How to build an exchange fit for Crypto 2.0

The recent market dislocation in crypto assets has dented confidence in this relatively new market, but the crisis could mark an important turning point in the technological and product evolution of the asset class which is essential for future institutional adoption.

With decline in crypto asset prices being primarily attributed to two factors – the quantitative tightening by the Federal Reserve and the collapse of TerraUSD, a stablecoin – a critical first step for the industry will be to rebuild trust in the asset class, and this, like with any other asset class, starts with having the right infrastructure in place.

If you build it, they will come

Building a robust financial infrastructure for crypto is essential to ensuring that the system can absorb future shocks and create the necessary conditions for greater institutional participation.

The critical question for the next phase of crypto buildout is therefore how to build a crypto exchange that can attract two types of market participants – retail and institutional – and create an environment in which these pools of liquidity and their intermediaries can co-exist and interact with each other.

To address the challenge ahead and capitalise on future opportunities for growth, exchanges will need to address both the technological and the product angle, which, in the case of crypto, are also interlinked.

Resiliency over UX 

From a purely technological standpoint, it is worth remembering that the first generation of crypto exchanges were built by Silicon Valley engineers who had a fundamentally different approach to exchange technology.

Their focus was on building exchanges which had the best retail user experience, but they lacked any depth of understanding of how capital markets infrastructure had evolved over the past 30 years. This lack of experience is evident in the fact that many crypto exchanges, when faced with larger volumes or volatility, have shown issues related to performance, latency, and load.

This issue is being acknowledged by the exchanges, and, to this end, many of them are already looking to address the technological shortcomings, increase capacity and improve performance by building new trading systems with the view to gradually migrating from old to new.

The exchange problem – built for retail

Another aspect of the technology challenge is that the first generation of crypto exchanges were built for retail investors, limited to web and mobile UIs. This made it difficult for institutional firms to interact with the exchange flow in its current form – these exchanges lack an industry-standard approach or FIX gateways with market data order flows and drop copies that institutions would expect to see – making it impossible to get reliable and timely order confirmations, for example.

For exchanges to be able to attract more institutional flow, providers need to start thinking about building exchanges with standardised FIX-based protocols, integrations with the OMS/EMS landscape, and institutional-grade UIs and APIs which are easier for institutions to access and provide liquidity.

Product diversification calls for a wider exchange offer

The second aspect for the exchanges to address is the product angle. While the first generation of crypto exchanges were mostly focused on spot products, as crypto matures, we will see further product diversification.

We are already seeing a growth in over-the-counter derivatives and options-based products which will attract more institutional liquidity.  Interacting with options flow vs spot flow is better suited to institutions from a risk management perspective.

The product expansion, however, comes with a huge increase in the scale and volume of message flows – faster moving, far more liquidity, and many more instruments being traded – which has implications for infrastructure too. This will require a bigger, better, and more flexible institutional infrastructure, one that can only be delivered by architectural approaches which are steeped in capital markets infrastructure knowledge and experience.

More: With regulation comes trust: The future of the UK crypto industry 

The crypto world is undergoing significant evolution – from a technology, product as well as regulatory perspective, creating arbitrage opportunities along the way. These changes will help mature the asset class and bring new participants to the crypto market who have the potential to critically expand the flows and volumes that we see today. Exchanges need to be prepared for growth by getting the foundations right – addressing the technology stack to take advantage of future opportunities.

 

 

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