What is the difference between prime brokers and OTC desks in digital asset markets?

OpEd Jul 13, 2021

In this article, we explore the fundamental differences between trading through a Prime Broker, and trading against an OTC desk in the crypto space.

Considering the sector has existed for less than a decade, cryptocurrency markets have expanded and professionalized at a phenomenal speed, with a market cap somewhere near $100B and thousands of exchanges in existence.

Yet, although the digital assets market is quickly maturing, it has a long way to go before it matches other markets in terms of deep liquidity or institutional adoption - and the proliferation of exchanges is, counterintuitively, one of the reasons.

Crypto exchanges tend to operate very independently from each other, with differing onboarding requirements, varied KYC processes and separate order books. Consequently, liquidity issues and low volumes can end up leading to wild price movements for even the most heavily traded assets such as Bitcoin or Ethereum.

This effect can be even worse for tokens issued via ICO or ITO, where high demand can drive unrealistically high prices at launch, while poor trading conditions on secondary markets often lead to low volume and high volatility and where large trades conducted on illiquid platforms can cause slippage - a significant issue for institutions and serious investors, whose trades are usually larger than the amateur retail investors who still make up the majority of participants in the crypto ecosystem.

The advantages of prime brokers

If a serious trader wants to open a position worth tens of millions of dollars in a particular asset, most single exchanges will not offer enough liquidity. Dividing the order between exchanges is time-consuming and capital-inefficient, as well as risking price variations.

In short, as more and more TradFi investors and institutions are drawn into the digital assets sector, the more demand there is for professional, regulated intermediaries offering full-service solutions: in other words, prime brokers.

At this point, many traders might be asking themselves what is the advantage of a prime broker over a market-maker. Note that in this context, we are not talking about the automated market makers (AMMs) that are the cornerstone of the DeFi (decentralized finance ecosystem), but rather, the OTC market-making companies that promise to provide liquidity for specific crypto-assets.

Why transparency is important

At first glance, market makers may seem an attractive option compared with using a prime broker, because brokers charge a fee for their services. Yet this is a false economy and in fact there are a variety of reasons why a prime broker is usually the better choice.

One key reason is transparency. Prime brokers offer connectivity to the cryptocurrency ecosystem either with direct market access (DMA) or direct strategy access (DSA) with best execution, and charge a fee for their services.

Hence investors know that the price at which they buy or sell the tokens is the actual price of the execution on the exchange. Investors know exactly what fee they are paying and what the broker’s margin is: in other words, there is no mark-up.

In contrast, investors who choose to use an OTC market maker will be shown one- or two-way quotes that are all-inclusive. This is not transparent, as the only way you can know what you are being charged for the market maker’s services is to guess by comparing the quotes you are offered with the best bids and offers on the exchanges they deal with.

With a prime broker, the fee is agreed and predictable, but OTC market makers’ mark-up may vary not only according to their relationship with the investor, but from trade to trade, depending on the market maker’s inventory and strategy. For example, if an investor wants to buy a larger quantity of tokens than the market maker has access to, the market maker may need to pay more to get someone else to sell to them, and the extra costs are passed on to the investor.

How to minimise risk

Everyone knows that cryptocurrency markets offer a higher risk profile than traditional markets, so the sensible approach is to minimise risk when dealing with intermediaries, so that investors do not pile unnecessary risk on top of existing volatility.

It can be tempting to go for the cheapest option, which may mean an OTC desk with the lowest markup, signifying they have a higher appetite for risk. A lack of risk aversion is a big red flag when choosing an intermediary, as in a worst-case scenario they may go bankrupt and impact their customers by not settling their leg of the transaction at all.

In contrast, the risk when using a prime broker is minimised because the investor’s trades do not go through the prime broker’s books. Instead, liquidity is guaranteed as long as there is liquidity on the exchanges the broker is connected to.

Reliability when the markets are volatile

Consistency is another important factor to take into consideration. You need to know that in periods of high volatility or other difficult market conditions, that your intermediary will not let you down. A prime broker will always provide best execution, while unfortunately the OTC market maker’s performance depends on the models they are using to stream quotes, and they may not be able to offer a quote on the side you are interested in, or to fulfil anything more than a small order.

In some circumstances, market makers may pull all their quotes to protect their PnL (profit and loss ratio). Because it is these moments of extreme volatility that have the potential to precipitate large gains or losses, you need to know that you are able to liquidate a losing position at the exact moment you need to - or to build up inventory if you have a winning strategy. Paying a fee to a broker to know that your trades will be executed on time, regardless of market conditions, should be crucial for every investor’s peace of mind.

In addition, prime brokers may also offer additional services such as custodial services, or fund administration and management or access to staking, which brings them even closer to the type of full-service solution that serious investors in traditional finance sectors have come to expect.

SheeldMarket helps some of the largest funds and blockchain foundations optimise their trading operations. Through a single account they can trade dozens of different pairs over the largest trading venues. No need to handle onboarding, fund allocation and connectivity. Get in touch if you want to learn more.


Oliver Yates

Founder & CEO @ SheeldMarket Solving complex problems with simple solutions

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