Originally published in AlgosForCryptos on Medium.com.

Review stock markets

Summary: Cryptos vs. Stock Markets

  • There are no brokers nor custodians involved in the cryptocurrencies ecosystem as the counterparty risk is eliminated by computational means and proof-of-ownership is encoded in a public ledger of pseudonymous transactions aka “the blockchain”. There is a strong expectation that the “crypto-custodial” services/providers will soon emerge since funds over 150M AUM are required to utilize 3rd parties to custody their assets under management.
  • Some of the other services traditionally provided by brokers are instead provided by the crypto exchange companies — e.g. margin trading.
  • In early 2018, real-time market data is provided by each crypto exchange and is free of charge.
  • All 15 top exchanges provide APIs which can be utilized to build custom trading bots / algos. API endpoints can be accessed only over the public internet (NO colocation). Many exchanges support both WebSocket and RESTful architectures. In case of RESTful access, all exchanges use throttling to prevent abuse and ensure the performance of their systems.
  • All client order management communication occurs over the public internet and access to account management pages can be degraded during peak usage or DDoS attacks.
  • You can trade with basic limit orders and most top exchanges also support market orders.
  • Currently, there are NO execution-algo type orders/facilities such as VWAP, TWAP, TVOL (only one top exchange provides TWAP). These are traditionally provided by brokers and utilized by traders to accumulate large positions: a hedge fund buying 20+ million dollars of some stock, would instruct their broker to utilize the broker’s VWAP algo engine to build this position over the course of several hours by “slicing” the big order into many small orders.
  • At least one high-tech prop trading company is present in the marketplace: Cumberland Mining (a division of DRW).
  • Traders in size must currently trade by hand or have to rely on OTC relationships.
  • Concurrent best prices can vary significantly between exchanges since arbitrage is manual and funds transfer costs are high.

Background: crypto markets

Being able to trust the ecosystem is a key requirement for any marketplace, including the stock markets and the crypto markets. In the most basic sense, both traders need be certain that their counterparty does indeed possess the “goods” (stocks or cash or bitcoin) and will deliver on their promises, once our orders have been matched with each other, by the neutral order matching engine.

In stock markets, this requirement for system-wide trust is implemented via a chain of two-party relationships:

  • My broker trusts me because I have already transferred cash to my brokerage account…
  • The exchange trusts my broker because of an earlier certification…
  • Therefore I trust my broker because they trust the exchange because the exchange trusts the other broker, who in turn trusts their client on the other side of the trade.

A much less efficient alternative to this chain would be for millions of traders to all get-together and meet each and every other trader and then to maintain millions (billions) of such direct relationship on standby should we end-up trading something with each other.

Another way to implement trust

is to make the ownership ledger publicly accessible to all parties and distribute the ledger maintenance responsibilities of this “blockchain” amongst multiple paid “volunteers”, in such a way that no one individual or group can counterfeit any portion of this public record because the maintenance methods utilize tamper-proof cryptography: voila, cryptocurrencies are born.

The entire history of all bitcoin creation and changes in ownership exists in a huge database “file” (140 GB of data in 2017) duplicated in many locations around the bitcoin mining network. The current ownership of all bitcoin units is recorded in this chain of transaction-blocks and ownership is designated with the pseudonymous ID of each current owner. Each pseudonymous ID’s balance can change only based on instructions generated & “signed” (mathematically) by its secret crypto key-holder to transfer its holdings to another pseudonymous ID. Whenever such instructions are received by the members of the ledger maintenance network, they first validate the truthfulness and then make updates to the blockchain.

Two consequences of the blockchain architecture are that the crypto trading ecosystems do not have an equivalent to stockbrokers nor the custodian services because they are not needed to provide “trust” as trust is achieved by computational means.

And because the stock exchange’s order matching engine processes only orders from its trusted brokers, the current stock exchanges are not able to trade crypto currencies along with their existing stock order flow like they could add another new stock — e.g. Spotify after their IPO.

Instead of trading cryptocurrencies on existing exchanges, we have a slew of new companies building order processing and matching engines with increasing sophistication and capabilities proportional to the growing public interest. Eventually, the demand for trading / transacting cryptocurrencies might drive its facilities to approach or surpass the sophistication and throughput of the global stock markets.

Process: steps to trade cryptos

  1. We must first select a cryptocurrency exchange from a growing list of more than 160 companies.
  2. Since all exchange companies exist in real-world jurisdictions and comply with laws, we will have to establish our identity (for tax purposes and all that).
  3. We have to transfer cash from the bank before the exchange’s trading systems will allow us to create orders.
  4. Upon deposit, we use the public internet to log in and type buy/sell/short/, limit/market order(s). This information is transmitted from the browser to the exchange’s order & account management system(s).
  5. Exchange’s account management system validates the funds necessary to fulfill the order and its order matching engine begins its “magic”.
  6. Meanwhile, another exchange user entered a similar but opposite order, in the sense that I wanted to Buy 1 bitcoin for $19,000 whereas “they” are looking to Sell 1 bitcoin for the best price.
  7. The order matching engine will match orders and update both accounts, internal to the exchange company.
  8. At this moment, the public blockchain is not yet aware that one bitcoin has changed owners: the blockchain records still show blockchain ID of the exchange company, as the coin was transacted and assigned from the other user’s ID to the exchange when the other user created their trading account.
  9. Eventually, we might want to “move” our coin to another exchange where coins might be trading for a higher price. To do so, we must 1st establish a wallet/blockchain ID (address) and then request that the exchange company execute a blockchain transaction from their ID to ours.

In case of problems, we can call the cryptocurrencies exchange company and they will reject our claims or resolve them entirely: there are no other third parties involved.

Actual ownership of all coins:

  • Is recorded on the blockchain only.
  • Ownership is associated with the public blockchain ID and is solely controlled by the private key (stored as a small file of random-looking text).
  • Whoever is in the possession of the private key file (or a copy of this key file) can generate transfer instructions for coin balance associated with the blockchain ID.
  • In most cases, trading on an exchange means that “your” coin is first transferred to the exchange’s blockchain ID and that you trust the exchange to return to you your balance upon your request.

Crypto Markets: Structure & Organization

  • You will have to transfer cash from your bank to another company since today’s banks do not have departments/facilities for crypto trading (whereas some do support stock trading from accounts linked to your regular banking).
  • At least eventually, you will have to get a cryptocurrency “wallet” in order to have full control of your crypto assets.
  • True crypto assets ownership / point-of-truth is the blockchain and there are no third parties to help you reestablish ownership should your funds / private keys become compromised, whereas, your “stocks” cannot be stolen from you or lost in the same way, since there may be records in multiple “locations” (e.g. at your broker, and at the DTCC).
  • Crypto markets are currently smaller and subject to fewer regulations.
  • Identical cryptocurrencies are traded on multiple exchanges and there are no regulations nor mechanisms in place to ensure that exchanges sync their best prices at all times: depending on your trading goals and positions, you may profit or lose on these differences in prices.

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