Since bitcoin’s creation in 2009, the digital currency has consistently been traded through off-exchange OTC transactions. The first major bitcoin OTC marketplace was based in an IRC chatroom called #bitcoin-otc and relied almost entirely on a feedback and rating system called the web of trust.
As trade sizes grew and more participants entered the market, more intuitive methods of OTC trading began to appear–mostly in the form of individual brokers and dealers. Today, many of the OTC trades that occur are increasingly facilitated by institutional and professional brokers, dealers, and traders.
When to Trade Bitcoin OTC versus on an Exchange
Completing trades over-the-counter is a time-consuming process that is either beneficial or disadvantageous depending on a trader’s particular situation. For bitcoin companies (i.e. Bitcoin ATM operators, bitcoin payment processors, wallet companies, etc.) seeking to hedge liquidity when buy or sell activity related to their business takes place, there is an advantage to trading directly on-exchange through an API. Trading executed on an exchange can be automated, while trading tied to the OTC market cannot. Furthermore, traders aiming to make real time markets or actively trade price movements will also benefit by trading directly on an exchange. However, for market participants that intend to trade very large quantities, the extra work involved in an OTC transaction may result in better prices for all parties involved.
While there is no steadfast rule on when the OTC market becomes more competitive than the exchange market, we generally believe it would only be worth considering an OTC transaction if a trade is $250,000 or greater in size. If an OTC counterparty can provide a higher level of convenience, enhanced trust, or faster settlement of bank transfers, there may be other situations in which an OTC transaction could be preferable as well.
Purchasing $1 Million Worth of Bitcoin
If you seek to purchase $1,000,000 worth of bitcoin but can’t find an exchange that has a sufficient liquidity in its order book to process the order without causing a significant movement in price, two options become available to you. First, you could sit on an exchange and slowly purchase bitcoins through multiple, smaller-sized orders. Every purchase made could in theory cause the market price to rise over time, so there is still risk of an inflated total purchase price. Alternatively, you could engage in an OTC transaction for the entire amount at a negotiated price. The negotiated price for the OTC transaction should in theory be better than the net price you would receive after slippage by executing the entire order on an exchange’s order book.
How OTC Negotiations Work
The process around negotiating a price for an OTC transaction can vary depending on a number of factors, including your counterparty’s preferences, the leverage each party has in the negotiation, and the size of the transaction. All OTC transactions begin by finding a counterparty for the trade. Once that relationship has been established, the liquidity-seeking party (the buyer in this case) will communicate the size of the trade, when the trade will take place, and possibly an asking price for the deal. The selling counterparty will then respond with its own offer price for the trade, often in the form of a percent above a leading exchange’s best ask price. For instance, the seller may offer “Coinsetter plus 1%,” meaning the price for all bitcoins purchased in the OTC trade will be 1% greater than Coinsetter’s best ask price at the time of the trade. This process can vary and will be reversed if the liquidity-seeking party is the seller rather than the buyer.
Once a price is set and the transaction is confirmed, funds will be transferred. If one of the counterparties resides in the United States, both parties may need to complete KYC (“Know Your Customer”) due diligence on each other to comply with federal laws. Consult legal counsel to understand if this applies to your particular situation. Finally, the buyer will send a bank transfer for the purchase price to the seller, and the seller will send bitcoins to the buyer.
Who Participates in the OTC Market
Large buyers of bitcoin can engage in OTC transactions through exchanges, brokers, dealers and professional traders. In our experience, smaller OTC counterparties have generally been the most competitive on price for transactions up to $100,000. These traders have, in effect, been willing to take more risk on these smaller transactions than larger firms we’ve come across. On the other hand, larger counterparties can deliver solid prices for transactions up to tens of millions of dollars in size–something not possible through the average OTC trader. These larger counterparties tend to be regulated broker-dealers, well-capitalized hedge funds, or bitcoin exchange OTC desks.
Dealers and Traders
A dealer or trader is someone who trades bitcoin through their own account, with their own capital. Since dealers and traders are trading with their own capital, they can move fast and are always your counterparty on a transaction. Dealers typically offload their OTC positions in pieces on an exchange or through separate OTC transactions at a markup. As long as they ensure they offload their position at a higher price than they paid to enter it, they make a profit.
A broker is an intermediary market participant that connects clients with a buyer or seller who will execute their trade. The transaction process through a broker may take longer than it would through a dealer, but one will typically gain the benefit of receiving multiple quotes on the trade and may have access to a higher quality counterparties. Competition between offers increases the likeliness that a trade will be completed at the best price possible. Brokers generally earn a profit by charging a fee for their services or by adding a spread to the quoted price.
Exchange OTC Desks
Some bitcoin exchanges operate OTC trading desks that help clients execute large transactions. Through their broad network of OTC market participants, exchanges are able to provide competitive pricing on transactions and can often provide a higher level of trust given their public exposure. Exchanges may act as a direct counterparty to the transaction, or in the case of a very large trade, may make introductions to other large counterparties. Exchanges can also add value by providing institutional-level custodial services of purchased bitcoins after the transaction is completed.
Which Trading Option Is Best for Me?
The best OTC solution for you is highly dependent on both the nature and magnitude of your market activity. While a large trader may prefer to work with a larger firm like Coinsetter, a mid-sized miner may choose to transact through an individual dealer that buys them steak. Additionally, while many transactions are suitable for the OTC market, it is still generally easier and more cost-effective to trade directly on an exchange’s order book.