics tend to focus on gas fees, while DeFi provides users with superior secure UX (unmanaged) and frictionless access. Scanning the QR code and signing MetaMask transactions is accessible, which is closer to using Snapchat than fiddling with traditional brokerage companies.
Although DeFi already has a deep spot trading and lending market, DeFi has not “eaten” CeFi. Throughput and high gas bills remain important structural obstacles. With the launch of L2 solutions, DeFi poses a real threat to centralized venues, because applications like Synthetix can copy synthetic assets with a ratio of BTC, and their user experience is comparable to using FTX.
What does this mean for CeFi players? There are several influences.
Better DeFi interface: Exchanges will rely on their scale efficiency to intermediary DeFi for users, just as they use betting services. Providing an interface for accessing DeFi is an inevitable way to prevent capital flight from the chain. Providing liquidity of locked assets, lower fees (through pooling), and additional off-chain margin are some of the ways that exchanges encourage users to access DeFi through interfaces. For many users, an exchange account may be the most convenient way to access on-chain protocols as a default wallet.
Standardization of non-custodial transactions. Non-custodial trading products are another natural “line of defense” to prevent capital flight. Binance and FTX have fully approached the challenge and established non-custodial DEX Binance Chain (Datong District) and Serum (on Solana). Agreements like Arwen can enable non-custodial transactions for exchanges that pursue a hybrid approach. Newer projects such as dYdX and DeversiFi (originally via Bitfinex) are building scale to compete with centralized UX, powered by StarkWare’s ZK-based L2.
“CeDeFi” is real: In addition to the non-managed window decorations, every major CeFi player will try to use “CeDeFi” without irony. Low-effort solutions can be structured products that try to mimic on-chain yields. A more comprehensive solution can include a fully EVM compatible chain that can be ported to DeFi, such as Binance SmartChain.
Institutional support for DeFi. Compared with large institutions, retail users have less friction to obtain DeFi and are subject to compliance or regulatory obstacles. As large companies begin to treat the DeFi market as a first-class citizen, service providers will seek to provide customers with frictionless access without affecting existing workflows. Over time, we may even see some projects gradually launch whitelist (KYC) liquidity pools. Off-chain DeFi insurance can alleviate mechanism and contract risks. On the basis of no/under guarantee, the coverage is much greater than this.
As scalability increases, the financial infrastructure on the chain will begin to compete with centralized infrastructure. However, the diversity of users and the importance of fiat currency on the chain mean that centralized venues will not disappear soon. The long-term winners are users, who can explore a spectrum of choices that span trust, price, risk, and user experience.
Conclusion
In the first ten years, the structure of the crypto market has undergone two major changes. Despite the rapid pace of innovation, the market is far from reaching maturity or the scale needed to support tens of trillions of dollars in market value.
The transformation of the crypto market has always been grassroots, bottom-up, driven by the needs of entrepreneurs and users. The optimistic view is that innovation is a long-term victory-today’s encryption sandbox is the design of every major market in the future.
Historically, the crypto market has been opaque and not understood. We hope that this article will provide a useful starting point for future conversations, because we will establish an open and efficient financial system in the next ten years.
