Bitcoin's recent price 'dislocations' highlight differences between the crypto and equities markets

"A total mess."

That's how Sam Bankman-Fried, CEO of crypto exchange FTX and trading firm Alameda Research, recently described the disparities in the price of bitcoin across the major market venues last month.

The phenomenon, known as price "dislocation," stems from the immaturity of crypto's market structure.

Crypto traders who were around during the heady days of 2017 may remember that one of the most glaring issues at the time was the divergence in the price of assets between various exchanges. When that would happen, it was difficult — if not impossible — for traders to have a big-picture view of what was going on across venues.

It turns out that while the situation has improved, neither problem hasn't been completely solved. Last month, as bitcoin reached all-time highs and nearly hit $20,000, the price again fluctuated widely across the venues.

Typically, the difference in the price of bitcoin across different venues stays within 1/100th of a percentage point. But when volatility spikes, this can change quickly. Having a clear view of what's happening across exchanges can mean the difference between winning and losing.

The chart below shows the spread between Bitfinex and Binance on November 28.

Looking for an edge, Alameda has examined historical dislocation events and found that they can be associated with an increase in liquidations — which occurred at a few big exchanges during the Thanksgiving holiday in the U.S. "$2 billion of selling pressure can move BTC a lot," said Bankman-Fried.

From November 19 to November 27, as bitcoin's price neared $20,000, there were a number of dislocations, according to Dave Weisberger, CEO of smart-order routing firm CoinRoutes. "It looks like there were some dislocations at the frothy part of the top of  around $100," he said.

The larger dislocations typically only last for a few minutes. It's also important to note that 2020's dislocations are much less extreme than those during the 2017 boom, when spreads between exchanges sometimes hit more than $500. The development of a more mature market-making infrastructure and an overall decline in volatility has helped tighten these spreads. 

It's "night and day" compared with 2017, one industry insider said. If you're making big enough trades, it doesn't really matter, they said.

Perhaps — but the dislocations highlight how primitive crypto's market structure still is relative to equity markets.

Trust issues

In the equities market, an established system of cooperation and trust between exchanges helps keep prices from dislocating the way they do in the crypto market.

Central clearing firms that sit behind the markets and instill trust in the system so that exchanges can trust that their peers are good for their money. Nothing like that exists for crypto today.

To offer equities trading in the U.S., trading venues are required by the Securities and Exchange Commission to either route trades to competitors or cancel them if they don't trade the so-called National Best Bid and Offer (NBBO): the lowest available ask price and the highest available bid price listed across multiple exchanges, which is calculated and distributed by two so-called Security Information Processors (SIPs).

Traders can rely on the SIPs to consolidates all bid/ask quotes into a single consumable data feed for post-trade processes. No such public feed yet exists in crypto, though CoinRoutes, Tagomi, and other service providers offer ways to access a better picture of where the price of bitcoin is trading in aggregate. 

Equities markets around the world also offer traders a cross-exchange margin, which allows traders to execute a trade on one venue based on the collateral they have on another. Crypto exchanges, on the other hand, do not let users trade coins that are deposited at other venues.

For something like that to work, "everyone needs to know that everyone is good for it," and that's not the case in today's crypto market noted one exchange executive, speaking anonymously.

The result is a limit to the degree to which a trader can buy low on one venue to sell high on another — a type of arbitrage trade that would bring prices on the two exchanges closer together. The exchanges themselves could also help quickly resolve the dislocation issue — if they wanted to, said Weisberger.

"The exchanges could route between themselves," he said. "They could offer a service where they take data such as ours and install delays when things get out of wack."

But "that will probably never happen" because those times also tend to be the highest volume periods for exchanges, he added.

Indeed, when volatility spikes, arbitrage trading fuels big profit days for exchanges. "It's a nice incentive," the exchange executive said with a hint of sarcasm.