Institutional investors and high-net-worth individuals (HNI) typically use over-the-counter (OTC) trading when they want to buy or sell a large amount of cryptocurrency. That’s because while 99% of people wanting to buy or sell crypto can do it directly on an exchange, placing an extremely large order that way, if not done right, can be a costly enterprise.
Say you’re an institutional investor trying to buy a million dollar's worth of Bitcoin, or you’re a startup trying to sell a million's worth raised as seed capital. If you try to place such a large buy or sell order on a cryptocurrency exchange, the order can move the entire market up or down — and lose you a fortune.
The reason is that large market orders typically go deep into the order book, leading to poor price execution.
In the example above, a 100+ BTC buy order will eat up the sell side of the order book from $13,124 all the way up to $13,220 and beyond. A large sell order will execute at a price significantly lower than the mid-market price of $13,124. Avoiding scenarios like these is the main reason why investors will trade OTC.
What is an OTC Trade?
Instead of placing a trade on a regular exchange, OTC trading is done directly between two parties. An OTC broker either supplies the trade with liquidity, or finds someone willing to take the other end of the trade. So, what's in it for you? Peace of mind.
With an OTC broker, you get a price quoted to you up front and you don’t have to think about order books, order book depth, markets moving, exchanges, trades failing and many other inconveniences of trading by yourself.
There are two main types of OTC venues:
- An inter-dealer broker, a firm that acts as an intermediary to match a buyer and seller. An inter-dealer broker will normally advertise a fixed fee to both counterparties for their match-making services.
- A principal OTC trading company, a firm that will act as the direct counter party and take on the trading risk. Principal OTC trading firms will charge the same as an inter-dealer broker or more, based on market demand and how well they can manage their risk. For example, if you ask to buy 100 BTC, they will look at the available liquidity in the market to calculate how quickly they could hedge themselves and add an additional profit (aka spread) to safely cover their risk.
While this sounds good in principle, crypto OTC trading is really opaque. On an exchange, you can see all the buy-and-sell orders in the order book. When you’re trading OTC, you don’t necessarily know what the market looks like or how big a spread an OTC broker is charging. Trading OTC provides anonymity and price stability, but it isn’t necessarily cheap.
How does an OTC trader make money? They follow the age-old adage, “buy low and sell high.” They buy from you at a lower price and sell for a higher price. This puts you at odds with the trader — every dollar they make is a dollar you lose. In game theory, this is referred to as a zero-sum game.
If you go into OTC trading blindly, you can end up getting played even worse than you would if you sold on an exchange. If you don’t know how the game is played, OTC brokers can and will profit off you. While the data on this is not publicly available, industry insiders estimate that OTC traders usually charge between 2% and 4%, so on a $10 million trade that's anything from $200k to $400k.
Tactic #1: Don't shop around
When trying to execute an OTC trade, people commonly believe that the best way to find a good deal is to shop around by calling multiple brokers and asking for rates. That way they can go with the cheapest option. While they think shopping around helps them find the best deal, what they often end up doing is showing their hand - information that smart brokers can use against them.
For example, say that one of the brokers called was an inter-dealer broker. After the call they’ll talk to people they know to find a counterparty for the trade. Now the network knows there’s a highly motivated seller. The broker, or the counterparties, can remove their buy orders from the market, moving the price of Bitcoin lower, so they can secure a more favorable rate when the large trade executes.
You could try this instead: Find a trusted partner before you really need to do a trade. Call the brokers ahead of time (maybe every day for a week or so). This way, they won’t know whether you are window shopping or ready for a trade. On the day of the trade, just focus on one to two brokers and execute the trade quickly.
Also, if you are going to call multiple brokers, talk to them simultaneously (say via a chat) so you can get the rate fairly close to each other. This way, you should be able to trade before that information moves the market.
Tactic #2: Ask for buy and sell rates
Even if you do only call a single broker on the phone with the details of your trade, that gives them enough information to front-run you. Say that you call an individual broker and say that you want to sell 1,000 BTC. The moment you hang up the phone, the broker rushes to sell some of their own Bitcoin.
If you do go with that broker, they can then simply buy Bitcoin back from you at a lower rate. Even if you go with a different broker, since your 1,000 BTC trade will move the market down, the broker you called can simply buy Bitcoin back from the market at a cheaper price.
Either way, the broker gets the upper hand because you’ve spilled the beans around your trade.
You could try this instead: When you call an OTC broker, ask them to provide both buy and sell rates for 1,000 BTC - even if you are only selling. This way, the broker doesn't know how to front run you - should they buy more because the price will increase or sell more because it will decrease.
Asking for both buying and selling rate has an additional benefit as you’re getting the broker to show their hand instead of exposing your own. You can look at the difference (the spread) between the buy-and-sell rates and that difference is a good estimate of the broker’s profit margins. This will also encourage the broker to reduce the spread and thus lower your cost of trading.
Tactic #3: Be unpredictable
Another common mistake people make with OTC is behaving predictably. Brokers can exploit patterns of behavior to their advantage. Let’s say that every time you want to make an OTC trade, you call the same couple of brokers for a rate. You do this each week over the course of a month.
OTC brokers are taking notes on how you behave and they’ll know that when you call, you’re talking to other brokers and looking for the most competitive rate.
To lock in your business, an OTC broker might give you a really attractive window price for your trade the first time that you call. After you’ve spoken to other brokers, you’ll go back because the first broker gave you the most competitive rate.
That’s when they stick you with the real rate, which needless to say, is substantially higher. Since this broker gave the best rate initially, you’re more likely to execute your trade with them even if the final rate is higher.
You could try this instead: Don’t be predictable with your OTC trades. Rotate the order in which you call the brokers and change the brokers you call. If an OTC broker gives you a rate that sounds too good to be true, it probably is. Call their bluff and ask them to lock in that rate for you.
Another thing to keep in mind is timing. Say you call on the first of every month, or every Tuesday, at say 2pm — this information can also be used by brokers to their advantage. Keep changing the times you call to execute the trade.
Tactic #4: Ask for rates on multiple different quantities
If you’re trying to buy or sell 1,000 BTC OTC, don’t make the mistake of trying to stuff the full amount into a single trade. The rate that you get for selling 10 BTC will be much better than the rate you get for selling 10,000 BTC.
With a large trade, they know you will go deep in the order book and thus the rate you will get even on exchanges won’t be strong. Further, there’s always the risk that the market will move and that the price will slip. OTC brokers price this risk into the rate that they give you. For a sell order of 10,000 BTC at a price of $10,000 per BTC, a 10% upward movement in the price can cost millions. OTC traders don’t share the same risk because they’re trading all the time — but they’ll still price this risk into your trade to widen profit margins.
You could try this instead: When you call an OTC broker on the phone, ask them to provide both buy and sell rates for 1,000 BTC, 500 BTC, and 100 BTC. This gives you a sense of how much the depth is costing you. You can then decide what is the right amount / price for you.
Another option is to not buy or sell the full amount of crypto in a single OTC trade. Split your order into several smaller trades of 100 BTC each. In this case, it does make to call multiple brokers and sell 100 BTC each; this way you can liquidate faster and get a favorable rate of trading a smaller amount.
Tactic #5 Don't trade OTC in a slow market
The chart above shows a sharp dip in 24-hour volume for Bitcoin on Christmas Day, 2016. Let’s say that you want to make an OTC trade on Christmas Day (or another weekend or holiday). Because it’s a holiday, there will be a lot less activity on the market and lower volume than almost any other day of the year. This means the order book will also be very sparse and many OTC brokers won’t be around. This will generally mean the broker can charge you a higher rate because you don’t have that many opportunities.
You could try this instead: Only OTC trade when there is a decent level of activity in the market.
Tactic #6: Don't trade during high volatility
Avoiding trading in slow markets doesn’t mean you go to the other extreme and trade when the market is highly volatile with big price fluctuations.
In theory, the market has higher volume during periods of high volatility because there’s a higher level of activity. Why this brings greater risk is because you really don’t know whether you can get your trade executed in a timely manner. But remember that OTC brokers charge a risk premium when they price a trade. If the market is volatile, it’s harder to know the price a trade will execute at, and OTC traders will charge a higher risk premium accordingly.
You could try this instead: Avoid OTC trading when the market is highly volatile. Given the volatility in the markets in recent times, this is easier said than done.
While OTC gives you a peace of mind, that peace of mind often comes at a high cost because you’re dealing with a middleman who’s active in the market. When you trade OTC, you need to account for the explicit fees that you pay the broker along with the potential soft costs you’ll incur by sharing information with an active market participant. Minimize the information you share to minimize your exposure to manipulation.
Above all, remember these three very important techniques when trading OTC:
- In general, don’t be predictable. Ask for buy and sell quotes. Ask for multiple quantities.
- Don’t share the exact time you want to trade, or the full quantity. Call at different times with different quantities.
- Do your homework. Know whom you want to trade with and when you are ready to execute the trade, trade quickly.
About the author
Akbar Thobhani is the CEO of SFOX — a broker-dealer for institutional cryptocurrency trading. He started his career as a software engineer at JPL / NASA, and began mining bitcoins while attending MIT. Akbar was head of growth and business development at Airbnb. Specializing in trading and payments platforms, he has developed solutions for ITG, Boku, and Stamps.com.
The above references an opinion and is for informational purposes only. It is not intended as and does not constitute investment advice,