Market Structure: Cryptocurrencies vs. Stock Markets

Published in

AlgosForCryptos

14 min readDec 18, 2017

Let’s review similarities and differences in structure & topology between the current markets for Cryptocurrencies in comparison with the modern Stock Markets

Additional Information:

Review Structure & Processes:

Steps to trade stocks & stock markets’ structure
Crypto markets’ background, steps to trade & summary

Conclusion: Cryptocurrencies vs. Stock Markets

There are no brokers nor custodians involved in the cryptocurrencies ecosystem as the counter party risk is eliminated by computational means and proof-of-ownership is encoded in a public ledger of pseudonymous transactions aka “the blockchain”;
Some of the other services traditionally provided by brokers are instead provided by the crypto exchange companies — e.g. margin trading;
All client order management communication occurs over the public internet and access to account management pages can be degraded during peak usage or DDoS attacks;
You can trade with basic limit orders and most top exchanges also support market orders;
Currently, there are NO algo type orders/facilities such as VWAP, TWAP, TVOL (only one top exchange provides TWAP). These are traditionally provided by brokers and utilized by traders to accumulate large positions: a hedge fund buying 20+ million dollars of some stock, would instruct their broker to utilize the broker’s VWAP algo engine to build this position over the course of several hours by “slicing” the big order into many small orders;
All 15 top exchanges provide an API which can be utilized to build custom trading bots / algos. Access is over the public internet (NO colocation) and there is throttling;
At least one high-tech prop trading company is present in the marketplace: Cumberland Mining (division of DRW)
Traders in size must currently trade by hand or have to rely on OTC relationships;
Concurrent best prices can vary significantly between exchanges since arbitrage is manual and funds transfer costs are high;

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Stock Markets Background

Today’s stock trading takes place in a wast network of computers, communicating over the public internet and via private dedicated high performance networks. The regulations, processes and systems in use have been built over many years and are based on contributions of many individuals.

A so called “order-matching” engine is located in the center of the trading network. It is an instance of specialized software tasked to “exchange” money for stocks and vice verse. Each such engine is owned and maintained by a company providing stock exchange services a.k.a. “The Stock Exchange”.

There are at least 4 main paid services provided by each stock exchange company:

Maintenance and operation of the order-matching engine software — e.g. market participants pay trading fees to send order messages and receive the results of the work performed by the matching engine;
Sale and distribution of market data necessary for all other interested parties to “see” what is going-on “inside” the order-matching engine;
Initial acceptance and ongoing review of companies whose stocks can be traded — e.g. a reputable stock exchange would reject application by your local doughnut shop because the exchange sets various conditions such as minimum yearly revenue etc.
Initial acceptance and ongoing review of companies which are allowed to trade — e.g. a reputable stock exchange would reject your trading application because they have minimum available capital requirements, certifications etc.

In other words, each stock exchange company has a department of people responsible to collect information about the companies whose stocks are traded in order to reduce the likelihood of financial fraud like another Enron or WorldCom.

Moreover, other companies submit to rigorous review of their finances and capabilities for the privilege to become trading members and to connect their internal trading systems to the stock exchange’s order-matching engine. This group is called “Exchange Members” and the stock exchange company is confident that its members do have both money and stocks that they claim to have, when they send orders to the matching engine.

Each exchange member is allowed to use their access privileges to make money as long as they adhere to applicable laws as well as regulations set by the exchange. These members may decide to buy and/or sell specific stocks using their own money and profit on the difference in price. The members can also re-sell access to the trading facilities and act as trading “brokers” on anyone’s behalf, including mine or yours.

Steps To Trade Stocks:

We must first find a company already a member of an exchange and also in the business of providing stock brokering services.
Once we create an account at our broker of choice and establish our identity, we have to transfer cash from the bank before the broker’s trading systems will allow us to create orders (and / or transfer our stocks from our previous broker).
Upon deposit, we use the public internet to login and type buy/sell/short/, limit/market order(s). This information is transmitted from the browser to the broker’s order & account management system(s). So far, the overall system performance is mostly subject to the personal computer and the ISP.
Broker’s account management system validates the funds necessary to fulfill the order and their order management system (OMS) validates its adherence to rules set forth by the destination matching engine.
Next, the OMS will “rename” the order and transmit it to the exchange for processing by their order matching engine and do so over a high performance network dedicated to each individual exchange member. The order message will be formulated in a way to identify the broker but will not have any information about its original “instigator”. In other words, the stock exchange company computers only know their members. Now days, the broker’s OMS is most often located in the same data center supporting the stock exchange.
Meanwhile, another broker has received a similar but opposite order, in the sense that I wanted to Buy 100 shares of AAPL for $50 whereas “they” are looking to Sell 100 shares of AAPL (for best price).
The order matching engine will match orders from two of its brokers and notify the brokers what happened. Since the stock exchange membership department has already certified both brokers, the engine trusts that my broker will pay $$ and also trusts that the other broker does have 100 shares of AAPL.
In real time or at least at the end of the day, the exchange and all the brokers will net all trades, net all accounts, transfer all money and all shares between brokers and do the reporting to various regulatory bodies (e.g. prevention of insider trading).
Brokers will also collect fees from clients in order to pay for their own services and for services rendered indirectly by other participants in the marketplace — e.g. the stock exchange trading fees, stock ownership registration fees etc.
The trade is finalized when my broker becomes the owner-representative of record for quantity of +100 shares of AAPL as recorded by a depository records corporation maintaining the custody all shares (DTCC in US). Should AAPL decide to pay a dividend AAPL shareholders, they will contact the custodian to begin the process of transferring the dividend amounts to brokers and their clients.

In case of problems, we can call our broker(s) and their client services team will undertake the necessary actions to convince us that we are mistaken and everything is fine indeed, or they will investigate the state of their account and order management systems and might even get in touch with the exchange since the exchange is not even aware that I exist (as it was intended).

The stock trading ecosystem is hub-and-spoke network with 3 layers:

client <-> broker<->exchange<->other broker<->other client

The Stock Exchange Company

manages data, connections, and trust-relationships with a relatively small number of brokers and can do so very efficiently for a great number of fast transactions. Likewise, each broker supports only their own clients and not the whole “universe” of individuals interested / participating in stock trading. Lastly, the DTCC records current quantities of shares represented by brokers who are then responsible to maintain records of ownership by their specific clients.

The alternative to this tiered-centralized approach would be to maintain one record of ownership for each specific share — e.g. 5.13 billion records for all of AAPL + another 606 million records for GOOG + 482 million records for AMZN and so on for about 4,333 publicly traded companies in the US alone.

Or, we could encode something similar in a public ledger “file” stored in a “network” and whose maintenance is distributed amongst voluntary participants who choose to perform a utility “bookkeeping” role in exchange for a (relatively small & well deserved) fee: eureka — I say we call this a blockchain!

Getting back to the stock trading ecosystem, it is important to cover additional characteristics, especially for readers with experience in trading on N.American or European markets.

In most countries / economies and for most companies, there is one (regional) stock exchange company as the only venue available for trading of stocks issued by companies incorporated (registered) in that specific jurisdiction — e.g. all Brazilian companies with publicly available shares are traded on the B3 exchange, only (in São Paulo). In such cases, any broker you choose, will always send your (renamed) order to the same exchange order matching engine and your trading will be subject to fees set by one such company only.

In N.America And The EU

the stock trading ecosystems are more competitive and therefore both more complicated and more flexible: shares issued by (almost) all companies can be traded on multiple exchanges simultaneously. You could buy 100 shares of AAPL on BATS exchange and immediately sell them on NASDAQ or NYSE. This means that your broker must undertake costs for network integration with multiple exchanges, if the broker wants to enable their clients maximum access to liquidity and best pricing fees as each exchange collects slightly different trading fees for different trading scenarios.

Since each order matching engine establishes prices based on the equilibrium of buy and sell orders available to that engine only, it is possible that the best prices might be different on each of the 11 main stock exchanges trading in the US. In order to protect the trading public, US regulators have initiated creation of price protection mechanisms: the result is that all US exchanges are networked to see each other’s best prices and will forward their orders to the matching engine currently “hosting” the best price, better than their own price. Moreover, several professional trading companies specialize in price arbitration by monitoring market data feeds from multiple exchanges in order to buy/sell directly across exchanges and profit while “forcing” the price equilibrium across the entire ecosystem.

The net result is that all best prices are (almost) always identical on all US stock exchanges and brokers don’t have to incur integration costs with all 11 trading venues.

In Europe, the situation is similar in the sense that one can trade most of the big stocks on 2 or 3 main exchanges, but these trading venues are not networked to forward orders to each other. Since the brokers compete for clients’ business, the brokers are incentivized to connect to each venue and utilize Smart Order Routing (SOR) applications to achieve the best prices for their trades.

In the US and in Europe, the stock custodian services and banks are able to settle stocks and cash from all trades across multiple exchanges (and borders) and the best prices for all stocks are (almost) always identical on all trading venues.

Summary For Stock Markets:

Your bank might have a division providing brokerage services or you have to transfer money to another company specializing in such services;
Your brokerage company holds your trading cash and stocks;
The broker represents & “vouches” for you at the stock exchange;
The stock exchange is run by another company which has no idea who you are: they only know & trust their registered brokers;
Your broker may offer additional services to help your get more out of your trading activity, such as: advanced order types implemented in the broker’s computers, lending of capital for (margin) trading, investment advice and research materials etc.;
In case of issues, your broker will investigate broker’s own systems;
If necessary, your broker will also speak with the exchange to investigate any possible issues there;
All best prices for individual stocks are (almost) always identical on all stock exchanges that trade respective stocks;
Cash & stock settlement (transfer) for all trades runs through a central provider / third party which is utilized by all brokers and stock exchanges.
Brokers, exchanges and settlement services act together to make cash transfers, stock ownership transfers and to eliminate fluctuations of best prices across multiple trading venues;
When you trade from your computer, you are communicating with your broker over the public internet and the broker is communicating with the stock exchange over a dedicated high performance network.
Brokers, stock exchanges and custodian companies are regulated by each other and by governments in their jurisdictions.

Crypto Markets Background

Being able to trust the ecosystem is a key requirement for any marketplace, including the stock markets and the crypto markets. In the most basic sense, both traders need be certain that their counter party does indeed posses the “goods” (stocks or cash or bitcoin) and will deliver on their promises, once our orders have been matched with each other, by the neutral order matching engine.

In stock markets, this requirement for system wide trust is implemented via a chain of two party relationships:

My broker trusts me because I have already transferred cash to my brokerage account;
The exchange trusts my broker because of an earlier certification;
Therefore I trust my broker because they trust the exchange, because the exchange trusts the other broker, who in turn trusts their client on the other side of the trade;
A much less efficient alternative to this chain would be for millions of traders to all get together and meet each and every other trader and then to maintain millions (billions) of such direct relationship on standby should we end-up trading something with each other.

Another Way To Implement Trust

is to make the ownership ledger publicly accessible to all parties and distribute the ledger maintenance responsibilities of this “blockchain” amongst multiple paid “volunteers”, in such a way that no one individual or group can counterfeit any portion of this public record because the maintenance methods utilize tamper-proof cryptography: voila, cryptocurrencies are born.

The entire history of all bitcoin creation and changes in ownership exists in a huge database “file” (140 GB of data in 2017) duplicated in many locations around the bitcoin mining network. The current ownership of all bitcoin units is recorded in this chain of transaction-blocks and ownership is designated with the pseudonymous ID of each current owner. Each pseudonymous ID’s balance can change only based on instructions generated & “signed” (mathematically) by its secret crypto key-holder to transfer its holdings to another pseudonymous ID. Whenever such instructions are received by the members of the ledger maintenance network, they first validate the truthfulness and then make updates to the blockchain.

Two consequences of the blockchain architecture are that the crypto trading ecosystems do not have an equivalent to stock brokers nor the custodian services, because they are not needed to provide “trust” as trust is achieved by computational means.

And since the stock exchange’s order matching engine processes only orders from its trusted brokers, the current stock exchanges are not able to trade crypto currencies along with their existing stock order flow like they could add another new stock — e.g. Spotify after their IPO.

Instead of trading cryptocurrencies on existing exchanges, we have a slew of new companies building order processing and matching engines with increasing sophistication and capabilities proportional to the growing public interest. Eventually, the demand for trading / transacting cryptocurrencies might drive its facilities to approach or surpass the sophistication and throughput of the global stock markets.

Steps To Trade Cryptocurrencies:

We must first select a cryptocurrency exchange from a growing list of more than 160 companies.
Since all exchange companies exist in real world jurisdictions and comply with laws, we will have to establish our identity (for tax purposes and all that).
We have to transfer cash from the bank before the exchange’s trading systems will allow us to create orders.
Upon deposit, we use the public internet to login and type buy/sell/short/, limit/market order(s). This information is transmitted from the browser to the exchange’s order & account management system(s).
Exchange’s account management system validates the funds necessary to fulfill the order and its order matching engine begins its “magic”.
Meanwhile, another exchange user entered a similar but opposite order, in the sense that I wanted to Buy 1 bitcoin for $19,000 whereas “they” are looking to Sell 1 bitcoin for best price.
The order matching engine will match orders and update both accounts, internal to the exchange company.
At this moment, the public blockchain is not yet aware that one bitcoin has changed owners: the blockchain records still show blockchain ID of the exchange company, as the coin was transacted and assigned from the other user’s ID to the exchange, when the other user created their trading account.
Eventually, we might want to “move” our coin to another exchange where coins might be trading for a higher price. To do so, we must 1st establish a wallet / blockchain ID (address) and then request that the exchange company execute a blockchain transaction from their ID to ours.

In case of problems, we can call the cryptocurrencies exchange company and they will reject our claims or resolve them entirely: there are no other third parties involved.

Actual coin ownership for all coins in existence:

Is recorded on the blockchain only;
Ownership is associated with the public blockchain ID and is solely controlled by the private key (stored as a small file of random looking text).
Whoever is in the possession of the private key file (or a copy of this key file) can generate transfer instructions for coin balance associated with the blockchain ID.
In most cases, trading on an exchange means that “your” coin is first transferred to the exchange’s blockchain ID and that you trust the exchange to return to you your balance upon your request.

Summary For Crypto Markets

You will have to transfer cash from your bank to another company since today’s banks do not have departments / facilities for crypto trading (whereas some do support stock trading from accounts linked to your regular banking);
At least eventually, you will have to get a cryptocurrency “wallet” in order to have full control of your crypto assets;
True crypto assets ownership / point-of-truth is the blockchain and there are no third parties to help you reestablish ownership should your funds / private keys become compromised, whereas, your “stocks” can not be stolen from you or lost in the same way, since there may be records in multiple “locations” (e.g. at your broker, and at the DTCC);
Crypto markets are currently smaller and subject to fewer regulations;
Identical cryptocurrencies are traded on multiple exchanges and there are no regulations nor mechanisms in place to ensure that exchanges sync their best prices at all times: depending on your trading goals and positions, you may profit or lose on these differences in prices.

Conclusion: For Retail & Institutional Stock Traders

There are no brokers nor custodians involved in the cryptocurrencies ecosystem as the counter party risk is eliminated by computational means and proof-of-ownership is encoded in a public ledger of pseudonymous transactions aka “the blockchain”;
Some of the other services traditionally provided by brokers are instead provided by the crypto exchange companies — e.g. margin trading;
All client order management communication occurs over the public internet and access to account management pages can be degraded during peak usage or DDoS attacks;
You can trade with basic limit orders and most top exchanges also support market orders;
Currently, there are NO algo type orders/facilities such as VWAP, TWAP, TVOL (only one top exchange provides TWAP). These are traditionally provided by brokers and utilized by traders to accumulate large positions: a hedge fund buying 20+ million dollars of some stock, would instruct their broker to utilize the broker’s VWAP algo engine to build this position over the course of several hours by “slicing” the big order into many small orders;
All 15 top exchanges provide an API which can be utilized to build custom trading bots / algos. Access is over the public internet (NO colocation) and there is throttling;
At least one high-tech prop trading company is present in the marketplace: Cumberland Mining (division of DRW)
Traders in size must currently trade by hand or have to rely on OTC relationships;
Concurrent best prices can vary significantly between exchanges since arbitrage is manual and funds transfer costs are high;