Institutional Crypto trading shifting to off-exchange and non-custodial solution

1. From P2P to Exchange Trading

Wall Street started as a peer-to-peer (P2P) market.
Shortly after the American Revolution ended, security traders and merchants started to meet between Wall and Water Street in New York to start trading goods and securities.

In 1792 a group of 24 stockbrokers and merchants on Wall Street decided to organize themselves in a membership-only trading group, the origin of what is today the New York Stock Exchange.

The Agreement itself was short—two sentences, with two provisions (article ref

1. The brokers were to deal only with each other
2. They would charge clients commissions on their trades, at a set rate of 0.25% per transaction

A few rules agreed upon among participants for an orderly trading.

Crypto markets also started as P2P, and still to this day a lot of transactions occur from person to person without intermediaries.

Originally people were buying and selling on public forums on the internet, and through P2P exchanges, and later moved to trading using centralized exchanges.

Crypto peer-to-peer (P2P) markets offer an efficient trading method without the need for additional execution time. They provide notable advantages in terms of speed and cost, particularly in spot trading.

However, it comes at a cost of a few extra risks, namely:

• Custody Risk: assets in custody can be lost or stolen if they are not secured with the right technology. Self-custody helps here as it reduces the reliance on potentially unsafe third parties, but it has to be done right. It has to be error-free, with extremely simple UX/UI, and with ultra-secure hardware. Crypto hardware wallet manufacturers spend most of their time resolving these exact issues. Mt. Gox, one of the first centralized exchanges, stands as glaring evidence.

• Fraud Risk: when exchanging crypto for crypto or crypto for goods/assets, the issue remains that you must trust the other party to execute its part of the transaction.

• Credit/Default Risk: one party can't fulfill its part of the deal because of adverse credit conditions.

• Market Risk: ensuring the best price in P2P transactions is challenging, and often impossible without market data aggregation. Giving the best price is a regulatory requirement in many jurisdictions and it is essential to provide trust to the trading parties engaged in the exchange.

All of the risks discussed above fall under the category: of “Counterparty Risk”.

In primordial Crypto P2P markets, counterparty risks were not originally considered as a primary concern.

2. From Exchange Trading to Off-Exchange Trading

FTX has shaken the foundations of Crypto Markets, the events that unfolded in 2022 in addition to the FTX collapse have radically changed the market landscape and perception, to the point where we can separate the two periods, as pre and post-FTX collapse:

Pre-FTX: Before the FTX collapse in Nov 2022, the institutional crypto trading market was primarily focused on solutions that provided connectivity to most of the liquidity available in the market.
The goal was to reduce the speed required to reallocate capital from one exchange/liquidity source to the other.

Counterparty risk was not as relevant of a topic, and, because of the not-so-dramatic market condition, transaction fees and time to trading were not the most relevant concerns of crypto traders.

Post-FTX: FTX shocked the institutional crypto trading market. It quickly convinced most institutional traders that placing unwavering trust in third parties to safeguard crypto assets was unjustified.

The dramatic flight to safety that we witnessed in the hours and days following the FTX collapse serves as evidence of a heightened emphasis on counterparty risk.

Substantial funds were rapidly redirected towards self-custodial solutions or withdrawn from the market, as individuals opted to convert their crypto assets into fiat currency.

Self-custody functions quite well to reduce custody risk as it eliminates the need to trust a third party to hold funds. However, it poses significant challenges when funds need to be traded. Since funds in self-custody are solely controlled by individuals holding the underlying keys, the question arises:

How can these balances be exchanged or utilized as collateral for trading without transferring control to a third-party liquidity provider (exchange, OTC, market maker)?

That’s where many regulated custodians have been coming out with interesting “off-exchange” trading solutions to have funds kept in custody while trading happens at the exchange. However, the market is still fragmented and different solutions have different benefits and flows.

A single coherent middleware/technology solution to unify all the different networks available is what the market is aiming to find. That’s why we are seeing multiple collaborations across market participants.

Such a solution has the potential to mitigate counterparty risk concerning third-party liquidity providers. Also, it can bring significant improvement in trading efficiency by reducing cost and time to trade as the interconnected communication layer among trading networks is supported by the same standard framework.

However, can we do better as an industry? Can we offer a software solution where agreements among trading parties are enforced by software with rules embedded in the protocol?

Can we remove the dependency from one or many software implementations?

3. From Off-exchange trading to Non-custodial Trading

Non-custodial networks are the next frontier for the institutional crypto trading market.
The ability to combine self-custody with governance rules to enforce cryptographically enforced trading agreements between participants.

A promising technology that could see wide adoption in institutional trading is Atomic Swap. Atomic Swap allows users to create cryptographically secure escrow accounts which require both parties to post collateral and acknowledge the receipt of a secret before the transaction executes. The transaction atomically swaps balances from one self-custodian to the other, effectively reducing counterparty risk to a minimum (namely the risk of cryptographic vulnerability).

We are confident that with time similar technology can bring to market superior products in terms of security, reliability, and efficiency while making P2P trading safe, cheap, and fast.

Conclusion

While Bitcoin and similar cryptocurrencies have brought to market the concept of digital scarcity and the technology of uniquely owning something digital (e.g. money), the issue of securing the exchange of assets was never fully tackled and left to centralized players.

DeFi and DEXs have been attempting to tackle some of these challenges. but in the process, they have tried to rewrite most of the market dynamics on-chain, which is not necessarily required. Because of that, they faced significant challenges such as balancing liquidity, providing fair and efficient trading, and giving an overall secure/stable trading experience.

Self-custody has significantly minimized custody risk compared to relying on intermediaries to hold funds. The next hurdle is to introduce secure exchange and escrow technology (Hash Time Lock Contract, Smart Contracts) to the market, facilitating secure trading on a larger scale. The next challenge is to bring secure exchange and escrow technology to the market to offer secure trading at scale.

This has the potential to usher in incredible innovation in the capital market and society as a whole. It could introduce new, currently unimaginable products such as short-term (minutes, hours) insurance, peer-to-peer lending, large-scale projects funded entirely through micro-financing, pay-per-streaming on the internet, and more.

The future holds great promise for cryptographic money and contracts.

Visit enterprise.ledger.com/tradelink if you want to learn more about off-exchange crypto trading.

About the Authors

Authored by Adriano Bertini - Head of Product & Strategy Enterprise at Ledger & Sebastien Badault - VP Enterprise at Ledger