How to Imagine OTC on DeFi?
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March 30th, 2022

TL;DR:

Estimates from Circle suggest that OTC desks process 2 to 3 times more volume than exchanges.

There are two main types of OTC operations. Principal desks take risks in the markets to fill trades for clients and charge a spread. Agent desks connect two parties for large trades and charge a broker fee for the service.

There are few OTC options outside of centralized, off-chain processes. For DAOs and other chain-native applications, it is unwieldy to deal with this interface to the real world.

Most of the current OTC on DeFi only provide the escrow solution and require traders to source their own counterparties.

Integral SIZE solves the “counterparty matching” issue, as traders are de facto trading with the liquidity pool. Orders will be always filled if there’s enough liquidity in the pool. It enables trading via smart contracts interaction versus contacting a trading desk, directly serving traders with peer-to-peer liquidity and direct on-chain order settlement.

The future of over-the-counter trading may look very similar on the surface, but behind the scenes, many pieces have not yet been realized. At Integral, we are looking to develop the next generation of decentralized building blocks for whale traders. To this end, we've been thinking a lot about over-the-counter trades and how they may work in a DeFi context.

In this article, we will dive into what a DeFi over-the-counter trading experience could be. But first, let's look at what over-the-counter trading is and how it works in crypto currently.

What is OTC?

Over-the-counter (OTC) trading is a type of trading that facilitates orders directly between counterparties and is not conducted on an exchange.

Over-the-counter trading is rarely discussed but is a major part of the traditional and crypto markets. While most of us can get by trading on an exchange, large traders and whales have a much harder time when trading huge volumes.

There are two main types of OTC operations, usually called OTC desks. Principal desks take risks in the markets to fill trades for clients and charge a spread. Agent desks connect two parties for large trades and charge a broker fee for the service.

OTC desk trades are usually conducted over a chat application. The OTC desk trader will receive a client request and then provide an execution price and a timeline for the trade. Once terms are agreed on, the client will wire funds to the OTC desk and the desk executes the trade accordingly.

In traditional finance, OTC desks traffic in less liquid equities that are not found on exchanges, trading derivatives, and other exotic products. Estimates for the notional value of OTC derivatives put the market at over $600 trillion in size with a gross market value of $12 trillion. Last year, OTC equities had over $500 billion in volume.

Crypto has become an important part of this OTC market. GBTC, which aims to track the price of Bitcoin, is the most traded OTC derivative by volume this year.

Alongside traditional finance OTC desks, a thriving industry has sprung up for OTC desks focused on crypto. When trading large amounts of crypto, whales have an even harder time executing trades than in the traditional markets. To facilitate these trades, most exchanges and many other companies have set up OTC trading desks to fulfill large orders.

OTC desks afford their clients privacy and OTC trades don't move the spot market directly, avoiding price impact. It is sometimes the only way to fill large or exotic orders.

In crypto, OTC usually implies finding a large counterparty that wants to go the opposite direction of a client's trade. Many OTC desks will help source the liquidity for the trade and maybe take on some of the risk themselves. Other desks focus on executing large illiquid orders on a variety of different venues over time.

While the private nature of OTC trades makes exact calculations of OTC volume impossible, estimates from Circle suggest that OTC desks process 2 to 3 times more volume than exchanges.

OTC Downsides

Nothing comes without costs, and OTC desks as they exist have several tradeoffs.

In TradFi and in crypto, if you use OTC, the fees are high. Whether it is explicit broker fees, execution fees, or other hidden fees, a trade that has to get filled off exchange will have a higher cost. There is also the potential for adverse selection and information leakage. OTC desks lack transparency, pricing clarity, and can refuse to trade products because of volatility or blacklisting.

The same benefits of privacy and exotic trading offered by OTC desks can also become a problem. Notoriously, mortgage-backed securities traded heavily in OTC markets were a key factor in the great financial crisis. These and other OTC products are traded in large volumes but with little oversight and few user protections.

What is missing in crypto OTC crypto?

In crypto, very few OTC trades are done on chain. Instead, most OTC desks turn to centralized exchanges to fill client requests. In turn, these trades are the exact opposite of the nature of those performed in DeFi.

The problem is that for teams that looking to raise funds in token sales or diversify treasury risk, there are few options outside of centralized, off-chain processes. For DAOs and other chain-native applications, it is unwieldy to deal with this interface to the real world.

Cobie, in his post "Incentives structures" writes about the dilemma:

Perhaps the team thinks selling 5-10% of their overall remaining equity to secure long-term fundraising through a bear market is a good idea. Hopefully they can secure that OTC with a professional fund, causing no market impact, but it is within their power to sell it on the open market too. It might even be the right decision long-term for the project to temporarily tank the market to ensure they have the funds to build through a crypto winter. Still, such an action would not be great for the token price in the short term and while the team might not intend to do it, the lack of significant cliff in the vesting makes it a possible action.

Without decentralized, on-chain markets for this kind of activity, teams can get stuck between a rock and a hard place. Fundraising can't always wait for a listing on a centralized exchange or help from off-chain OTC partners. In the absence of options, teams have to turn to what is available. Uniswap, Balancer, Curve, and the later generations of distributed exchanges have pioneered trading on chain, but they are not optimized for large block trades in illiquid markets.

This is clear when we look at data on price impact for large trades on chain.

A study by Integral showed that trading for $100,000 worth of $APE would incur an average price impact of over 13%. Trading for $1,000,000 pushes price impact past 30%.

There have been many experiments with OTC markets on chain. As early as 2017, MakerDAO was working on smart contracts to replicate OTC order books on Ethereum. We've seen launches for OTC-adjacent products like Airswap's Peer-to-Peer trading protocol, but these only provide the escrow solution and require traders to source their own counterparties. Some aggregators like 1inch have OTC features, but the trading is done off-chain with traditional API matching engines.

The problem of replicating a typical OTC trading experience in a decentralized way remains an area of active experimentation.

The Future of DeFi OTC

If we are going to improve the experience for whales and others looking to sell large batches of tokens, we'll have to develop new DeFi legos that tackle the unique features of OTC markets. We think that there is a large space to play here.

A typical OTC experience works like the following.

A user has a large number of tokens, a price expectation, and a time frame to execute the trade. Assuming the OTC desk can take fulfill the expectations, the trade will go through around the regular market price, but outside of busier exchange infrastructure and with zero price impact.

Integral SIZE is a new decentralized exchange that works on a similar principle.

Instead of a traditional swap, Integral SIZE uses Uniswap v2 as a price oracle. Once an order is submitted, the protocol queries Uniswap to get a 30-minute TWAP and then executes the order with this price.

As a result, SIZE will be able to execute trades with zero price impact similar to an OTC trade. In addition, there is a transparent mechanism for pricing the trade since it executes transparently on chain. SIZE takes the workflow of OTC trading, but reduces it to on-chain protocol interactions.

Although SIZE looks like a typical DEX on the front-end, it is powered by a new DeFi primitive that enables many of the same use cases covered by OTC trades.

SIZE solves the “counterparty matching” issue, as traders are de facto trading with the liquidity pool. Orders will be always filled if there’s enough liquidity in the pool.

We can add whitelist-guarded pools to SIZE. With these, two counterparties who know each other can use SIZE as an escrow contract to execute the order using the 30-minute TWAP as a fair price anchor.

SIZE even allows directional block trades on the open market. By creating a new liquidity pool and providing only one token as liquidity in the pool, a DAO or other block trader can whitelist swaps in to the pair token at the 30-minute TWAP. With SIZE’s nearly 100% capital efficiency, every token can be swapped out and the full trade realized.

SIZE serves as an on-chain venue for OTC style orders to settle with the unique properties of a DeFi protocol. SIZE enables trading via smart contracts interaction versus contacting a trading desk, directly serving traders with peer-to-peer liquidity and direct on-chain order settlement.Naturally market participants like DAOs and whales that seek OTC-like experience on-chain will find the value proposition relevant.

You can read more about the specifics in the SIZE documentation and whitepaper.

What's Next?

Last year since we launched Integral FIVE (formerly Integral) offering a five-minute TWAP product. To date, FIVE has executed nearly $500m in trading volume. Now with SIZE, we have a further extension to a 30-minute TWAP.

As we get feedback from our users and the rest of the community, we expect to continue expanding the options available through SIZE. The smart contract architecture will allow the additions of new token pairs and different TWAP durations. The first altcoin pools will be launching shortly based and we welcome input from the community on which pairs to add to the roadmap.

We are excited to see how SIZE is adopted to facilitate large-block trades with zero price impact.But we see SIZE as just the next piece in a larger set of tools to help move trading volumes from centralized services like exchanges and OTC desks to decentralized ones running trustlessly on blockchains.

If you are a DAO or crypto fund looking for options to sell large volumes of tokens, we are open for collaboration and you can reach us at info@integral.link. If you’re interested in joining our journey, we are looking for interested smart contract engineers.

You can find more information about Integral on our Discord or on Twitter. Start trading with SIZE today at: https://integral.link/

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