The crypto market has come a long way since the retail bubble of early 2018. The maturation of the entire crypto ecosystem, both retail and institutional, has been nothing short of transformational. Despite the pandemic, crypto has accelerated adoption by traditional institutions on the back of an increasingly inflationary global monetary theme. At the same time, crypto’s actual use cases, whether the readily understandable case of digital gold with BTC or ETH’s powering of the decentralized finance (DeFi) movement, adoption really started to take hold in 2020.
Up until this point, crypto infrastructure was mostly focused on custody and access to liquidity. That’s understandable. When an asset class is new, early participants simply want to ensure it’s safe and available. But as an asset class matures and evolves, as crypto has in the past three years, the interaction with that asset will have to mature as well. Crypto was born in the retail world, therefore higher level needs such as scalability of market infrastructure were not prioritized in the early days. With the entry of true institutions in the last year, be it asset allocators, macro hedge funds, endowments, corporates or global banks, that has all changed.
A primary example of this is in crypto execution. While the question of how to best access crypto liquidity and get the most efficient execution has always been top of mind (and was one of the main reasons why I left State Street Bank & Trust to start Omniex), it wasn’t until recently that clients reached the scale and developed the sophistication to ask the harder questions and appreciate the challenges.
Liquidity challenge: A fragmented landscape
Institutions entering the crypto market today face two major challenges when it comes to liquidity access: the current crypto market structure is bifurcated and fragmented.
Liquidity is bifurcated in the sense that it’s currently accessible via two primary channels: exchanges and Over the Counter (OTC) markets. Examples of exchanges are names such as Coinbase, Gemini, Binance, FTX and LMAX. These exchanges operate a central limit order book (CLOB) based continuous order matching system very similar to an equity style exchange like NYSE or NASDAQ, though they are not yet regulated as such.
The second liquidity channel is OTC markets, or bilateral channels where names like Genesis, Jump Trading, Cumberland, B2C2 and Galaxy come to mind. Whereas in the CLOB exchange model participants are trading with each other anonymously via the exchange clearinghouse, the OTC model has a maker-taker style, fully disclosed model very similar to those of traditional FX methods.
In addition to the challenges of bifurcation, liquidity fragmentation also exists in both channels, further exacerbating the issue. This is because disruptive technologies do not follow a traditional evolutionary path. Many entrepreneurs and risk takers took to crypto and created their own liquidity venues, as did traditional firms comfortable enough to embrace the risk. So for each channel, there exists many different liquidity venues.
My goal here isn’t to scare the timid away from crypto, it’s quite the opposite. The technologies exist today, even in this nascent market, to provide large institutions easy and familiar access to crypto. In the remainder of this article, we look at some important capabilities to which a participant should pay close attention, whether building in-house or partnering with a platform provider, to achieve “Best Execution” in the world of digital and crypto assets.
Building and adapting to Crypto market structure
For the purposes of this article, we will focus on the exchange and OTC styles of execution that resemble those of equities and FX, respectively. Decentralized exchanges (DEX) are also significant, but the complexities and large scale institutional access to DEX is beyond the scope of this piece.
The key to finding the right technology and platform provider revolves around three key capabilities: access to liquidity, experience with algorithm design & data analysis, and ability to provide infrastructure at scale.
1. Access to Liquidity
As stated earlier, liquidity is bifurcated and fragmented. For efficient execution, one must be able to gain access to a wide source of liquidity. While on the surface this appears to be a simple matter of linking the various liquidity providers, both exchange and OTC, the reality is more difficult. The sheer number of venues presents a challenge to even the most sophisticated engineering teams. Given there is no readily available standard, each venue implementation is different. Protocols can vary, with each having its own nuance and idiosyncrasies. The OTC front can be even more complicated as the bi-lateral method of trading is not as straightforward as a CLOB style exchange, and market makers have their own way of representing RFQ, RFS, and streaming prices.
The technology platform of choice, be it external sourced or internally developed, must be able to expand quickly to ensure proper liquidity coverage. This does not mean linking to a new exchange the moment it’s announced, but reacting quickly when liquidity and flow change. A good example here is the liquidity landscape following the March 2020 flash crash. As a result, the once dominant BitMEX exchange lost it’s title. Many funds had to quickly shift to other exchanges to find deeper pools of liquidity.
System monitoring is also vital, as venue reliability differs greatly, especially during the significant market volatility we have experienced in recent months. Execution platforms’ ability to detect liquidity venue outages in real-time, sometimes via heuristics, is vital to notifying clients and algorithms so overall execution decision making can be as efficient as possible.
2. Trading Algorithms and Data Analysis
Now we come to the heart of the discussion around crypto best execution. To achieve best execution, the algorithms must be robust and well designed. While traditional models of algorithm design can generally apply to the world of crypto execution, the nuance of the liquidity venues, depth of liquidity, and overall market structure can impact effectiveness of the execution algorithms.
In recent years, participants’ needs in execution requirements have steadily progressed in sophistication. At the start, the need was simply about access to liquidity via a Smart Order Router (SOR) by sweeping the top of the book. While this does not seem efficient at reducing market impact for the experienced trader, this was a giant step forward for early crypto traders accustomed to sitting in front of multiple exchange screens “swivel chair trading” back and forth. Synthetic order types such as Icebergs and OCO were then introduced, overall benefiting the trader from a convenience point of view, but still far from achieving best execution.
The second path saw the need and sophistication progress into long running benchmark algos such as TWAP and VWAP. While this still did not help in minimizing cost and market impact, it did move us along the path toward best execution and into “fair execution” range. As larger crypto funds emerged from the 2018 crypto bubble, providing fair execution for their LPs became increasingly important. Providing long running algos on top of the SOR added the benefit of reasonably reducing market impact by splitting the trade over time. While most funds and platforms did not have the ability to measure post trade market impact via mark-out analysis, it was readily understood that spreading executions over time helped reduce market impact.
As true institutions start to enter today’s world of crypto, platforms need to support a full spectrum of sophisticated crypto execution algorithms. Whether a fund is quantitatively focused and expects minimizing cost of execution to improve profit or a regulated long allocator that must comply with best execution mandates, crypto trading algorithms must answer these calls. Crypto market infrastructure players and algorithm providers increased in numbers and while many claim passive execution and measurable results, it’s important to speak with the company and push for details beyond just reading a product slide. Bolting crypto connectivity on top of an existing platform by no means guarantees effective execution when the algorithm was never designed for crypto.
Knowhow of traditional algorithms still applies if the algorithm itself can be effectively adapted to crypto. We see the latest institutions coming into crypto demanding sophisticated passive algorithms familiar to equity and FX traders. Aside from effectively replicating traditional passive algorithms, perhaps more importantly for crypto execution is the ability to accurately analyze crypto market data, ex-ante and ex-post, to effectively route and execute large orders.
To truly provide passive execution, the provider must accurately predict fill probability and volume expectations. Depending on the duration of the execution, effective algorithms must properly apply historical data to predict future market conditions. Pre-trade analytics to inform traders of real-time information around actual volume predictions during the length of execution and volume participation rate are huge advantages as many crypto traders are new to institutional trading. On the flip side, traditional traders sometimes underestimate the volatility of crypto, so any pre-trade information is always helpful.
Omniex’s approach involves providing natively developed algorithms, specifically built for the crypto asset class and based on traditional financial experience. This purpose-built platform provides a clean canvas to optimize data collection and provide best execution. From standard SOR, TWAP, and VWAP algorithms to more sophisticated Passive VWAPS and one-side market maker algorithms, Omniex has created a full suite of execution algorithms that fit all situational needs of discretionary GUI traders as well as systematic and quantitative API traders.
3. Infrastructure at scale
Even with vast, deep liquidity pools or smart execution algorithms, if the infrastructure itself cannot perform at the requisite scale, it is all moot. Given the necessity of aggregating disparate pools of liquidity in crypto to achieve optimal execution, the infrastructure must be able to handle the expected data load from this fragmented market.
If the participant is only looking to execute a few large and liquid tokens or only looking to trade at a few venues, scaling is perhaps less of an issue. But given crypto’s volatility and fragmentation, at least in the near to mid term, data load will be commensurately high. On a multi-asset trading & execution platform like Omniex, we have experienced peak loads of close to 600,000 rate updates per second when overall crypto volatility was elevated across all connected venues (e.g. mid December 2020). It is vital to ensure the provider you choose can scale to grow with the market and your business.
An asset class to last
Crypto as an asset class is here to stay. Just like the Internet, a majority of its usefulness won’t be understood for years or decades to come. We are now at an inflection point of institutional involvement in crypto. For institutional participants to embrace this new asset class does not necessitate undue technological execution risk. Companies like Omniex are building a capital market infrastructure that looks and feels familiar to existing investors, but provides easy, efficient access to this new asset class otherwise difficult to attain.
Business models will evolve and technologies will reinvent themselves. For those businesses looking at crypto and blockchain as the new market and ecommerce rail, the market is still developing. For capital market players excited to participate in the investment and trading of this new asset class, the time is already upon us to jump in head first.