Institutional Bitcoin Trading
As a rates trader, the regular 20% intra-day moves in ethereum and bitcoin freak me out. The general immaturity of the market infrastructure freak out a lot of institutional traders, and events like the implosion of ethereum on Coinbase’s digital currency exchange (GDAX) last week aren’t helping:
On 21 June 2017 at 12:30pm PT, a multimillion dollar market sell was placed on the GDAX ETH-USD order book. This resulted in orders being filled from $317.81 to $224.48, translating into a book slippage of 29.4%. This slippage started a cascade of approximately 800 stop loss orders and margin funding liquidations, causing ETH to temporarily trade as low as $0.10.
Aww, how cute, it’s your very first flash crash. Welcome to the club, digital currency traders!
The blowback was so hard against Coinbase that it decided to write checks to all the people who lost money:
For customers who had buy orders filled — we are honoring all executed orders and no trades will be reversed.
For affected customers who had margin calls or stop loss orders executed — we are crediting you using company funds.
It’s a smart move by Coinbase. They’re VC-backed, so they have little incentive to focus on short term profits. They have a license to lose money to build a much larger business in the long run. And canceling bad trades is not without precedent. Sell-side firms frequently cancel trades for institutions that accidently send incorrect wrong orders. (Shockingly, they only ever eat losses, as trades in their favor never get canceled.) Even equities exchanges will sometimes break trades that are really off-market.
Until bitcoin can attract more institutional investors, more incidents like the GDAX blow-up will continue to haunt the markets. There’s just not enough critical mass in the system to absorb shocks like these. But to get those institutional investors, fundamental improvements to the marketplace must happen. So, if I was Satoshi Nakamoto for a day, I’d work on the following problems to improve the digital currency ecosystem:
- Exchanges are islands. Digital currency exchanges currently operate as their own independent islands. Exchanges act both as a store of customer funds (holding digital currencies and dollars) and the venue that matches orders. If you want to trade on GDAX, you have to deposit dollars or bitcoin at Coinbase. If you want to trade on Kraken, you have to deposit dollars or Ether at Kraken. This is really inefficient. I might have very little risk outstanding, but Kraken sees me as long 100 bitcoin and GDAX sees me as short $250,000 dollars and requires me to margin (or fully fund) both positions. Greater interoperability between digital currency exchanges would allow me to better allocate resources.
- Exchanges concentrate risk. Exchanges pool customer funds in a single wallet so a single security lapse can wipe out both an exchange and its customers . This isn’t exactly how mature markets are structured. Exchanges in capital markets typically hold very few customer funds and instead focus on providing the best matching services. Broker-dealers, which outnumber exchanges 10x to 100x, hold customer funds and are responsible for managing customer orders. The development of well-capitalized digital currency broker-dealers that facilitate trading with many exchanges would better isolate risks in the system and increase the portability of customer order flow.
- Leverage and shorting the market is difficult. Building on the ‘exchanges are islands’ idea, the lack of interoperability between exchanges makes it difficult for firms to lever up or to even be able to short the market. Some exchanges, because of the inherit risks in margin trading that were exposed through the GDAX incident, don’t even offer margin or the ability to short the market. Without a robust way of shorting the market, it is difficult to establish a fair value for a security. Without leverage, the return on equity calculations make it difficult for an institutional trading firm to justify the investment.
- Some exchanges can’t be trusted. Too many digital currency exchanges operate on shaky legal ground. Too many more feel like they can take their time in returning money to investors. Stefano Bernardi, an old YC colleague, commented that Poloniex (the second largest exchange) has refused to wire him his money for 20 days. A lack of guarantee of getting cash back is a non-starter for many institutions. Regulations exist in the capital markets to prevent these kinds of shenanigans. The digital currency market would be wise to shun exchanges that are less trustworthy and unregulated.
- Coinbase is terrible. GDAX is the 8th largest digital currency exchange, but it goes down when more than 3 people trade on it. Every time it crashes, people panic, and this create a vicious downward pressure on the price. The market needs to shift its attention (and trading) to more reliable exchanges that are built on a much better technological foundation.
