By Guilhem Chaumont, Co-Founder & CEO of Flowdesk
The cryptocurrency markets have come a long way in their maturity journey, particularly over recent years. After the 2017 bull run and subsequent crash, many critics felt vindicated after issuing death notices for Bitcoin. However, after a relatively short “crypto winter,” 2020 saw significant development, particularly in the availability of derivatives and hedging instruments such as options. Furthermore, blockchain developers have made headway in solving legacy issues such as scalability and interoperability. All of this has paved the way for an influx of institutional investors in 2021.
However, one of the biggest problems that still remains is liquidity. Even in a market that looks set to reach $2 trillion in cumulative value this year, there’s a risk that liquidity won’t be able to support the increasing demand from institutions. One of the most significant issues is fragmentation. A recent survey carried out among institutional investors indicated that only one-fifth of respondents viewed market fragmentation as a positive, with close to half seeing it as unfavorable.
The Relationship Between Liquidity and Fragmentation
The challenges of liquidity and market fragmentation have several components. Firstly, there’s the fact that the crypto-asset markets are still orders of magnitude smaller than many other assets. For example, the global stock markets have a combined market cap of nearly $90 trillion, compared to crypto, which only recently surpassed the $1 trillion milestone.
There’s also a significant amount of liquidity concentrated into Bitcoin and Ethereum, with the rest fragmented across many other assets. Currently, Bitcoin and Ethereum account for two-thirds of the total market capitalization of the cryptocurrency markets.
The third-biggest asset, currently Binance Coin (BNB), has a market cap that’s only one-fifth of the value of Ethereum and 0.4% the value of Bitcoin. This accounts for why most institutions new to the space tend to focus only on Bitcoin, and to a lesser extent, Ethereum. The nearest competitors are still far from being able to support the size of trades favored by asset managers.
Then there’s the challenge of fragmentation across exchanges. An increasingly competitive exchange market has led to a large number of participants. However, they aren’t connected, and there’s significant friction involved in moving funds around.
The largely unregulated state of the markets has also led to a proliferation of bad practices that simply don’t exist in the regulated financial sector. In the past, researchers and analysts have uncovered manipulation practices, including “pump and dump” schemes, wash trading, and front running. Many in the markets have worked hard over recent years to clean things up, but issues persist.
Professionalization Can Level Up the Markets
What the market needs is professionalization – the entry of parties who can be trusted with carrying out activities like market-making in the same way that they are in the traditional markets. As the crypto space grows, many from traditional finance have stepped in, and as that growth continues, it’s important that the industry is able to continue attracting a stream of talent that can help bridge the gap between traditional markets and digital assets.
There also needs to be a greater desire to demonstrate compliance. In the US, market-making in securities, a classification that applies to many crypto-assets, is explicitly forbidden by FINRA. However, hiring a market maker for liquidity isn’t uncommon in general, and it’s a practice that’s extending to the digital asset markets too. For instance. Blockstack paid liquidity providers outside of the US to trade its STX token. However, if token issuers ever want to attract professional investors to their projects, they need to ensure they’re engaging only those market makers that display the very highest standards of compliance.
However, none of this can come at the expense of being able to deliver on the needs of professional token issuers and institutional investors. Unlike the traditional markets, cryptocurrencies are traded 24/7, meaning that infrastructure has to be robust and with zero downtime. Data delivery needs to happen in real time with low latencies despite the high level of fragmentation of trading venues. Providers need to provide scalable infrastructures due to the much higher quantity of available assets and trading pairs which increases the subsequent volumes of data to be processed.
If digital asset issuers, projects, and exchanges start to congregate around the market-making providers displaying these characteristics, then the institutional trust in the system will start to embed. As money flows into the space, investors will automatically seek out new opportunities, and liquidity will begin to spread across the markets.
Guilhem Chaumont is the Co-Founder & CEO of Flowdesk. The company provides market-making solutions for spot and derivatives cryptocurrency markets, as well as liquidity infrastructures for exchanges and digital asset projects. You can follow the company on twitter here.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.