With market volatility rising again, investors are scrambling to navigate price fluctuations and poor liquidity. Trading digital currencies is no exception with institutional investors struggling to find sufficient liquidity for their larger trades. These professional traders, miners, and asset managers typically go to the over-the-counter (OTC) market to find counterparties to match their orders. The OTC market for digital currencies is a multibillion-dollar industry and one of the main channels for providing liquidity to family offices and institutions. OTC trading offers advantages over the digital currency exchanges, but it is also an opaque market with little regulatory oversight. Yet emerging technology is helping these high-value investors overcome these challenges giving them the ability to source liquidity and trade with suitable transparency in a Know-Your-Customer (KYC) and Anti-Money Laundering (AML) compliant and competitive marketplace.
Last year, Bloomberg estimated the daily OTC market was $30 billion per day, making it twice the size of the daily trading volume on digital currency exchanges. The reason we believe in the growth of the OTC market is associated with its ability to help prevent price slippage. Given the immaturity of the cryptocurrency market, placing large orders on an exchange has the potential to move the market price substantially. Plus, OTC orders are not restricted by the trading and withdrawal limits prevalent on many exchanges, giving traders greater flexibility to execute trades of any size.
We have also seen extreme volatility in the exchange market. For example, bitcoin’s average daily price range, defined as the average difference between the daily high and low in a given month has fluctuated over 100% between January and March  this year. OTC trading is one way for institutions to minimize wide bid/ask spreads. Imagine placing a large sell order through an exchange without enough buy orders to match. It could potentially cause a market crash much like the impact of recent auto liquidations of large leveraged futures positions. On an OTC desk, a broker communicates with a network of liquidity providers to find respective buyers and sellers who best match their client’s volume and pricing on a deal.
Source: CoinDesk data as of 5 May 2020
Despite advantages over the exchanges, the OTC market has not reached its full potential due to an inherent lack of transparency. Some institutions cite a lack of publicly available information on both the deals and the counterparties as a hurdle to participation.
OTC desks are typically less formal and not subject to the listing requirements of an exchange, so settlement and operational risks could be driven by the credit risk involved with counterparties having little to no information about each other and/or the quality of the broker. The digital OTC market does not have the comprehensive monitoring and surveillance tools of traditional trading systems and few brokers offer secure custody solutions. There are also multijurisdictional KYC issues when onboarding counterparties in countries with inadequate compliance standards. Counterparties are unknown to each other so the onus falls on the reputation of the broker who matched them; there is no guarantee the asset will be delivered, or cash paid.
We believe OTC trading will be even more prevalent amongst professional traders and multinational corporates if brokers and intermediaries recognize the importance of stringent KYC and AML policies plus other compliance best practices. There is also emerging technology to distribute liquidity across counterparties and deliver transparency on OTC deals. Qualified By Diginex (QBD) for example is an invitation-only blockchain-enabled OTC platform that sources pre-qualified liquidity, matches brokers and uses QR codes to distribute real-time information on the status, pricing and volume of deals to vetted counterparties.
More market players are enabling blockchain solutions to bring transparency to their OTC deals and ensure clients and counterparties follow KYC/AML processes and due diligence checks on asset provenance. Some industry leaders are actively participating in standard-setting bodies such as the Global Digital Finance (GDF) council that promotes the adoption of best practices in the digital assets space. In addition, more established technology providers will offer a range of security options from cold storage inside high-grade vaults to multi-layer protection warm custody solutions.
These are the first of many steps in the right direction. By building a platform that distributes transparency and liquidity efficiently, and by upholding high compliance standards, the OTC marketplace can overcome transparency challenges and provide vast and bright opportunities for digital asset investors to weather any market environment.
Matt Blom is Global Head of Sales Trading at Diginex.