Crypto Traders Flock to OTC Markets as Exchange Liquidity Dries Up Amid Regulatory Clampdown

Crypto traders are turning to over-the-counter (OTC) markets to source elusive liquidity following a regulatory crackdown that has resulted in a substantial decrease in market depth on centralized exchanges.

OTC demand has been steadily on the rise since the collapse of FTX in November, with subsequent spikes being attributed to the collapse of several crypto lenders last year and more recently the SEC's decision to sue Binance, according to Zahreddine Touag, head of trading at Paris-based market making firm Woorton.

The catalyst for this demand has been the sharp drop in market depth across exchanges. Market depth is a metric that measures liquidity by assessing how much capital would be required to move an asset in either direction, typically measured at a spread of 2%.

Last month, Jane Street and Jump, two prominent market makers, announced that they were at very least reducing their trading activity. This compounded the liquidity woes that had been felt since FTX's collapse, with market depth on exchanges sliding by more than 50% between November and May, according to Kaiko.

And this week it emerged that market depth on Binance.US, the exchange at the center of the SEC's lawsuit, had plunged by more than 76%.

This effectively means that traders looking to execute larger transactions will have to deal with inevitable slippage as order books remain thin. As a result, the OTC market, which allows traders to conduct large transactions without needing to go to an exchange, looks to be becoming more prevalent.

"We've been receiving a lot more [OTC] demand," Woorton's Touag told CoinDesk. "Spreads are tight due to daily recurring flow we have on both sides from payment providers, brokers and algorithmic traders."

This trend is eerily reminiscent of the time after Mt Gox, the largest crypto exchange at the time, got hacked and subsequently ceased operations in 2014. Despite the largest exchange falling, the demand for digital assets continued, with peer-to-peer markets on exchanges like LocalBitcoins emerging as the champions of the 2014 bear market.

But as crypto continued to thrust itself into the world of traditional finance, the stature of firms getting involved in the industry began to notably increase. By 2020, counterparties would no longer be an arbitrage trader on LocalBitcoins, and publicly-listed companies like MicroStrategy dealt directly with Nasdaq-listed exchange Coinbase.

This week the world's largest asset manager, BlackRock, filed for a spot bitcoin ETF as it attempts to create a secure investment vehicle for funds and trading firms to gain crypto exposure. But until that is approved by the increasingly combative SEC, traders will have to turn back to OTC deals.