I have recently begun hungrily devouring all the knowledge I can around cryptocurrency trading as not a day goes by without it being discussed somewhere. It really seems to be the Wild West at the moment with seemingly hundreds of cypto exchanges popping up everywhere, all with the ‘nirvana’ of offerings.
Now as I started my working life designing the first automated trading platform (Called APT) for LIFFE as a PA Consulting group consultant and then went on to head IT at the International Petroleum Exchange, I do know a bit about how large-scale exchanges work. The difference between the new crypto exchanges and existing exchanges (also known as RIEs, or Recognised Investment Exchanges) is vast.
Mind The Gap!
The new exchanges don’t, in fact, look like exchanges at all, but more like a retail platform with payment, CRM, and affiliate marketing bolted together. The RIEs have some knowledge of crypto trading but little about retail trading. The second big area of confusion is between margin trading and physical trading. In the retail FX world that I live in, never the twain shall meet as they serve very different masters. But in the crypto world there is no distinction (yet) and this causes massive confusion.
Just imagine the difference between exchanging GBP for USD to go on holiday to punting in the GBP/USD market with a leverage of 1:100, and trying to use the physical exchange to punt on! It doesn’t bear thinking about, but that is just what is happening in the crypto world. So we need to develop the idea of a real margin crypto market with some leverage (probably very small due to the high volatility) with an aggregated executable price feed across multiple crypto exchanges to give the best option for price discovery and trading.
This all cries out for the introduction of a derivatives market for cryptos, such as the CFDs we have as a proxy for equities in the stock exchanges. CFDs allow people to trade on the price move without ever having the bother of owning the actual stock. Brokers will often hedge CFDs against real stocks in the market, in order to manage their risk.
Time goes by, so slowly…
I am sure that many people assume that as cryptos are so new, that they must operate at light-speed with instant settlement and no risk, but unfortunately this is not the case. Bitcoin, for example, uses the public blockchain to record all transactions.
Transactions can be recorded quickly but are not validated as legitimate until a consensus of miners has run their proof of work. As the public blockchain is growing all the time and there is a maximum data rate allowable, this validation can take from 10 minutes to a couple of hours.
The question has to be asked – “What happens if validation fails, and how does the trade unwind?” The answers I have had to this vary from ‘no Idea’, ‘it doesn’t matter’, to ‘the exchange, acting as a broker, owns this and will stand by the trade’. This is analogous to a futures trade that is cleared by a clearing house. The bilateral traders are counterparties to the trade until it is ‘novated’ to the clearing house, and therefore carry counterparty risk.
It’s a Mad Mad World
Full depth pricing in Bitcoin can be a scary place to be, as liquidity is so fragmented, and volatility is so high. It can be difficult to know the real price of a Bitcoin all the time. This brings in an interesting idea that the Chicago Mercantile Exchange (CME) brought to market fairly recently to solve this issue; the CME Bitcoin Real Time Index.
CME take 6 or so crypto exchange Bitcoin prices and build a reference price in real time, discarding prices that fall too far out of line. This can then be used by anyone as the current real price of Bitcoin. It is currently free to use, but that may change over time as exchanges do like to charge for data and it is a significant revenue stream for them.
Which Coin will be NEO (The One)?
Whilst most of the focus is on Bitcoin and its public blockchain, there are many other cryptocurrencies trading happily away today, with Ethereum, Ripple and Litecoin being next in line to the throne.Ethereum, for example, is taking a novel approach to the slow validation issue by introducing proof of stake rather than proof of work. Look here to understand this very complex idea! It aims to achieve consensus and validation much more quickly than can be achieved with proof of work, but time will tell if it is accepted.
Ultimately all cryptocurrency trading will take place on exchanges, but will this be existing RIEs like CME that adapt to the new world or the current crypto exchanges that will have to grow up to meet the stringent demands regulators will place on them? Due to their scale I think the RIEs have a good chance of winning, but they need to move mindset from where they are now to a more flexible, cheaper, and directly connected place. Equally, the new exchanges have no legacy systems and are quick to move so can build the necessary functions very quickly. Time will tell I guess. Whilst we are definitely still in the hype phase, cryptocurrencies are here for good and will be part of our future, there is no doubt about that.