By Stéphane Reverre and Chadi El Adnani @SUN ZU Lab
October 2022
Having already covered in this previous article the basics of market liquidity, with a focus on crypto markets, we decided to turn our attention to a new question: Has crypto liquidity become a question of survival for crypto venues? Indeed, the current harsh global macro environment has caused a liquidity crunch across all asset classes, especially risk-on assets such as cryptocurrencies. This situation has left crypto venues with no choice but to enter a race-to-zero on trading commissions to try and protect their market share, at the expense of revenues. Is this situation sustainable? When and how is this deadly spiral going to end? This is indeed a question of survival: trading venues and intermediaries cannot afford not to monitor their liquidity against their competitors. It is fast becoming a significant competitive advantage, probably the only one that will allow a favorable re-pricing of commissions.
Amid an overall bearish year for cryptocurrencies and other risk assets, Binance-US “surprised” the crypto ecosystem recently by adopting a zero-commission policy for BTC and other cryptos. The announcement led to an all-time high of more than 600K BTC traded on Binance the day the policy took effect, while Coinbase shares fell by almost 10%.
The effect on Coinbase’s shares is not a surprise. Like any exchange, it has historically relied heavily on fees from trading volumes. Unfortunately, those have declined in sync with prices, creating instantaneous and significant pain, leading all crypto exchanges to look for ways to diversify their revenue streams.
The zero-fee trading phenomenon is not an innovation by Binance; US neo-broker Robinhood first introduced it a few years ago. Major stock brokers soon adopted the disruptive business model shift, including Charles Schwab, Fidelity Investments or E*Trade Financial. Presumably, the measure will generalize in the crypto space, which will also create tremendous revenue pressure on non-exchange liquidity providers.
In TradFi this cannibalization of revenues has been addressed in different ways. For example, large established brokers are offering premium services such as wealth management. By contrast, Robinhood is a bare-bone online broker without much in terms of service to make up for zero-fee transactions. It had to implement Payment For Order Flow (PFOF) to generate revenues.
In the PFOF model, a broker routes its clients’ orders to market makers. The market maker earns a profit by collecting a spread between buying and selling prices, paying the broker in return for the right to fill the investors’ orders. PFOF came under a harsh spotlight in early 2021 after chaotic trading by a group of retail investors on Reddit led to the spectacular GameStop short-squeeze. This episode put Citadel Securities and Robinhood on the SEC’s radar for potential conflicts of interest on how retail investors’ order flow data is being used against them. According to Bloomberg, the largest US brokerage firms earned a combined $3.8bn in 2021 for selling their customers’ stock and options orders. Interestingly even service-rich brokers adopted PFOF: Charles Schwab racked up $1.7bn, followed by Robinhood with $974m, for which Citadel Securities accounted for 22% according to the company’s 2021 annual report (34% in 2020).
Two things should be noted about PFOF:
- Firstly, it is somewhat counter-intuitive. Market-makers provide liquidity, and as such take on risk in the form of inventory. To carry this risk, they are usually compensated by the beneficiaries. For example, EUREX (a European derivatives exchange) offers market makers commission rebates, which is equivalent to outright payments. The fact that Citadel and others are willing to pay to get the flow suggests that their liquidity-providing algorithm is entirely different from that of traditional market markers. Indeed it most probably doesn’t incorporate the same constraints. The natural question then becomes: who benefits most?
- Secondly, even if it’s an impressive number ($3.8bn), we don’t know enough to assess the economic value of PFOF to parties involved. Suffice it to say that retail trading flow is indeed a very rich source of information, as “bankable” as it comes. Capital market professionals have known for long that it is the “gold standard” of un-informed trading, offering tremendous low-risk opportunities.
What’s the relationship of the above with the original crypto introduction? Well, we venture one recommendation and one supposition. Under pressure on commissions, exchanges should consider liquidity as the “gold standard” of their future profitability. Hence the recommendation: “know thy liquidity”. Monitoring it and measuring it to assess, for example, its robustness across different market regimes should become a strategic objective.
As for the supposition: the same cause having the same effects, we should expect some form of PFOF to emerge in crypto markets sooner rather than later. All of which raises again the question of value creation, repartition and eventually transparency: of the value extracted, what should the “fair” partition be? Regulators in traditional markets have looked hard at this question, and no doubt they will also consider crypto soon enough – an excellent reason to look at it beforehand.
References:
- Crypto Exchanges Cut Fees to Gain Market Share From Rivals (WSJ)
- Coinbase shares fall after rival Binance.US drops spot bitcoin trading fees (CNBC)
- Charles Schwab, Citadel Securities, Robinhood report windfall on sales of investors’ order flow (Financial News)
- Robinhood Markets 2021 Annual Report
Questions and comments can be addressed to research@sunzulab.com
About SUN ZU Lab
SUN ZU Lab is a leading data solutions provider based in Paris, on a mission to bring transparency to the global crypto ecosystem through independent quantitative analyses. We collect the most granular market data from major liquidity venues, analyze it, and deliver our solutions through real-time dashboard & API stream or customized reporting. SUN ZU Lab provides crypto professionals with actionable data to monitor the market and optimize investment decisions.
