Crypto traders move to OTC markets as exchange liquidity shrinks

According to Zahreddine Touag, head of trading at Paris-based market-making firm Woorton, the rise in OTC demand has been steady since the collapse of FTX in November, and subsequent spikes have been attributed to the failures of several crypto lenders last year as well as the recent SEC lawsuit against Binance.

In the face of stringent regulatory actions that have led to a significant decrease in liquidity on centralized exchanges, crypto traders are increasingly gravitating towards over-the-counter (OTC) markets to access much-needed liquidity.

The catalyst behind this growing demand lies in the sharp decline in market depth across exchanges. Market depth, which measures liquidity by evaluating the capital required to move an asset in either direction, experienced a notable drop. Typically measured at a spread of 2%, market depth on exchanges has plummeted by over 50% between November and May, as reported by Kaiko. Moreover, it was recently revealed that market depth on Binance.US, the exchange entangled in the SEC lawsuit, has witnessed a staggering plunge of more than 76%.

Consequently, traders seeking to execute larger transactions now face the challenge of dealing with slippage due to thin order books. As a result, the OTC market, which offers the advantage of conducting large transactions without relying on exchanges, is gaining prominence.

Woorton’s Touag acknowledged the surge in OTC demand, stating, “We’ve been receiving a lot more [OTC] demand. Spreads are tight due to the daily recurring flow we have on both sides from payment providers, brokers, and algorithmic traders.”

This trend bears resemblance to the aftermath of the 2014 hacking and subsequent closure of Mt. Gox, the largest crypto exchange at the time. Despite the collapse of the dominant exchange, demand for digital assets persisted, and peer-to-peer markets like LocalBitcoins emerged as prominent players in the bear market of 2014.

However, as the crypto industry increasingly integrated with traditional finance, notable firms began entering the space. By 2020, counterparties were no longer limited to arbitrage traders on platforms like LocalBitcoins, as publicly-listed companies such as MicroStrategy directly engaged with Nasdaq-listed exchange Coinbase.

The regulatory clampdown and subsequent decline in exchange liquidity have prompted crypto traders to seek alternative avenues, leading to a surge in OTC trading. With slimmer order books on exchanges, the OTC market has emerged as a preferred option for executing larger transactions. This shift in dynamics resembles the pattern observed after the Mt. Gox incident, as the demand for digital assets persisted through alternative trading channels. As crypto gains recognition in traditional finance, the involvement of established firms further underlines the growing significance of the industry.