New players are reshaping crypto market structure, and that's bad news for exchanges

The structure of the cryptocurrency market is changing in a big way – and exchanges might come out as the losers. 

The market structure of the crypto world is drastically different from U.S. equities. In equities, traders place a trade via a broker, such as TDAmeritrade or E*Trade, who in turn either route the order to an exchange venue or high-frequency trading (HFT) shop to be executed. In the crypto market, traders have historically either engaged directly with exchanges or — for much larger trades –  have tapped into the over-the-counter trading (OTC) market.

Now, a new class of crypto trading firms is emerging: agency brokers.

Tagomi and Fidelity are perhaps the best-known of these companies, which act as middleman in-between investors looking to trade and the broader market. Fidelity's crypto arm, similarly to TDAmeritrade and Robinhood, exclusively routes its crypto order flow to market making of HFT firms. Tagomi routes approximately 30% of its client orders to market making firms. 

In equities, market makers see even more action. Robinhood isn't a member of a stock exchange and so it routes orders to high-frequency trading firms like Citadel Securities and Two Sigma. TDAmeritrade sends 100% of its non-directed orders to market making firms or UBS's dark pool. 

"I think right now there's probably better size liquidity with OTC providers than what's displayed in an [exchange order book]," Fidelity Digital Assets president Tom Jessop told The Block in a recent interview, meaning OTC desks can handle larger trades than their exchange counterparts. The firm, to be sure, is looking to start routing to an undisclosed exchange in 2020. Also, Tagomi and Fidelity still handle a small amount of volume relative to the broader market. 

"Agencies do such small volume right now," one industry insider said. "Call me when thinkorswim do crypto," he added, referring to the TDAmeritrade subsidiary. 

Breakdown of Robinhood's routing for non-directed orders for securities listed on New York Stock Exchange. 

Still, brokers routing orders to market makers is just one force that is siphoning flow away from exchanges.

Dave Weisberger, chief executive officer of CoinRoutes, told The Block that other headwinds include the cost and difficulty involved in trading on an exchange. Trading across crypto exchanges is complicated because investors and traders are required to pre-fund their accounts and, since exchanges are not connected with one another, firms have to keep a firmer grip on their asset management processes.

"Trading firms have to constantly manage their coin and fiat balances on multiple exchanges to use them, while MMs do so internally and allow clients to trade without such treasury management," Weisberger noted. 

"Exchanges in my opinion are shooting themselves in the foot by not working together on cross platform settlement," he added. 

To be clear, even if investors and brokers opt to trade via market makers, that doesn't mean exchanges will be completely out of the picture. HFT firms might still route their hedging somewhere, but that also gives such firms a lot of power. 

"It turns [Jump Trading] into a kingmaker," one trading executive noted, referring to the little-known, Chicago-based HFT firm previously covered by The Block. "They can concentrate their hedging somewhere and decide which exchange wins."

Still, B2C2 founder Max Boonen noted in a message to The Block "the holy grail of liquidity provision is to never have to hedge on an exchange."

"For most market participants, off-exchange is better for *both* small and large orders," he said .This is the reason for the continuous growth of our institutional volumes compared to the stagnation of exchange volumes."

This piece was updated to include commentary from B2C2 founder Max Boonen.