The crypto market is one of the most fragmented financial ecosystems in history. Unlike traditional markets where liquidity is combined around several dominant exchanges, crypto trading takes place on more than 700 exchanges around the world. This fragmentation presents opportunities and challenges, but poses great concern to institutional players as it complicates price discoveries, reduces implementation quality and reduces market efficiency.
In this report, Finery Markets analyzes how fragmentation affects market liquidity, transaction costs, and execution efficiency. This report examines structural differences between centralized exchange, decentralized exchange and OTC markets. It covers the fragmentation of the OTC market and how institutions navigate these complexities.
Fragmentation: The paradox of competition and inefficiency
Market fragmentation of crypto is a paradox. In contrast to the integrated market where traders compete for the best prices at the same venue, competition is shifting venues in fragmented markets. This forces them to compete through cost structure, incentives and better liquidity. Fragmentation promotes innovation, but spreads liquidity across multiple venues, making it more complicated and expensive to implement.
The impact of market fragmentation is particularly pronounced in the OTC market, which affects both the execution model and post-trade settlement. The OTC market relies on quote-driven systems through bilateral agreements, electronic communications networks (ECNS), and smart order routers (SORS) compared to centralized and decentralized exchanges that use order-driven models for price discovery. ECNS promotes direct trade execution by matching liquidity candidates with liquidity providers without intermediaries. Meanwhile, SORS scans multiple venues to optimize execution and ordering to the best possible source of liquidity.
The lack of centralized reporting in the OTC market complicates liquidity aggregation and market participants on liquidity providers (LPSs) to absorb order flow imbalances. Second, LPS offers solid pricing or indicator pricing. This increases liquidity, but reduces transparency compared to traditional order books.
To mitigate this, hybrid execution models have emerged. Integrates purchase order depth with a private request (RFQ) mechanism. These models combine the transparency of the order-driven market with the efficiency of RFQ systems to improve execution quality and liquidity sourcing.
The post-trading settlements in the OTC market remain underdeveloped. Unlike exchanges that internally match and resolve orders, OTC transactions rely on external custody solutions, extending payment times and increasing counterparty risk. Due to the lack of standardized clearing mechanisms, bilateral settlements remain as defaults, adding complexity to post-trade operations. These inefficiencies discourage institutional participation, increase operational risks and reduce capital efficiency. As market participation grows, it is essential to establish a standardized execution protocol across venues to minimize fragmentation and improve market scalability.
The impact of regulatory development and institutional adoption on market fragmentation.
Beyond technology inefficiency, market fragmentation is affected by regulatory differences across jurisdictions. An uneven regulatory environment increases operational costs and forces businesses to navigate complex compliance requirements. In response, many crypto companies are actively seeking additional licenses to meet evolving regulations. For example, under the leadership of CEO Richard Teng, Binance has expanded its regulatory approval to 21 countries.
This shift is expected to accelerate as policy makers clarify their stance on crypto. The development of regulations will also affect institutional capital flows over the coming years. The stance of President Donald Trump’s administration and the custody of the European MICA framework is two such examples. Major companies such as BlackRock, Fidelity and JPMorgan Chase have already launched crypto-related services and products. At the same time, crypto-based M&A activity is on the rise, with trading activity increasing by 22% in Q1 2024.
As more companies enter the space, market infrastructures need to evolve to reduce inefficiencies and improve the quality of execution.
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