In 2000, Internet businesses told us that we were in the midst of Business 2.0, that business would be fundamentally changed by the Internet. After the dot-bomb bubble collapsed, we found that business was quicker and more efficient as a result of the web, but no, the fundamental rules of business hadn’t changed.
Now, the proponents of cryptocurrency tell us that things have changed since twenty four stockbrokers met under a buttonwood tree on Wall Street and signed an agreement among themselves. In the two hundred years since, we’ve defined the roles and responsibilities of the parties to a stock transaction. These lessons have survived or grown from market crashes, deregulation, Supreme Court cases, and the desires of the investor. The school of hard knocks has lead to a robust stock market. It’s folly to believe that cryptocurrency will develop significantly differently – not if its fans think it will earn the trust stock exchanges across the world have.
Exchanges, or bourses, provide the infrastructure for others to conduct their businesses. In days gone by, they provided the physical trading floor. Now they provide the computer systems that match orders. Exchanges provide record-keeping and dispute resolution.
Originally, exchanges were mutual enterprises, owned by member firms. At the NYSE, that ended in 2005. Then as now, investors did not deal directly with the exchange. They deal with brokers who in turn have exchange priveleges. The exchange itself maintains records but it is a neutral body in the relation of investors and their brokers
In a stock market, a broker brings buyer and seller together. The broker has a relation with the exchange that the individual or institutional investor does not. The broker provides information about the stock, including quotations. The broker collects and remits the money associated with the sales and purchases. Brokers typically hold shares on behalf of their clients. In certain instances, brokers may lend one client’s stock to another for short sales.
The cryptocurrency market has not promoted the role of broker in coin transactions. Despite their names, cryptocurrency exchanges are the analog of broker-dealers. A broker-dealer deals with investors (the broker part) and also trades for its own account (the dealer part). Cryptocurrency exchanges offer the range of services a stockbrokers does. It will loan money to buy on margin. It will hold cryptocurrency on the client’s behalf.
An investor in cryptocurrency is well advised to remember that there is no neutral exchange to straighten out mistakes in bookkeeping. For the most part, there is no government regulation of these transactions. When the amount of bitcoin comes up short in your account, you are dealing directly with the company that has to pay when the mistake is corrected in your favor. If that doesn’t work, there is no New York Stock Exchange or Securities and Exchange Commission to look into your complaint.
Academics describe the value of a stock today as an expression of the discounted future dividends and the associated appreciation in price. Cryptocurrencies promise no future dividends. Many cryptocurrencies promise that they can be used to pay for a service described by the coin’s white paper. Those services are not yet priced, so there is no measurable intrinsic value of the coin.
In a very few cases, the issuer of the coin promises that holders of the coin will get a percentage of transactions of all the coin. HERO coin, a construct that allows online sports betting without an intermediary (the “house”, or bookmaker), promises every holder of HERO a piece of each wager. In this way, all holders of HERO are promised some return. the return is hard to estimate, but it is a reward simply for holding the coin.
A Perfect Cryptocurrency market
From the coinholder’s view, a perfect cryptocurrency market would have several attributes.
A perfect view of the book
The book is a list of offers to sell just above the current price and a list of offers to buy just below the current price. The book is a means for buyers and sellers to see the price even without a trade being made. The book is a means for buyers and sellers to know whether there is a willing counter-party for the size of trade they intend. Transparency helps reduce price volatility because all market participants can base decisions of value on the same data.
Investors don’t need a perfect view of the book, but they suffer mightily when others have that view and they don’t. The solution is transparency for all. The book is a prospective view of the market. Seeing the depth on both sides of a potential trade allows investors to make rational decisions. There remains mystery about the orders that may be brought to the market; it will likely always be so.
An individual would like a single view of the consolidated book – the offering on all exchanges. In the short run, in a market with multiple exchanges and prices, the trader with the best view of all operating exchanges will prosper at others’ expense. In the long run, arbitrage will tend to equalize markets.
A perfect view of the tape
An investor needs a timely report of all transactions. First, it is his or her indication that the book represents the current state of the market. Second, it is a demonstration that his or her last execution was in line with other trades. The cryptocurrency market is different from your father’s stock market. In 1999, you could watch round lots (100 shares) go by, priced in sixteenths of a dollar. You had no idea which one was yours on the tape. Today, when lots of coin are described to six digits and prices also to six digits, your transaction is immediately identifiable.
In 2018, there is no demonstrable consolidated tape for cryptocurrencies. To be a credible data source, the tape needs to identify the product, price, quantity, and time. In the days of telegraphic printers (when it really was paper tape) or a Trans-Lux on a broker’s wall, time was not such an issue; one would look at the clock. In the United States, stock prices are always quoted in dollars. Until 2001, stock prices were quoted in dollars and sixteenths. Most crypto coins today are traded for other cryptos. Particularly where the less prominent coins are concerned, seldom are there transactions for dollars. They are traded for bitcoin or etherium. Price quotes in dollars aren’t the record of actual transactions. They are the product of the price of a coin in terms another multiplied by the latest quote of the second coin in dollars.
The NYSE Euronext made a stab at a consolidated tape, using the FastMatch infrastructure it had built for foreign exchange traders. After an announcement in early March 2018, updates to the feed stopped a week later.
Liquidity and a reasonable bid-ask spread
An investor needs to know that there is a liquid market for her crypto coin, a place real or virtual where there are sellers with coin and buyers with money. The more participants there are, the more likely it is that the investor can quickly buy or sell coin at close to the same price – a small spread. The spread is a measure of the efficiency of a market.(Roll (1984))
A perfectly liquid market would be always open with traders ready to deal. The New York Stock Exchange is open six and a half hours a day. The other eighteen hours, there are secondary markets or investors cool their heels.
The alternative to a market that is always open is an auction in which a large group of buy and sell offers is aggregated to maximize the volume changing hands (“market clearing”) at a single calculated price. The theory supporting this market-clearing techniques is called Walsrasian tâtonnement. The New York Stock Exchange conducts these auctions three times each day: at 4:00 am, at 8:29 am (just before the market opens), and at 3:59 pm (just as the regular trading session concludes). In the bitcoin world, the Gemini Treust exchange conducts bitcoin-dollar auctions every day at 7:00 am and 4:00 pm (Eastern time).
For the minute that an auction takes place, there is no bid-ask spread. There is only a single market-clearing price. This price is considered reliable enough that it is the basis of settlement for futures contracts. The Chicago Board of Option Exchange uses the Gemini bitcoin auction price to define its bitcoin future contract.
Commissions that reflect the savings of automation
In 1792, stock brokers agreed on commissions for the nascent New York Stock Exchange – .25% – for hand-written trades. In 2018, there are cryptocurrency brokers that are charging even even more than that – for a trade that does not even pass a set of human eyeballs.
Don’t confuse trading commissions with the costs of transferring money into and out of an account. If you choose to buy bitcoin with your Visa card, someone needs to pay the merchant fees that apply on all credit card transactions. None of the crypto exchanges give you a break for debit cards, which is peculiar. COSTCO lets you pay with any debit card, even if they only promote one credit card each year. Similarly, if you want the exchange to credit your card, expect to pay for that, too. If you choose wire transfer, there will be a charge.
Where the commissions themselves are concerned, cryptocurrency exchanges have taken a singularly different direction from stock markets. Discount stock brokers in the U.S. at least offer a single flat commission for every order. Cryptocurrency exchanges seek to invite traders to engage in the kind of trading that market makers do: orders that go onto the book and are not exercised until someone else comes along with a market order. These exchanges offer low or no commission on so-called “maker orders”. They make it up on “taker orders”. All market orders are taker orders, but the trader has no way of knowing whether his limit or stop order is a maker order and subject to a commission, until it arrives at the exchange.
Any situation in which a consumer is not equipped to estimate costs before a transaction occurs is fraught.
Reality not as fine as the dream
Some cryptocurrency exchanges commonly offer low trading commissions but high accessorial charges. It makes sense that an exchange would pass along the cost of a credit card transaction to fund a trading account.
Crypto exchanges don’t typically issue checks. They prefer bank transfers. Most don’t say whether they use the SWIFT system (a real “wire” transfer) or simply an ACH transaction (a common “paperless check” transaction). Bitfinex charges 0.1% for both deposits and withdrawals by wire transfer with a minimum of $20. A minimum charge of $20 in or out is reasonable for SWIFT but not for ACH. If you ask for prompt service, Bitfinex will send your wire transfer within twenty-four hours but charge one percent to do so. That is outrageous.
In stock markets regulated by the SEC, for decades, settlement for trades was required by the fifth day after the trade. In 1993 settlement went to the third day. In 2017, the standard went to T+2. In the old days, if you really needed the money, a brokerage could sell for cash, and send you a wire transfer the same day. You’d take a haircut, but not one percent.
Bitfinex charges $150 to correct deposit errors.
FUD in the twenty-first century
The mainstream press has been suitably impressed by the growth of the cryptocurrency market and just as explicit about the dangers of government regulation, robbery and failure of cryptocurrency exchanges, and the insecurity of certain crypto wallets. Crypto fans dismiss these warnings as FUD (fear, uncertainty and doubt) with the same indifference as the White House dismisses fake news.
Cryptocurrency is new, but the scams are not. Many crypto fans are not old enough to remember Blinder Robinson and First Jersey Securities which dealt with what were called in those days “penny stocks.” Today they are called micro-caps.
Resurrection of ancient scams and technical analysis
Modern mathematics has fundamentally disproven the old practice of technical analysis: the prediction of price movements based on the shape of the time-series. “Head and shoulders”, “pennant”, and “cup and saucer”” are the equivalent of seeking patterns in tea leaves. Nonetheless, YouTubers cannot contain themselves in making predictions about the cryptocurrency market, constructing word-salad prognostications that are no more help than the days’ horoscope.
The more advanced players engage in all of the traditional stock manipulation schemes, including wash sales (described earlier), pump and dump and short and distort, which are both based on fake news. Because training in cryptocurrencies is unregulated, miscreants are seldom pursued.
The result is that amateur videos are likely to have less useful information in them than the economics class you took in college. If trading cryptocurrencies is so profitable, you have to ask yourself why the YouTubers are begging you so hard to subscribe to their channels.
Roll, Richard. 1984. “A Simple Implicit Measure of the Effective Bid‐Ask Spread in an Efficient Market.” The Journal of Finance. American Finance Association. https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1540-6261.1984.tb03897.x.