Sofian Berrahal, CEO of Nexdesk
Over-The-Counter (OTC) trading (also known as off-exchange trading or dealer trading) has been spreading beyond its core markets recently. Trading has expanded beyond derivatives into traditional assets such as stocks, bonds, real estate or even art and collectibles. Now the OTC trade is taking another new direction as the emergence of decentralized OTC Desks breathes new life into the sector and opens up new opportunities as well as challenges.
OTC trading
Conventional OTC trading is a way of trading securities or other financial instruments such as derivatives, as well as foreign exchange, commodities and cryptocurrencies, without being listed on a formal exchange or supervised by an exchange regulator.
It is mediated through a network of dealers or brokers who act as market makers and announce the prices for buying and selling. The buyer and seller negotiate the price and terms of the transaction directly with each other rather than through a public order book or an electronic trading platform. Trades can be customized to meet the specific needs of the parties involved, such as the quantity of the asset, the settlement date, and the payment currency.
- For high net worth individuals (HNWIs), OTC trading can offer more privacy and confidentiality, as they can trade large amounts of securities or assets without revealing their identity or intentions are not publicly visible on an order book. OTC trading can also offer more flexibility and customization, as they can negotiate the terms and conditions of the contracts with their counterparties.
- It can help corporations raise capital through the sale of stock or debt securities without having to meet the listing requirements or pay the fees of formal exchanges. OTC trading can also help to hedge risks or leverage business operations using derivatives that are tailored to specific needs and exposures. And it simplifies accounting and operations by providing a single price for a deal.
- For institutions, OTC trading can provide access to a wider range of financial instruments and commodities that may not be available on standard market exchanges. OTC trading can also allow them to execute large trades directly with their counterparties without going through the public order books, which can reduce the market impact and transaction costs.
While conventional OTC trading may have less regulation and more flexibility than trading on standard market exchanges, it also involves more counterparty risk, since the parties involved rely solely on each other's creditworthiness to fulfill the terms of the trade. There is limited transparency too, as trades are not publicly visible on an order book making it difficult for investors to assess the fair value of the assets being traded.
In addition, OTC trading often involves higher transaction costs than traditional exchanges due to the lack of liquidity and the need for specialized services.
Increasing demand for crypto OTC trading
Crypto OTC was already expanding but the FTX crash has triggered substantially bigger demand for crypto OTC services as investors look for alternative crypto exchange methods amid weak trust in Centralized Exchanges (CEXs).
Exact statistics on crypto OTC trading can be challenging to obtain since the majority of OTC trades happen privately, and data is not always publicly available. However, according to a report by the research firm MarketsandMarkets, the global crypto OTC market size is expected to reach $1.1 billion by 2026, growing at a CAGR of 4.2% from 2021 to 2026.
Some sources claim that post-FTX OTC trading volume may be comparable to or even exceed that of exchange trading volume for some crypto assets, such as Bitcoin. In December, for example, the value of the interdealer flow on the institutional-grade, over-the-counter (OTC) communications platform Paradigm was pushing towards half (43.5%) of the total crypto options trading volume of $1,455 million. And in April, Asian crypto giant HashKey Group was licensed to start OTC trading in Hong Kong.
The big names in OTC crypto are Coinbase, Genesis and B2C2 but there are also many smaller desks that cater to specific regions or niches. The OTC desk space is also witnessing consolidation as larger players acquire smaller ones to increase their market share. For example, in 2020, Coinbase acquired Tagomi, a crypto OTC desk, to expand its institutional trading services.
The emergence of decentralized OTC desks
Decentralized OTC desks are gaining popularity as they offer greater security and transparency than centralized platforms, as well as improved privacy with greater censorship resistance. They can also reduce trading costs and overheads, as they have the potential to remove the need for specialized brokers and services.
Platforms such as Bisq, DODO, and Matcha are leveraging blockchain technology to create permissionless and non-custodial peer-to-peer (P2P) trading environments. For example, Bisq or HodlHodl, are both open-source, decentralized OTC desks that operate on a P2P network, with all trades secured by multi-signature escrow accounts.
LocalCoinSwap’s open-source and community-driven platform allows users to trade a variety of cryptocurrencies, including Bitcoin, Ethereum, and Litecoin, with all trades secured by smart contracts.
Regulatory developments needed
However, users should be aware that while decentralized OTC trading addresses some of the downsides of conventional OTC desks, it is still not subject to the same level of regulation as traditional exchanges.
Counterparty risk does not vanish. The possibility that one party will default or fail to fulfill their obligations before the completion or expiration of the contract is higher in decentralized OTC markets because there is no clearinghouse or exchange to guarantee or enforce the contracts.
This is connected to the difficulty or impossibility of verifying the identity, reputation, or solvency of the counterparties, as well as the price, volume, or quality of the traded assets. This risk is higher in decentralized OTC markets because there is no central authority or regulator to monitor or disclose the market activities.
There is also potential for market manipulation, where malicious actors influence market prices or volumes by exploiting the information asymmetry, low liquidity or network vulnerabilities of the decentralized OTC markets.
Regulators around the world are already starting to pay more attention to OTC trading generally. In the US, the SEC has proposed new rules that would require OTC trading platforms to register as broker-dealers. In Europe, the EU's Markets in Financial Instruments Directive II (MiFID II) requires OTC trading platforms to report their transactions to regulators.
Whether a decentralized OTC trading platform has to comply with the MiFID II reporting requirements depends on the nature and characteristics of its transactions and instruments, as well as the regulatory status and jurisdiction of its operators and participants.
How to mitigate risk
Fortunately, there are ways for clients who want the benefits of decentralized OTC to mitigate these risks.
First, clients should look for larger, EU-based virtual assets service providers because being part of a bigger group prioritizes safety for clients assets, is more likely to imply the use of advanced technology, and tends to result in better price competitiveness.
Second, seek out providers who use appropriate financial institutions, ensuring safety of your funds at all time. The same goes for custody of digital assets - hot wallet storage is not recommended.
Finally, insist your provider offers a liquidity aggregator that accumulates prices and volume from many counterparties at the same time (to limit risk and increase depth). This way you get access to large trades using top of the market prices from many sources, instead of having to rely on a liquidity depth of just one, which is very likely to mean a worse price.
In the end, the choice whether to choose the decentralized OTC desk, or centralized one is up to each business’ preferences and risk tolerance. The privacy and cost benefits of the decentralized desks are offset by the greater counterparty and regulatory risks. The reliability and total anonymity of the trades with decentralized OTC desks are what many larger traders are looking for, and solutions now exist to provide exactly that.
About the author
Sofian Berrahal is CEO of Nexdesk, a B2B self-service digital asset OTC trading desk, available to all users across Europe. Before launching Nexdesk in 2023, Sofian as CBO was running business development in Nexpay, a Vilnius-based provider of banking infrastructure for digital companies, and managed a multinational team at Dukascopy Bank SA, an innovative Swiss bank.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.