The cryptocurrency market is a delicate one, and a little splash can make huge waves that impact investors and projects across the world. Take the recent news that Mt Gox may be tanking the market by selling off large chunks of Bitcoin. Moreso than the traditional market, the cryptocurrency market is easily spooked, and that’s because there’s not as much money in it as you might think!

 

It’s currently valued at $275 billion – wow! That’s a lot of money. So people have actually spent $275 billion on cryptocurrency already?!

 

Afraid not! Not yet, at least. Only a fraction of that is required to create the market cap we see before us – a JP Morgan analyst believes that the specific amount invested to create the $300 billion+ market we saw recently was only $6 billion. Here’s how that works – let’s say there are 10 Bitcoins, and they’re each worth a dollar (tempting, I know!). The total market cap of Bitcoin is then $10.

If I buy a Bitcoin for $1, the market cap stays at the same price.  But let’s say you want my Bitcoin so badly that you’ll pay $1.10, so I sell it to you – suddenly not only is that Bitcoin worth $1.10, they all are. The new market cap is decided by the last sale, so while you’ve only invested an extra $0.10 into the market, you’ve raised the market cap by ten times that amount.

So you can see the problem – the value of one token changes the value of all units of currency, making it really difficult to exchange large amounts without making the market, you know…

That’s where OTC markets come in.

OTC Trading

OTC stands for “over the counter”, and it’s a way for the super-wealthy to buy and sell Bitcoin and other assets or cryptocurrencies without seriously inflating or deflating the price, maximizing their trading power. A regular exchange simply can’t handle the purchase of several million dollars worth of Bitcoin in one go. As the order is being fulfilled, suddenly the price is going up accordingly, and you’ll end up with a fraction of the Bitcoin you aimed to buy or paying A LOT more than you’d expect. Traders call this “slippage”.

More money more problems, eh?

To get around this, people with that kind of trading power operate outside of exchanges altogether and engage in what are known as OTC trades. They’ll simply reach out to a network of traders and investors and put the word out that they’re looking to buy. They’ll get in touch with someone who has what they need, or often several different someones, and in exchange for a markup on the market value they’ll fulfill their large order without tripling the price of what they’re trying to buy.

Typically the people who provide OTC trades to needy whales are hedge funds or other wealth managers, as well as people who are simply reeeally rich and own a lot of crypto.

How does this affect me?

Assuming that you’re not in the 1% of the world’s super elite population (if you are, no offense intended and please PM me for my tip address), OTC markets can still affect you and the crypto market as a whole. Not a lot is known about OTC trading volume, because the details are usually pretty hush hush (although one OTC market site, Genesis, has a minimum OTC value of $75,000, which indicates the kind of trading we’re dealing with here).

And, well, that’s kind of the issue! Because there’s no way of monitoring the value, there’s no telling how much Bitcoin is actually being traded. The market value isn’t really the market value, because for every $1000 that some new investor is putting in, $1,000,000 might have just been sold, or bought. The exchanges only tell part of the story, and because OTCs are for whale trades only, we’re missing a really big piece of the puzzle.

That makes it even more difficult to place an actual value on Bitcoin, and the market as a whole, which in turn leads to more volatility.

OTC Markets Can Cause Bubbles

I mean, I’m using the word market loosely here. Think of it more as a network of loosely affiliated brokers and dealers. They interact through OTC sites like Genesis, but also over the phone, over Telegram, even in person. There are no rules, not really, and the dealers hold all the cards.

Let me put it this way – ever seen the movie The Big Short?

Apart from it being fun to watch Christian Bale as a one-eyed aspergic millionaire in charge of a hedge fund, the movie did a good job of explaining how OTC trading was one of the main causes of the housing crisis/economic collapse in 2007. There was a market for ensuring mortgages, but behind the scenes investors and traders were essentially betting on whether the mortgages would be paid off, and people were betting on their bets as well, a market over 20 times more valuable than the mortgages themselves.

Here’s a clip from the movie breaking down how that worked.

 

In OTC markets there’s the customer market and the interdealer market – when dealers are looking to sell their commodity, they’ll go on a dealer run, figuring out the demand and setting prices (whatever price they like, and maybe different prices for different customers). However, there’s also the interdealer market – dealers can find themselves overexposed on a certain position (for example, maybe they’re offering 5 – 1 odds that Bitcoin will go up, and if it does they’ll lose five times what they stand to win). To offset this they can have other dealers get in on their action, meaning the dealers are taking bets from customers and also betting amongst themselves on the results to hedge their losses.

While one person losing a bet won’t affect the market much, OTC trading can result in a huge interconnected web of people who will all be effected by the loss of one person, and even within that network it can be very difficult to figure out how many people are involved or what the total risk is. Because the trades are hidden, OTC trading can cause the true value of a commodity to be grossly overestimated (or underestimated, potentially), leading to bubbles, collapses, and other catastrophic market failures that none of us probably want to think about right now.

As Vinny Lingham said:

Scary! Bitcoin is basically not yet liquid enough to handle large trades, meaning OTC trading is the only viable way for real whales to do business. As adoption continues, so too will the liquidity increase.

Big whales make big waves, and they do it out of sight, but hopefully the level of OTC trading will decrease as liquidity rises – the market is crazy enough on the surface as it is.