Cryptocurrencies: Exploiting Market Inefficiencies to Make It Big

ICOBox’s Dima Zaitsev breaks down how new breeds of exchanges are changing trading.

In the 1990s, John Levine, a young fintech programmer, released his Electronic Communication Network (ECN) "Island." At the time, nobody knew NASDAQ and the largest securities brokers in the world would follow suit, and nobody, including the most sophisticated financial institutions in the world, foresaw the impact it has today. Now, whenever you log into major exchanges like Fidelity or Robinhood, your orders route through something similar to, if not exactly, what Levine created.

Levine unintentionally developed a purely decentralized market. His ideology attracted the attention of hungry market makers and middle men, who quickly turned it much more centralized. The novel profit-making methods were so badly needed that everyone wanted a piece of the game. But this genius structure was also flawed, posing several questions: What happens when both the market and the traded asset are decentralized? How can companies stay afloat if they can't make a profit? For the first time in decades, institutional money hit a roadblock.

With Levine's new technology and the ever-growing user base, financiers realized they couldn’t rely on outdated money-making mechanisms. And here, available to them online, was a more cost-effective trading tool. It prompted the emergence of the recent zero-fee approach, which largely relies on poor investor awareness. The hottest market players started adding complex algorithms to take fees off of perceived low-priced trades. The ideology was clear: those with better grasp of the technology will turn more profit. Instead of being vulnerable to market uncertainty take advantage of market inefficiencies!

Dima Zaitsev, economics Ph.D. and Head of International PR at ICOBox explains, “Let’s take a quick look at market making as a whole. One of its most competitive areas is commissions and trading fees, so those offering lowest or zero fees would attract the most retail investors. Many exchanges offer this zero-fee model, but in reality it is misleading as trades aren’t actually free. If primary concerns are speed and price, this "free" model is actually quite the opposite – something quite far from transparent, almost scandalously so. A more natural market growth calls for better models.”

“Traditionally, most profits are made through wider spreads in exchange for reduced fees. Low or no-fee trading is offered at the cost of wider spreads. While theoretically retail investors are not charged any commission or fees, the spreads on these trades are often inflated, with a premium added to the spread. This exact mechanism is not always used, but this illustrates the means used in cryptocurrency trading that are not available in traditional markets.”

Zaitsev elaborated by laying out two different exchange models.

Model 1: Wider Spreads/Lower fees

“Spread inflation is not uncommon, but cryptocurrency makes it easier. Traditionally there's your typical bid/ask prices accommodated by commissions. But in crypto, the spreads are inflated by smaller cents, and the premium's pocketed. This has initiated a larger debate over whether exchanges damage the blockchain's "no middleman" philosophy. Looking at liquidity and availability of an asset in the market, most retail investors don't differentiate well between dozens and dozens of exchanges – an important point if we want to ensure the integrity in the cryptocurrency market. Inadequate regulatory oversight, coupled with external order routing, further exacerbates the situation.”

“Lack of legal protection can make a market newbie wary, and routing orders externally is simply impossible in traditional markets with their clear structure and established mechanisms. But cryptocurrencies are a different story. An exchange can route orders through another exchange in a different jurisdiction, which allows the inflation spread. What's illegal in one jurisdiction may be perfectly kosher in another. Profits can then be split legally – a no-go in a zero-sum market, as this stacks the odds against the retail investor.”

Model 2: High Frequency Trading (HFT) Firm Partnerships

“Mastering the HFT firms' trading strategies can take years, but what's important is that they basically practice really fast and intricate trading – milliseconds, not minutes. HFT firms hate risk and love cryptocurrencies because they are entirely digitized, with everything, unlike in traditional markets, done virtually. A model that effectively eliminates risks ins the day. And the digital cryptocurrencies fit the bill precisely: they wipe out risks in high frequency trading, bringing higher and faster returns.”

“Let's look again at the free stock and crypto exchange Robinhood. Its founders originally took their working product to 75 VC firms, all of whom laughed at them. Many market players were certain the newcomer won't survive – how can a free trading platform make a profit? Their Q3 SEC report explained: Robinhood rerouted retail investors' orders to HFT firms, who instantly scalped cents off prior to execution. Most retail investors use Robinhood simply because it’s faster and easier. HFT firms place orders nearly instantly before retail investors' orders are executed, shaving off cents from each retail order. Small players don’t get the exact price but rather join a market order, essentially agreeing to the market price. And virtually unregulated cryptocurrency allows to scale this model way up. While definitely genius in principle, this model needs to be used judiciously not to disrupt the marketplace: some economists argue that the constant selling of crypto for fiat puts serious downward pressure on crypto prices.”

The unexplored territory of digital markets allows for large speculation – that's why they've been branded the "Wild West." Many use these inefficiencies to turn huge profits. But ultimately one can't help but wonder if the end costs to the markets' health may not be too high.

Experts like Zaitsev and his team at ICOBox are helping businesses navigate the ever changing world of finance and fundraising by developing market savvy practices that tap into the latest trends and inefficiencies. Knowledge is power, and being able to effectively identify and leverage the latest strategies is key to positioning any enterprise at the forefront of progress.

Reading now