Sourcing Cryptocurrency Liquidity: Exchange or LP?

This article was written by Adinah Brown from Leverate.

With the growing profile of Cryptocurrencies amongst traders, forex brokerages are beginning to expand beyond traditional currencies, into digital currency offerings. Whilst it might seem like forex brokers are only now beginning to offer these currencies, they have in fact been offering cryptocurrencies since 2013, when two well-known brokerages began offering Bitcoin and Litecoin.

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At the time, this strategy was simply to attract traders that were specifically interested in trading cryptocurrencies. Today, with cryptocurrencies attracting unprecedented levels of attention, not offering a selection of cryptocurrencies is a severe disadvantage for a brokerage, where traders may jump ship to another brokerage to pursue their interests in crypto.

Quick fix

Thankfully, there are a variety of different turnkey solutions that allow for a brokerage to offer cryptocurrencies, whether within their existing platforms or as a standalone cryptocurrency platform. This makes it easy for a brokerage to upgrade quickly to provide a digital currency offering and keep up with their competitors.

However, the turnkey solutions only solve part of the problem. Even with the ability to offer these new instruments to traders, a broker still needs to link their instrument to an exchange or a Liquidity provider. Cryptocurrencies, being both relatively new and smaller than its forex cousins, simply doesn't have the same breadth of options in this regard. Below are the advantages and disadvantages of an exchange versus a liquidity provider.

Direct linking – Exchange

Linking directly to a cryptocurrency exchange sends the client’s trades direct to the exchange. Whilst this seems simpler from an integration perspective, it is actually more complex, since you need to adapt your software to meet the needs of the exchange feed. With different cryptocurrencies having different exchanges, integrating multiple cryptocurrencies can create significant complexities.

Exchanges tend not to be geared to offering leverage, meaning that at most, the leverage will be 3:1. From a commission perspective, using an exchange is actually beneficial, since there are less parties involved cutting into the potential profits. Exchanges therefore tend to offer better base points per trade (somewhere between 20 - 30 base points), which is better than liquidity providers.

An exchange can have poor market depth, which means that positions do not get filled, volatility is high or spreads are particularly wide. These issues tend to frustrate traders and impart a negative impression.

Most cryptocurrency exchanges require that the margin be posted in Bitcoin, rather than USD or major fiat currencies. For a company that does not want to hold Bitcoin, this can present a challenge. This is a further issue when considering that cryptocurrency exchanges are unregulated, meaning that the funds posted do not have regulatory protection in place to ensure they are safe. Therefore, putting large amounts of funds into an exchange is a significant risk.

Liquidity providers

Liquidity providers (LP) are an intermediary between the broker and exchange that facilitates the transfer of the trade on to the exchange. As a result, they can aggregate multiple exchanges and provide stronger leverage and have easier integration, since their software is made to integrate into existing broker’s software.

Possibly the strongest advantage is the ability to fund the margin account in a variety of traditional currencies, as well as provide a greater level of fund safety due to the provision of broker protections. As a results of these services and the minimized risk involved, the cost is higher than using a direct exchange.

Although it may not seem particularly important, the added benefit of customer support can be critical if there is a technical issue. Resolving management or operational issues tends to be easier with liquidity providers, and depending on their size, LPs are able to confer greater benefits than what a broker would be able to generate.

Though each method has its advantages and disadvantages, each integration of a new cryptocurrency will determine what the more advantageous method for a broker. As time goes on and cryptocurrency exchanges generate higher trading volumes, the advantages will become more similar to those that currently exist for forex exchanges.