Current decentralized/centralized exchanges are great for the average crypto trader. It allows individuals to purchase crypto with minimal entry barriers. However, it may not be the best option when investors are looking to execute a sizable trade.
Fragmented exchanges with low trading volumes compared to traditional markets cause liquidity and slippage issues. The introduction of brokerages can address such concerns in order to achieve a more efficient ecosystem within crypto.
The Basics of Slippage and Liquidity
Slippage occurs because your market order has exhausted the liquidity at a specific price point and the order execution engines of the exchanges fill out your remaining order with whatever liquidity is available.
For example, a trader wants to buy a set amount of tokens, but price differs when they place an order on the exchange. That change has different implications due to their position to buy or sell. The results can lead to better than expected or worse than expected prices as slippage does not refer to a positive or negative movement.
Periods of volatility, large orders, and market orders can all lead to slippage. One quick fix to slippage would be to create a limit order rather than a market order. However, this brings us to the next issue with the current crypto environment – liquidity.
Liquidity is the concept of how a particular token can be bought or sold without affecting the general stability of the token. Cash is considered to be the most liquid asset as it can be easily accessed and spent. Within crypto, liquidity can be measured by the ability of a token be easily converted into cash or other tokens. With thousands of cryptocurrencies available on exchanges, attracting investors and traders can be difficult.
Adding additional trading pairs and exchange listings can improve liquidity. Also, crypto-to-crypto exchanges have better liquidity compared to fiat accepting exchange which goes through a tighter verification process. A low liquidity environment causes volatility and spikes in the prices of cryptocurrency. Good liquidity often leads to stability and a better representation of the token price.
Why Brokerages Can Minimize Such Problems
If I am an ordinary equity investor, I will have to go through an online brokerage that is registered with a regulator within a specified jurisdiction in order to buy/sell equity shares in a stock exchange. Unique from traditional stock exchanges, crypto exchanges remove such barriers by allowing investors to directly purchase their desired token on the exchanges.
This raises the question for the necessity of brokerages in the crypto ecosystem. Full-service brokerage may make sense due to the additional services and face to face interactions offered to clients, but what about investors who are seeking a platform purely for execution?
One option would be to make several smaller transactions across different exchanges over a certain period of time. Alternatively, investors can go through a brokerage which offers both exchanges and OTC platforms as trading options.
I believe brokerage platforms can help such issues by providing the following services:
- Smart order routing – With smart order routing, bots can effectively identify the best prices and orders from multiple exchanges and sources to provide the best execution from a user standpoint. This allows users to view exchanges as a single pool of liquidity.
- Wholesale rates – Most platforms provide incentives for users who trade frequently with exchanges. Instead of having to build up this relationship as an individual, one can piggyback off a brokerage service and enjoy more competitive fees. Due to the strong relationships between brokerages and exchanges, brokerage clients can benefit from the attractive trading/withdrawal rates offered by exchanges.
- Block order execution – Brokers identify sellers and buyers who hold large amounts of crypto asset and pair them for the sale through their vast network. This benefits the client by having access to the best quote in real-time without having to worry about slippage and liquidity issues.
Exchanges may set the price of crypto assets but large trades usually do not occur from one account. Unlike trading equity investment, finding a crypto broker with market visibility and access ensure investors the best execution for trades of any size, regardless of marketing conditions. Opportunities to improve the way we do banking is one of the most exciting and disruptive parts of blockchain technology.
Update – The definition of “slippage” was updated.
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