10.1.2020 | Arjun Balaji
In the early 2010s, the crypto market consisted of a handful of small, retail-focused brokers. Over the last decade, the market has grown to over $15B of daily volume across spot, derivatives, and on-chain markets. Today, BTC sits among the most liquid assets in the world.
The quirkiness of crypto-assets has created a novel market: Crypto markets are open 24/7. Users all over the world can access completely fungible assets. Public blockchains allow frictionless transfer of crypto and fiat in minutes. Individuals can custody assets themselves as securely as the banks. Unlike the NYSE or Nasdaq, retail users can trade on the largest crypto exchanges directly without intermediation.
Even with these advantages, the crypto market structure is opaque and poorly understood due to global fragmentation, rapid change, and the diversity of participants.
This essay outlines the two significant evolutions in the crypto market over the last decade and articulates a vision for what the future could hold.
The prehistory of the crypto market began with p2p trading over Bitcointalk and IRC. The first real market structure began in earnest in July 2010 with the launch of Mt. Gox. Over the next five years, many early exchanges launched fiat on-ramps to service individuals.
With bitcoin’s nascency, accessing stable banking channels was a challenge, leading to the rise of stablecoins like Tether. As adoption grew, over-the-counter (OTC) desks began servicing the handful of early institutional firms. Without sophisticated market makers, liquidity was poor. Cross-border and cross-venue spreads were often measured in single-digit percentages.
The influx of new market participants in December 2017 overwhelmed exchanges daily and marked the end of an era. It’s not worth reflecting on this bygone time further; thank you to the early builders who got us here.
Since December 2017, the crypto market evolved to a 2.0 iteration, growing from a market designed for individuals to one that’s institutionally accessible. Over this time, derivatives volumes grew over 25x while bid-ask spreads fell 10x. The market matured from manual, expensive, and BTC-denominated to fully electronic, cheap, and stablecoin-denominated.
The major drivers of this shift are:
We’re in the early stages of the next structural evolution, from 2.0 to 3.0.
At maturity, the 3.0 iteration will (1) be radically more capital-efficient and (2) bridge centralized markets to emerging decentralized finance (DeFi) markets.
Crypto trading remains capital inefficient due to market fragmentation and a lack of industry-wide credit assessment.
Today, exchanges have high margin requirements, and firms cannot cross-margin, i.e., use margin posted at one broker or venue to collateralize a position elsewhere. This forces firms to fully fund nearly all their trading activity and subjects trade settlement to many block confirmations (at-minimum). Full funding is especially taxing in highly volatile environments when on-chain congestion is most significant.
As a result of these inefficiencies, the perpetual swap has become the dominant source of short-dated funding. Crypto perps: “Came for incremental capital efficiency, stayed for the 20x leverage.” Dependence on the perp market as the backbone of market funding is very sub-optimal: cascading liquidations in March 2020 resulted in over $1.6B notional liquidations on BitMEX alone, much of which should be preventable in a more capital-efficient market.
Credit creation and shortened trade lifecycles drive capital efficiency. Credit creation allows firms to get more than $1 of buying power per $1. Shorter trade lifecycles mean the same $1 can go around more times, increasing liquidity per dollar.
Some specific ways we’ll see credit creation and shorter trade lifecycles:
Decentralized finance (DeFi) first appeared in late 2017 and grew parallel to Market Structure 2.0. As DeFi continues to gain structural importance, CeFi and DeFi will converge as they see overlap in market participants, liquidity pools, and product UX.
Even in its 1.0 iteration, DeFi has already begun disrupting “CeFi.” Some examples:
Though DeFi already has deep spot trading and lending markets, DeFi hasn’t “eaten” CeFi yet. Throughput and high gas fees remain significant structural barriers. As L2 solutions come to market, DeFi presents a real threat to centralized venues as applications like Synthetix, which can replicate BTC-margined synthetic assets with UX that’s comparable to using FTX.
What does this mean for CeFi players? A few implications:
As scalability improves, on-chain financial infrastructure will begin competing with centralized infrastructure. However, the diversity of users and the importance of fiat on-ramps means centralized venues aren’t disappearing any time soon. The long-term winners are users, who can explore the spectrum of options across trust, price, risk, and UX.
The crypto market structure has gone through two significant evolutions over the first decade. Despite rapid innovation, the market is far from maturity or the scale needed to support a multi-trillion dollar market cap.
Crypto market change has always been grassroots, driven by entrepreneurs and user demand. While this has resulted in some wheel re-invention, the optimistic view is that innovation wins long-term—the crypto sandbox of today is the design of every major market in the future.
Historically, the crypto market has been opaque and poorly understood. We hope this essay provides a useful starting point for future dialogue as we build an open and efficient financial system over the coming decade.
If you are focused on Market Structure 3.0 (or 4.0+, we won’t discriminate), we’d love to explore it together. Please reach out at any stage, the earlier the better: firstname.lastname@example.org
Acknowledgements: Thanks to the builders and size traders for valuable conversations on market structure—Tiantian Kullander at Amber, Kevin Johnson at Tagomi, Kyle Davies at Three Arrows, Michael Shaulov at Fireblocks, Josh Lim at Genesis, Tarun Chitra at Gauntlet, Darshan Vaidya at X-Margin, Dave Farmer + Sam McIngvale of Coinbase—and to my partners at Paradigm, particularly Fred Ehrsam, who’s spent most of the last decade building robust crypto markets.
Disclaimer: This post is for general information purposes only. It does not constitute investment advice or a recommendation or solicitation to buy or sell any investment and should not be used in the evaluation of the merits of making any investment decision. It should not be relied upon for accounting, legal or tax advice or investment recommendations. This post reflects the current opinions of the authors and is not made on behalf of Paradigm or its affiliates and does not necessarily reflect the opinions of Paradigm, its affiliates or individuals associated with Paradigm. The opinions reflected herein are subject to change without being updated.