- Despite an influx of institutional capital, the cryptocurrency market remains highly fragmented and inefficient
- Cryptocurrency in its current state is reminiscent of the U.S. stock market prior to the implementation of Regulation NMS (“Reg NMS”) in 2005
- Additional investor safeguards are needed to progress in the technology adoption life cycle
Despite the fact that 2020 has likely been one of the most challenging years of our lives, the cryptocurrency market has never been stronger. Institutions, including hedge funds and publicly traded companies, have been pouring billions of dollars into Bitcoin in an effort to protect against global inflation that is almost certain to take hold over the coming years.
This institutional capital has helped propel Bitcoin to all-time highs and sent investors into a bout of euphoria. However, in order for crypto to continue its transformation into a thriving financial market that meets the needs of many different customers, changes will be needed.
Equity and Cryptocurrency Markets have Similar Objectives
In general, financial markets serve two main purposes:
- Access to Capital – Companies can issue shares in order to raise the necessary funds to finance development and growth. This is also true for cryptocurrency miners as they need to sell tokens in order to cover their operational costs as well as generate a profit. Cryptocurrency projects also have the option to raise funds through Initial Coin Offerings (ICOs) and Initial Exchange Offerings (IEOs).
- Price Discovery – Once a company becomes publicly traded, buyers and sellers come together to facilitate determination of a fair price. Investors in both equities and cryptocurrencies can turn to exchanges to access liquidity. While the equity exchanges are connected through an inter-market linkage system, cryptocurrency exchanges are not.
Today’s global financial system is extremely sophisticated in comparison to the marketplaces of many years ago, undergoing a complex evolution that worked out the inefficiencies inherent in any complex system.
For example, prior to 2005 the trading of US equities was similar to that of today’s cryptocurrencies: fragmented, inefficient, and expensive. What changed? Regulation NMS was introduced, which helped pave the way for 15+ years of massive growth and innovation.
Could Reg NMS do for Crypto what it did for Equities?
In 1975, the SEC and Congress were concerned that investors might not be getting the best price possible when they traded stock. This concern led to the passage of the Securities Acts Amendments of 1975. These Amendments allowed the SEC to establish a National Market System that would focus on increasing efficiency, price transparency, and best execution.
Over the next 30 years, the SEC would continue making enhancements and ultimately pass Reg NMS, a transformative set of rules that have taken the equity markets to heights few in the 1970s could have ever dreamed of, with roughly 10 billion shares now trading daily.
The most important rules that were implemented from Reg NMS were the “Access Rule” and the “Order Protection Rule.” Both of these rules stipulated that trading centers must give non-discriminatory access to price quotes, must not charge egregious fees and must fill orders at the best possible price.
These rules helped to promote transparency and fairness which eventually led to increased liquidity and reduced volatility.
The Access Rule had a monumental impact on equities as it demonstrated how important high quality market data is. Traders must be able to get a picture of the entire market, including the best available price, even if it’s on a different exchange. In order to determine the best price for a particular asset, traders need to have access to multiple exchanges, something which is quite difficult in crypto.
To trade on the best price, traders then need to have multiple funded exchange accounts, each accessed through a separate web browser, in order to determine where to execute a specific trade. One potential solution to this issue is executing through an entity that aggregates data across multiple exchanges, similar to how most equity traders submit their orders to an executing broker.
Order protection, or the concept of best execution, could play a major role in cryptocurrency’s growth in several ways. First, it would encourage crypto exchanges to execute trades at the best available price. Most exchanges are often motivated to maximize their own transaction fees, not to provide their clients with the best execution price.
Second, if displayed prices were reasonably protected, this would work wonders to promote transparency within the cryptocurrency markets. Additional transparency would reduce the fear that many have about potentially entering the space. Liquidity would almost certainly increase with an order protection concept or focus on best execution. It could also lead to expansion in other areas, such as the introduction of a Bitcoin ETF which the SEC has thus far declined to approve over concerns about the underlying spot market.
Another major change in equities over the past 80 years has been the continual decline in trade execution cost. In reference to the 1975 changes, Charles Schwab said, “With the sudden arrival of negotiated stock trades that were less than half the cost they had been, a major barrier to investing went away for the average American.”
Schwab also made a seismic move in 2019 to introduce commission free trades, a move that was quickly copied by other brokers. Cryptocurrency traders, on the other hand, have to deal with exchanges that charge extremely high commissions on both buying and selling, especially for smaller retail traders. Coinbase and Gemini, two extremely popular exchanges, are among the most expensive. This is one aspect that will need to improve dramatically for cryptocurrency to experience a similar growth trajectory to equities.
Regulation is often a word that elicits mixed emotions from people. On one hand, people recognize that regulation is needed to attract institutional capital which can help catapult the crypto market into the next phase of growth. On the other hand, nobody wants to see crypto lose its identity as a decentralized way of conducting financial transactions.
So, the answer as to what lies ahead is likely to be a mix of both self-regulation and government oversight, similar to how the equity market has FINRA (as the SRO) and the SEC for oversight. It’s important to note that cryptocurrency is truly a global marketplace so no single entity will be able to control it.
Innovation Occurring at Breakneck Speed but Challenges Remain
Cryptocurrency is growing at a rate that has never been experienced in human history. The smartest engineers and developers from around the world, armed with an entrepreneurial spirit and a desire for progress, have gravitated to the space in droves. It can be easy to forget that Bitcoin has only been around for 11 years. And although innovation has been occurring faster than ever before, the market is essentially brand new.
The technology adoption life cycle is a sociological model that describes adoption or acceptance of a new product or innovation. The chasm represents the hurdle that needs to be crossed in order to continue progressing towards mass adoption.
However, before that can be achieved, it’s important to recognize the challenges that crypto must overcome. A few of those challenges include:
- A global market but no single regulatory body can control it.
- Lack of uniform regulation across cryptocurrencies. Some like Bitcoin and Ethereum are not securities, while others like XRP have been deemed to be securities.
- Elevated regulatory standards for institutional investors.
- Lack of inter-market linkage or consolidated tape.
Cryptocurrency is here to stay but its usefulness and viability as a marketplace will depend on how well proponents of self-regulation and regulatory bodies can co-exist.