Market Mechanics – Part 3, Types of exchanges

Part of a 6-part series on market mechanics:

  1. Introduction
  2. Functions of an exchange
    1. Custody
    2. Settlement
    3. Tax reporting
    4. Matching
    5. Market data
  3. Types of exchanges
    1. Order book
    2. Over-the-counter (OTC)
    3. Derivatives
  4. How order books work
    1. Mechanics
    2. Types of orders
      1. Market
      2. Limit
      3. Stop
    3. Matching
  5. What’s in a price?
  6. Market pitfalls
    1. Slippage
    2. Market cap
    3. Hidden supply
    4. Flash crash

Order book

Order book exchanges are the most common – if you are reading this series and learning anything new from it, you will probably be trading on an order book. All of the Big-10 exchanges are based on order books, as are the other 80 or so that may appear on some market data sites, and foreign regional exchanges like Bithumb in Korea or Golix in Zimbabwe. If you’ve gotten recommendations for Coinbase Pro, Binance, Bitstamp, Gemini, etc, these are all order book exchanges.

Order books are essentially ledgers of who is willing to buy or sell cryptocurrencies. The general public can place orders; whenever someone is willing to buy at a price higher than someone else is willing to sell at, they are matched up and a trade occurs. The trade happens automatically, via matching algorithm, and then settlement and all the other functions of an exchange also happen automatically. A single order might be matched up against multiple other people and split so that you get the best price available in the market.

A snapshot of the Coinbase Pro order book

The rest of this blog series will focus on order book exchanges, because they are the most common, the most interesting for daily trading, and usually offer the best prices and liquidity.

Over-the-counter

An over-the-counter (OTC) exchange also matches up buyers and sellers, but unlike order books:

  • Bids are not (always) public.
  • You’re matched against one specific other person; orders are not split up. You can choose to trade with multiple people, but must handle all of those interactions yourself.
  • You’re responsible for settling the trade yourself – you must manually send the Bitcoin or other cryptocurrency to the buyer using your wallet software of choice. OTC exchanges handle only the matching function of exchanges, not custody, settlement, tax reporting, or market data.

An OTC exchange could be as simple as a chat room, Telegram group, or message board where you post a message saying “Hi, I’m looking to buy Bitcoin. Is anyone selling?” and then sellers private message you with their offers. There are also specific OTC websites like Whaleclub that cater to specific types of traders.

A Dubai-based OTC exchange based on spreadsheets and Telegram

OTC exchanges are frequently used by institutional investors or wealthy early Bitcoin adopters (“whales”) to conduct transactions worth several million dollars. They have a few benefits over order books in this situation:

  • Privacy. Most wealthy cryptocurrency holders do not store the bulk of their wealth on the exchange, because they’d need to trust the exchange to hold millions of dollars worth. If they wanted to trade on an order-book exchange, they need to first transfer their coins to the exchange, and then actually place the order. But many traders watch the addresses associated with exchanges and wealthy individuals, and will trade ahead of them (getting a better price) if they see large movements of funds. With an OTC desk, no transactions occur on-chain until a price has been agreed upon and the trade has been made.
  • Liquidity. As you’ll read later, the price that you get on an order-book exchange is not always the price at the start of a transaction, and for multi-million-dollar transactions, the difference can be appreciable. Since OTC trades have only a single counterparty, you agree on a single price for the transaction beforehand, and are guaranteed to get that price.

One exception to the “OTC exchanges are for rich people” rule of thumb are message boards like LocalBitcoins. These service ordinary people, often transacting small amounts, yet still function like an OTC desk. In many regions these are the only option for buying cryptocurrency, but if order-book exchanges are available in your jurisdiction, the latter usually offer better prices and liquidity.

LocalBitcoins listings

Derivatives

Derivative exchanges don’t actually trade cryptocurrencies. Rather, they’re effectively ways to bet on the price of cryptocurrency. You deposit some funds (usually Bitcoin) into them as collateral, and then can open positions that expose you to risk (if the market moves against your position) or gain (if it moves with you). Once you close out all your positions, you can withdraw your original collateral, along with any gains that you’ve made through prudent trades. When you make a trade on a derivative platform, you aren’t actually buying or selling the underlying cryptocurrency. Rather, you’re buying and selling a contract to win or lose a certain amount of money based on the value of that cryptocurrency in the future.

BitMEX derivative purchase screen

The most common positions are longs (margin buys) and shorts (margin sells). In traditional stock trading, these aren’t technically derivatives, because you are actually buying and selling the security, just doing so by borrowing it. A margin buy is when you borrow money from the brokerage to buy a stock, sell it, and then pay the brokerage back with money from the sale. A short is when you borrow the stock from the brokerage, sell it (without actually owning it), and then buy it back at a later time and repay the brokerage with those shares. Most cryptocurrency blockchains don’t have a way to express borrowing, so when you do margin trades on a cryptocurrency exchange, the exchange just nets out the value of the currency they loaned you, without performing any transactions on the blockchain.

The effect of margin trading is to multiply your returns at the expense of multiplying your risk. If you have a long position with 20x leverage and the coin goes up by 5%, you double your money. However, if you have a 20x long and the coin goes down by 5%, you lose everything: you get liquidated, the exchange seizes your collateral and closes out your position, and you can’t trade any more unless you put in more collateral. Shorts work the same way, but in the opposite direction: if you have a 1x short and coin goes down by 50%, you double your money. If you have a 20x short and the coin goes down by 5%, you double your money.

There are also other forms of derivatives like puts and calls, which give you the right (but not the obligation) to sell or buy (respectively) a coin. Valuing these options can get fairly complicated, and is usually the domain of professional investors.

Derivatives exchanges are for people with very high risk tolerances and enough money that they don’t particularly care if they lose some. It’s possible to lose everything very quickly in pursuit of large gains. Be careful.


Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s