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The biggest challenge for crypto exchanges is global price fragmentation


10 Aug 2021

#Bitcoin

For decentralized markets to scale globally, the interoperability between cryptocurrency exchanges must be seamless. It’s no secret that Coinbase has played an instrumental role in bringing new users into the crypto space. Coinbase’s friendly onboarding process and status as a publicly traded company allow it to appear as a more traditional investment platform to non-crypto savvy investors, leading to greater trust.

However, it seems almost weekly that another article hits the internet about Coinbase and its excessive fees for retail and professional traders and investors. The gripe generally unfolds with a comparison of pricing between a couple of different exchanges. With increased competition, the pressure for Coinbase and exchanges around the world to lower fees is mounting. Nevertheless, the biggest pricing issue facing Coinbase and other exchanges is far greater than simply fee structures.

Commoditization and price

Commodities are goods that are fungible. In other words, the market treats goods in their various appearances as effectively equal. When a good or service is commoditized, there is no further differentiation between sellers, and all negotiation is based exclusively on price.

Discussion about trading fees is rooted in a belief that the price of cryptocurrencies is static across all exchanges — a commodity. If Bitcoin (BTC) were a true commodity, trading fees would be the only issue at play and the discussion around Coinbase’s fee structure would be valid.

However, this view of Bitcoin belies an underlying problem within the market. The price of Bitcoin is not a static number and can often vary across exchanges. Because of market fragmentation, consumers are often over or underpaying without even knowing it.

Fragmentation and true price

Market fragmentation occurs when contact and interaction between exchanges are poor. This results in differences in pricing between exchanges and a dearth of liquidity in the market at large. When these price variances are large, they rapidly subsume any variance in fees between exchanges. Investors and traders have been trained to only see the price on a single exchange. But this fragmentation means that the true price of any cryptocurrency is its price on a single exchange plus the fees on that exchange, compared with the same calculation on another exchange.

If the price of Bitcoin is relatively low on one exchange, it matters very little if that exchange has zero fees. Why? If the price of Bitcoin is $60,000 and the fee is 0.50% on one exchange, one could pay for a Bitcoin on another exchange at $60,120 with a 0.30% fee. Yes, with hundreds of exchanges in the market, the price gap can get this big at times. This variance has led to a proliferation of arbitrage investing — buying Bitcoin on one exchange at a lower rate, and then reselling the same coins after a transfer to another exchange for a higher price.

The biggest issue this causes, however, is that Bitcoin is no longer a commodity. With too many pricing variances, Bitcoin becomes nonfungible, and the market stagnates. This motion away from commoditization will eventually cause a potential market implosion. But there is hope for change.

Market stabilization

This type of market chaos is not new nor isolated to the cryptocurrency market. The same issues have occurred in bonds and equities markets, but have been solved over time through regulation. For example, the United States Securities and Exchange Commission has a policy called National Best Bid and Offer, or NBBO. This regulation requires all brokers to execute trades at the best available ask price nationally when an investor wants to buy a security, and the best available bid price nationally when an investor wants to sell.

In this way, the regulation stabilizes the market and protects consumers from overpaying on any given exchange. Brokers are held in check, and market forces work cooperatively rather than unilaterally.

The cryptocurrency market, however, because it remains in its infancy, does not have this time of normalization in place. Exchanges function with relative autonomy, and the market’s current state of fragmentation means that retail and institutional investors often pay different prices based on these exchanges. The problems with implementation of this system in the cryptocurrency market are manifold — lack of communication, restrictive regulatory compliance and dry liquidity pools holding back any meaningful change.

Building a truly unified global crypto market

The root cause of the issue in the market is a lack of communication or interoperability between exchanges, resulting in a high degree of market fragmentation. However, the current digital infrastructure is substantial enough to support constant exchange interaction. But for markets to scale globally, this interoperability between exchanges must be seamless.

Bitcoin is a global asset, arguably even more so than Apple or Tesla stock. So it’s unfair that traders cannot get the best bid and offer at any given time, as the NBBO provides for traditional equities. More enterprise-grade technologies and liquidity will also help mature digital asset trading. All of this could eventually allow for one unified global trading market in a similar way that traditional stocks are traded on exchanges like the Nasdaq or the NYSE.

Without these solutions to reduce fragmentation, trading fee arguments and debates are misdirected and do not tell the complete story. It’s time to level the playing field of fairness with the right regulation and technology in place. Ultimately, it’s not a race for lower trading fees, it’s a race for something similar to the NBBO in crypto — a truly global best bid and offer.


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