Brian Nibley

Institutions want to get into crypto. No one argues this point much anymore. The thing is, it’s not easy for traditional finance players to participate in blockchain-based digital asset markets.



And while regulation is often cited as the main problem holding back institutional adoption, there are other, more logistical issues that need to be addressed as well.



The most significant bottlenecks faced by TradFi traders looking to trade digital assets include:



<ul class="wp-block-list"><li>Counterparty risk</li><li>Collateral management</li><li>Balance sheet control&nbsp;</li></ul>



Today’s stock exchange process dates back at least 100 years, with things gradually becoming digitized within the last 50.



Due to the way blockchain ledger technology works, crypto trading looks a little different. Namely, crypto exchanges require traders to prefund every trade.&nbsp;



This creates an operational nightmare for trading firms because it requires them to manage spreadsheets that track trades across multiple exchanges and custodians as well as bilateral settlement with OTC desks. Many firms claim that over 40% of their staff focus on the sole task of sorting out this problem.



Why do things work this way, how does it create a problem, and what are some potential solutions?



<h3 class="wp-block-heading">The nature of the problem</h3>



Blockchain tech has led to an inherent restructuring of the clearing and settlement process.



In traditional finance, this process involves three steps: execution, clearing, and settlement. These are handled by an intermediary known as a clearing house.&nbsp;



Execution is when a broker fills an investor’s order to either purchase or sell a security. It is the broker’s responsibility in this process to fill the order at the best price possible. Once the order is filled, it enters the clearing stage. It is at this point that another party called a clearing house takes the responsibility of validating the identity of the other party and confirming that they have the asset in question. Once all necessary parties are cleared, the trade enters the settlement stage. It is here that the asset officially changes hands between the clearing house and the investor&#8217;s custodian.&nbsp;



The clearing house exists to provide a neutral party to the transaction between the exchange and custodian. And it marks the key difference between blockchain settlement. Since traditional settlement requires trust, the opposing parties use neutrality of the clearing house to represent both parties&#8217; interests fairly. It is what ultimately permits the clearing house the authority to officially transfer deeds of ownership.



But it is important to note that the clearing house does not exchange assets with the custodian on an individual basis. This would make the process exponentially more inefficient. Instead, the clearing house and custodians net transactions across their balance sheets in a way that reduces the number of individual transfers. For example, a pending transaction from the custodian to the clearing house can cancel out or net an equivalent pending transaction from the clearing house to the custodian.&nbsp;



This type of accounting permits the investor the ability to fund the trade after it is settled with the custodian. This creates capital efficiency for all parties involved &#8211; which increases the volume of total trades.&nbsp;


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<figure class="aligncenter"><img decoding="async" src="https://lh4.googleusercontent.com/sJh5LFRIQ2rnrW9gi_GNReUuJe3pLIutD5JnpvlTXiLh18AUBGxW7PDoFPhNmIyJtJUreOxAhfElE-Q9bJnIBvhM8TCfQuFfexi4hP8RmBshSUONWtWybNCPdJ-o2W7chlNHsY2jug6XzcWKoyCOZvBUKA-OCwFxSeqxggrB63vVto44iJIJp3ej2kPjLw" alt=""/></figure></div>


<h3 class="wp-block-heading">Settlement on the blockchain&nbsp;</h3>



But when trading is executed on a blockchain ledger, clearing and settlement can happen simultaneously. Parties already have their identities verified and the price and volume of a trade has been agreed upon in the form of a transaction on the ledger. But this expedited process is a double edged sword. Since there is no clearing house managing a balance sheet with regulated custodians, exchanges are forced to require prefunding for every trade. There is no T + 2 settlement time which allows a window of time for funding to occur. Blockchain-based transactions can happen on a T + 0 basis. When using a crypto exchange, “you have direct access to the market,” as <a href="https://www.youtube.com/watch?v=-cZPoqnRZq4" target="_blank" rel="noreferrer noopener">Gary Gensler</a> put it in a 2018 lecture at MIT on post trade clearing, settlement, and processing.



The requirement for institutions to adapt to this model has slowed the pace of adoption to a crawl. Instead of having transactions handled by a clearing house, the blockchain-based model makes it necessary for institutional desks to track trades between multiple exchanges using spreadsheets.



About 68% of trading firms state that inefficient funding and settlement workflows were the primary obstacles they faced when it came to scaling their business.&nbsp;



What can be done to mitigate this monumental roadblock?



<h3 class="wp-block-heading">The solution</h3>



Fortunately, the team at Apifiny has been working on ways to solve this problem.



With the Apifiny platform, users create a single account with a single set of onboarding and APIs. The platform is connected to over 20 exchanges, allowing users to manage all of their trades in one place. Fund transfers can also be managed from the main account to an external exchange, or between different exchanges, all from Apifiny.



This solution addresses the capital efficiency obstacles from a different angle. Instead of instituting a trusted third party for netting, it makes direct access to the market more approachable.&nbsp;



Apifiny clients can transfer between their sub-accounts without having to maintain reserves on multiple platforms. This flexibility makes the operational bottlenecks less inconvenient and opens the door to greater institutional interest. The platform also supports secured transfers via Fireblocks and instant transfers on select exchanges.



While these technological innovations make the funding cycle more streamlined, Apifiny is also working on developing solutions to address the systemic challenges. They believe that a regulated clearing system can be instituted in a way that leverages the efficiency of blockchain technology without forcing custodians and exchanges into bilateral settlement with OTC desks and market makers.&nbsp; Haohan Xu, founder and CEO of Apifiny said,



“We’re focused on building the infrastructure for professional traders or institutions to access the complete route to the market in the most seamless way possible.”



A comparison between the current fragmented market illustrates their approach.&nbsp;


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<figure class="aligncenter"><img decoding="async" src="https://lh4.googleusercontent.com/EUm8nlaI30VZ7QtFnwDvR4QlxZOQI2VdKrS2BNhWvOp-bwbEDNCmaT-Me4T0MyQg-3W0YJ-ZmLe0GUT4pZcBNws8XpxVq5UXF0uC1WeWM00QVdCGfNOy1Y4_t-sW9mKigUlDXD9LXNHPuaaVA56IHYKeaVz-1ijr_aAVZ0CR7nDEDQJ7OhBYrLrMekXIVg" alt=""/></figure></div>


Haohan Xu went on to add, “So, our end goal here is using strong infrastructure as a method to consolidate and glue together a complete crypto market so that traders can have one-stop access from price discovery and liquidity; cross-trading venue fund rebalancing and management; to post-trade reporting and analysis.”



This content is sponsored by <a href="https://www.apifiny.com" target="_blank" rel="noreferrer noopener">Apifiny</a>.



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Understanding the Biggest Institutional Adoption Bottleneck: Poor Settlement

<div id="highlights-block_631f4cbd9e227" class="highlights">
 <ul>
 <li>If global bitcoin market fragmentation were to remain unaddressed, it could hold back the market’s maturity</li>
 <li>If crypto markets were regulated like commodities markets, there would likely be capital reserve requirements that prevent lending institutions like Celsius from over leveraging customer deposits</li>
 </ul>
 
</div>



As of July 2022, there are 498 crypto exchanges. No two exchanges have the exact same price quote for bitcoin at any given time.



This creates problems for institutional investors, liquidity, and bitcoin’s fungibility, as well as its future.



For insight into bitcoin’s market fragmentation, what it means, and potential solutions, we spoke with the team at <a href="http://apifiny.com/?utm_source=blog&amp;utm_campaign=das_nyc_2022&amp;utm_medium=sponsored_content" target="_blank" rel="noreferrer noopener">Apifiny</a>.



<h3 class="wp-block-heading">Bitcoin market fragmentation&nbsp;</h3>



In traditional markets, asset trading takes place within a regulated framework established by some kind of financial authority. In crypto markets, exchanges use bids and asks in an order book to determine their own price.



Because these exchanges lack a central regulatory body, there lacks a hierarchy of pricing authority.&nbsp; There is no singular metric that anyone can point to and say “this is the price of bitcoin right now.” The closest alternative is an aggregate price indicator that averages prices across some exchanges.



We spoke to Haohan Xu, founder and CEO of Apifiny, for more on bitcoin market fragmentation.



Haohan began by defining fragmentation as “the disconnected and scattered marketplaces in crypto.” He went on to note that crypto exchanges are regional and tend to “dominate their respective markets with respective fiat currencies.” In such markets, prices tend to conform to their regional supply and demand, or as Haohan put it: “…This creates many isolated liquidity pools for Bitcoin. Each exchange essentially is their own marketplace, and participants in each marketplace are only trading amongst themselves and have a very hard time utilizing liquidity from another exchange.”



This kind of market structure prevents many institutional investors and professional traders from getting the best price for and desired liquidity of Bitcoin and other cryptocurrencies at any given time. One solution is to use <a href="http://apifiny.com/how-apifiny-smart-order-routing-works?utm_source=blog&amp;utm_campaign=das_nyc_2022&amp;utm_medium=sponsored_content" target="_blank" rel="noreferrer noopener">smart order routing</a> to find the best price. Apifiny includes this tool in one of their service offerings, <a href="http://apifiny.com/apifiny-connect?utm_source=blog&amp;utm_campaign=das_nyc_2022&amp;utm_medium=sponsored_content" target="_blank" rel="noreferrer noopener">Apifiny Connect</a>, but is working toward comprehensive solutions to fragmentation.



<h3 class="wp-block-heading">The state of bitcoin fungibility</h3>



Fiat currencies are fungible. The value of a dollar is the same in California, New York and across the globe.



Bitcoin market fragmentation, on the other hand, makes it less fungible. The price varies from exchange to exchange. And because the number of exchanges is rapidly changing across the globe, the price of bitcoin also varies from region to region. This lack of fungibility can create issues for those working with large amounts of capital, as Haohan described:



“If you&#8217;re trying to buy a large order of Bitcoin at one time, let&#8217;s say 10 Bitcoin. A single exchange does not have enough liquidity to execute that trade with minimal price slippage. So, you want to try to execute that across multiple exchanges at the same time, but a couple years ago there just wasn&#8217;t any infrastructure to do that.”



<h3 class="wp-block-heading">Liquidity challenges</h3>



In 2022, a crypto liquidity crunch caused cascading consequences throughout markets. The current bear market or “crypto winter” has been marked by many exchanges and borrowing/lending platforms suspending withdrawals and filing for bankruptcy.



Crypto companies like Celsius Network, Three Arrows Capital, Voyager Digital, CoinFLEX, BlockFi, Bancor, Babel Finance and Vauld were all affected in one way or another. And as a result, they were forced to liquidate any assets they could to pay off debts. Fragmented markets exacerbate this type of sell pressure because they make it difficult to move liquidity where it is needed most.&nbsp;&nbsp;&nbsp;&nbsp;



For example, massive sell pressure from a liquidation event can cause dramatic price slippage on illiquid exchanges — meaning the large market order pushes down the price it is sold at. As a result, a single trade can produce a major price imbalance between exchanges. Arbitrage traders may be able to fill in the gap, but this tends to exaggerate losses as it incites more fear and perpetuates the liquidity crisis.



If crypto markets were regulated like commodities markets, there would likely be capital reserve requirements that prevent lending institutions like Celsius from over leveraging customer deposits. But this would not solve the price fragmentation problem. Bitcoin price discrepancy is a consistent reality, regardless of liquidity crises.&nbsp;



In 2021, Taylor and Francis Online published a <a href="https://www.tandfonline.com/doi/full/10.1080/1350486X.2022.2080083" target="_blank" rel="noreferrer noopener">report</a> from Jakob Albers highlighting the persistence of bitcoin market fragmentation. Order book data they gathered across a sample of exchanges indicated that exchanges with higher volume and liquidity consistently lead the smaller exchanges in price movement. This demonstrates that price fragmentation is a consequence of liquidity fragmentation.&nbsp;



<h3 class="wp-block-heading">The future of bitcoin&nbsp;</h3>



If global Bitcoin market fragmentation were to remain unaddressed, it could hold back the market’s maturity. Typically, as assets evolve, they gain liquidity and become more regulated, which helps to reduce volatility. According to Haohan, continued fragmentation could mean Bitcoin remaining volatile for the time being:



“All the smaller exchanges, when there&#8217;s less liquidity, will lose lots of bids and asks being thrown around and during volatile times, prices can change a lot. So, over the years, if the issue of fragmentation doesn&#8217;t get addressed, Bitcoin will continue to be a very volatile asset.”



How can this be addressed? The answer could involve a mix of both regulation and innovation. The two rely on each other to some degree. As Haohan put it, “regulation can’t solve any of this without the proper tools and obviously, innovators are the ones that bring the tools. But innovation needs regulation and so regulators…might say ‘I want to regulate crypto in a certain way’, but if the tools to do that simply don’t exist, there’s not much they can do.”



It all comes down to addressing liquidity fragmentation by uniting the settlement systems of different exchanges. Haohan explains: “the fragmentation actually exists in the clearing settlement layer, not in the markets layer. So, let&#8217;s say you unite the wallet systems or the clearing settlement systems of Coinbase or Gemini, then that trader can use their funds to trade on both Coinbase and Gemini and there wouldn&#8217;t be so much of a price discrepancy issue, because they&#8217;re all in the same ecosystem.”



<figure class="wp-block-image"><img decoding="async" src="https://lh5.googleusercontent.com/R7bMaW0MAOPU2_yE4nnKRVWEmr0yDHDvv90YWjbcr7-E0GSk5lejhgkLY3IfZd2dd8pQ4i6je6pv-eA13SocMxM7PIARBOPEd6la4B9RpL-xZYYm7fDXT9l4xUS2BPUTAlcg46yYie8iHKLZqH4olcqO55IYbrmk6h3R5ALUAgh7utkBdl2JGiQ2uQ" alt=""/></figure>



We asked Haohan what Apifiny is doing to solve these issues. He replied: “We&#8217;re focused on building the infrastructure for professional traders or institutions to access the complete route to the market in the most seamless way possible. So, our end goal here is using strong infrastructure as a method to consolidate and glue together a complete crypto market so that traders can have one-stop access from price discovery and liquidity; cross-trading venue fund rebalancing and management; to post-trade reporting and analysis.”



Apifiny has been working hard to address one of the biggest challenges for the crypto market. It requires a delicate synergy between innovation and regulation. But once the two reach a clear and ubiquitous solution, they have the potential to unlock a massive wave of adoption. Solving market fragmentation will lead to price stability and real world utility. Companies will be more willing to use it to conduct business, financial advisors will feel more inclined to recommend digital assets to clients, and consumers will be attracted to its ease of use and store of value.



This content is sponsored by <a href="http://apifiny.com/?utm_source=blog&amp;utm_campaign=das_nyc_2022&amp;utm_medium=sponsored_content" target="_blank" rel="noreferrer noopener">Apifiny</a>.



<hr class="wp-block-separator has-alpha-channel-opacity"/>



Start your day with top crypto insights from David Canellis and Katherine Ross. <a href="https://blockworks.co/newsletter/empire">Subscribe to the Empire newsletter</a>.



Explore the growing intersection between crypto, macroeconomics, policy and finance with Ben Strack, Casey Wagner and Felix Jauvin. <a href="https://blockworks.co/newsletter/onthemargin">Subscribe to the Forward Guidance newsletter</a>.



Get alpha directly in your inbox with the <a href="https://blockworks.co/newsletter/research">0xResearch newsletter</a> — market highlights, charts, degen trade ideas, governance updates, and more.



The Lightspeed newsletter is all things Solana, in your inbox, every day. <a href="https://blockworks.co/newsletter/lightspeed">Subscribe to daily Solana news</a> from Jack Kubinec and Jeff Albus.