The crypto and FX markets have notable similarities: both are global and decentralized. In both cases, there is no primary exchange in each jurisdiction, with the most transactions taking place without any centralized intermediary (exception: Futures traded on CME and few other Exchanges). As a result of these structural considerations, we might expect the dynamics of the crypto market to have more similarities with FX than with traditional equities.
However, the FX market is older and more developed than crypto. Thus, it may be instructive to examine how the FX market has developed over time to get a sense of some trends we may see replicated in the crypto space.
FX – A Fragmented Market Becomes Integrated
In the early 90s the FX industry was opaque and dominated by phone based RFQs with liquidity spread over tens of thousands of banks, very limited price information and no way to electronically compare prices in real time.
There was a clear-cut differentiation between the bank dealer and client segments of the market. With only dealers having access to interbank (institutional) pricing, giving them not only an immense information advantage and by far more favorable rates than industry outsiders, bank dealers would not only take advantage of the lack of information of their clients but potentially also quote further in their advantage by anticipating whether a client was a buyer or a seller.
In the late 90s and early 2000s, a number of platforms emerged that sought to aggregate liquidity data and compare prices. Such portals — including 360T, FXall and FxConnect — enabled a client to send RFQs (Request-For-Quotes) to many venues simultaneously. This made price discovery radically more straightforward and hereby eventually paved the way for best execution by delivering proof of market prices available at the very millisecond of an actual transaction. This led to more competition between the banks, and hence to better pricing for the clients.
Think: Expedia for FX!
This technology helped to change both, the scale and composition of the global FX trading market. The chart above, sourced from the Bank of International Settlements Triennial Survey, shows the evolution of the global FX market since the late 80s, with non-dealer financial institutions accounting for a hugely increased share of the market.
After transparency and price discovery were introduced, FX trading became increasingly electronic, with participants connecting to a diverse array of trading venues using automated trading algorithms. This increased the speed of trading, provided more choice and competition, and enabled a greater variety of trading strategies to be pursued.
Crypto – A Market On The Cusp of Integration?
Similarly to the FX market in the 90s, crypto liquidity is spread over many different spot exchanges, which total over 300 globally, joined by an array of other venues such as local brokers, OTC desks, market makers and DeFi exchanges.
As a consequence, the crypto market currently lacks integration, making price discovery complex. This is reflected by studies that find large and reoccurring arbitrage spreads in digital asset prices across exchanges globally.
A key difference, however, is that the crypto market has been driven mainly by the retail sector historically, whereas the FX market is dominated by dealers and financial institutions. However, this may be beginning to change as institutions become more engaged in the crypto sector. CoinShares data, for instance, shows that yearly institutional inflows into crypto currently total US$9.3bn in 2021, compared to US$6.7bn in 2020. As institutional participation in crypto grows, studies suggest that they will play a greater role in price discovery for the entire market.
Another key difference is the pace of market innovation. While the FX market developed slowly in stages as the internet emerged and expanded creating new possibilities for digital trading, the crypto market will not have that technological limiting factor. Platforms like AlgoTrader can already offer broader visibility, better price discovery, automated trade execution and even integrated settlement. As a result, it is likely that the trends witnessed over decades in the FX market could be replicated within a few years in crypto.
With more and more institutional traders entering the crypto markets, the arbitrage opportunities (= price differences between trading venues) will over time vanish. Yet it is still expected that the market will remain highly fragmented, and no central trading hub will exist in the foreseeable future. For this reason, the inter-connectivity to a number of trading venues, ideally a mix of different types, will remain mandatory for best market access and continuity of services.