【Translation】Cryptocurrency Market Structure 3.0: Paradigm Partner Insightfully Discusses the Past and Future

The Block's research director, Larry Cermak, described Paradigm as one of the most important Ethereum ecosystem funds today. Last week, Arjun Balaji, an investment partner at this renowned institution, wrote an article titled "Crypto Market Structure 3.0", which Larry regards as a benchmark. He mentioned that very few individuals can match the understanding of the crypto space exhibited by these individuals.

We have translated the entire article for you. But before we dive in, let's briefly understand what Paradigm is.

What is Paradigm?

Paradigm is a company specializing in cryptocurrency investments, founded in June 2018 and based in San Francisco, USA. Its co-founders are Fred Ehrsam and Matt Huang, with Fred Ehrsam being a co-founder of the leading exchange Coinbase, and Matt Huang a partner at Sequoia Capital, involved in many early cryptocurrency investments. Both were early investors in Bitcoin in 2011-2012.

According to public data, the company currently has 20 investments, with notable investments in the past two years including Uniswap, Keep, Argent, Amber Group, and Libra.

The author of this article is Arjun Balaji, a former independent cryptocurrency analyst who provided investment advice to hedge funds and family offices.

"Cryptocurrency Market Structure 3.0" Full Text

In the early 2010s, the cryptocurrency market was dominated by a few retail-focused small brokers. Over the past decade, the market's daily trading volume in spot, derivatives, and on-chain markets has grown to over $15 billion. Now, Bitcoin ranks as one of the most liquid assets in the world.

The uniqueness of crypto assets has created a new market: the crypto market is open 24/7 worldwide. Users around the world can access this highly tradable asset at any time. Public blockchains can transfer cryptocurrencies and fiat currencies frictionlessly in minutes. Individuals can securely store assets like a bank. Unlike the New York Stock Exchange or Nasdaq, retail users can trade directly on the largest cryptocurrency exchanges without intermediaries.

Despite these advantages, the cryptocurrency market structure remains opaque and poorly understood due to its global fragmentation, rapid changes, and diverse participants.

This article outlines two significant developments in the cryptocurrency market over the past decade and elucidates future prospects.

Market Structure 1.0: 2010 to 2017

The prehistoric era of the crypto market involved peer-to-peer trading through Bitcointalk and IRC. The earliest market structure began in July 2010 with Mt.Gox, and over the next five years, many early exchanges introduced fiat currency channels to serve individuals.

Due to the origin of Bitcoin, obtaining stable banking channels was not easy, leading to the rise of stablecoins like Tether. With the growth in adoption, over-the-counter (OTC) platforms began serving a few early institutions. Due to the lack of mature market makers, liquidity was poor, and cross-border and cross-market spreads were often measured in single-digit percentages.

In December 2017, the influx of new market participants overwhelmed daily trading volumes, marking the end of an era. It was a past period not worth further reflection, thanks to the pioneers who brought us here.

Market Structure 2.0: 2018 to Present

Since December 2017, the cryptocurrency market has evolved into its 2.0 iteration, transitioning from a market focused on individuals to one where institutions can participate. During this time, derivatives trading volume has grown over 25 times, and bid-ask spreads have decreased by 10 times. The market has evolved from a manual, expensive, and Bitcoin-denominated market to a fully electronic, low-cost, stablecoin-denominated market.

The primary drivers of this transformation are:

• Dominance of Derivatives Liquidity over Spot: Since 2017, the focus of cryptocurrency liquidity has shifted from spot markets to derivatives. Cryptocurrency derivatives lagged behind spot volume in 2017, but current trading volumes are 3-5 times that of spot, with daily trading volumes exceeding $10 billion. With increased bidirectional liquidity, Bitcoin's volatility has significantly decreased. The current 60-day volatility range is 2-4%, compared to 4-8% in 2017-2018 and over 7-10% in 2013-14. The derivatives market is diverse, including regulated markets like CME, Bakkt, global market participants like FTX, Deribit, and products from international spot exchanges such as Binance, Huobi, and OKEx.
• Electronic Execution of OTC Trades: Since 2017, OTC trade spreads have compressed by an order of magnitude, from 50-200 basis points to 5-10 basis points, with eight-figure Bitcoin trades. In 2017, OTC trades were primarily conducted through voice and chat. Today, it is entirely electronic, dominated by quantitative trading firms like Jump, B2C2, Amber, and Alameda Research. Clients no longer need to use Skype but can directly connect to platforms hosted by market makers and stream quotes, executing trades via APIs.
• Emergence of Lending: In 2017, there was nearly no credit market in the cryptocurrency space. Today, trading firms can access over $2 billion in Bitcoin and stablecoin loans, with intermediaries serving retail clients like BlockFi, Celsius, Blockchain.com, and institutions like Genesis. The lending market has reduced market makers' funding costs, narrowed spreads, benefited institutional clients, and provided high-rate returns for retail users.
• Stablecoins as Cryptocurrency Reserve Assets: In 2017, most mainstream trading pairs for crypto assets were denominated in Bitcoin. During high volatility periods, this led to significant price chaos and liquidity loss. Today, the most liquid trading pairs among the top 30 crypto assets are stablecoin-denominated. Since January 2018, stablecoin total issuance has grown tenfold from $2 billion to $20 billion, with stablecoins replacing Bitcoin as the cryptocurrency market's reserve assets.
• Institutional Services and Products: In 2017, institutions could only enter the market through retail channels. Today, in addition to existing companies like Coinbase and Genesis/BitGo, institutions can enter the market through multiple qualified custodians, electronic execution firms, and newcomers in the lending market like Tagomi, Fireblocks, and Anchorage. Electronic communication networks (ECNs) like Paradigm.co have improved the workflow for large trades, while specialized institutions like LMAX Digital now lead global BTC to USD liquidity.

Market Structure 3.0: ~2020 to?

From 2.0 to 3.0, we are in the early stages of the next structural evolution.

When mature, the 3.0 iteration will (1) significantly enhance capital efficiency and (2) bridge centralized markets to emerging decentralized finance (DeFi) markets.

1. Capital Efficiency

Due to market decentralization and lack of overall industry credit assessment, crypto trading still suffers from low capital efficiency.

Currently, exchanges have high margin requirements, and companies cannot use cross-margining, a process where brokers or dealers can open positions elsewhere with margin. This forces companies to provide full funding for almost all trading activities, with settlements requiring confirmation of the minimum block count. Full funding is particularly costly in highly congested chain environments, especially during periods of high volatility.

Due to inefficiencies, perpetual contracts have become a major source of short-term funding. Cryptocurrency perpetual contracts: "To improve capital efficiency and maintain 20x leverage." The backbone of market funds relies on contract markets, which is not the most ideal state: the huge liquidation in March 2020 alone on BitMEX exceeded $1.6 billion. In a more capital-efficient market, this can be prevented.

Credit creation and shortened trade cycles can enhance capital efficiency. Credit creation allows companies to gain over $1 of purchasing power for every $1, and shorter trade cycles mean the same $1 can be traded more times, increasing liquidity by $1.

We will see specific ways to create credit and shorten trade cycles:

• Specialized Major Brokers: Large exchange balance sheets are the most robust in the crypto industry, enabling them to expand credit massively. Indirectly, mainstream brokers like Coinbase can enable clients to margin trade across platforms and enhance trading cycle efficiency through chain-offline trading.
• Crypto-Native Derivatives Clearing: In traditional markets, derivatives traded on exchanges are cleared by central clearinghouses maintaining a general ledger of margin calculations. In recent years, companies like Zero Hash and ErisX have attempted to directly transplant this model to cryptocurrencies. Additionally, practices like X-Margin can directly prove encrypted collateral on the chain.
• Regulated Repo Markets: The repo market, with $2-4 trillion daily turnover, allows institutions to borrow funds on a secured short-term basis. Through perpetual contract financing, the crypto market already has an informal repo market and bilateral settlement OTC trading repos $50 million daily. A regulated institutional repo market can make large short-term borrowings possible without relying on perpetual contract platforms.
• Fewer Chain Confirmations Standards: A deep understanding of on-chain settlement guarantees can shorten the confirmation times between known counterparties. Fireblocks' digital asset transfer network settles over $25 billion monthly on-chain and enables members to choose "instant" settlement among themselves. Transactions initiated by Fireblocks are signed by SGX, ensuring unconfirmed transactions come from a unique signature of a given UTXO. It guarantees that once a transaction enters the memory pool, exchanges like FTX can accept entries from other Fireblocks users.

2. CeFi <-> DeFi Convergence

Decentralized finance (DeFi) emerged at the end of 2017 and developed in parallel with Market Structure 2.0. As DeFi continues to gain structural importance, the convergence of centralized finance (CeFi) and DeFi will occur when market participants, liquidity pools, and product usage experiences overlap.

Even in its 1.0 version, DeFi has already begun disrupting "CeFi." There are some examples like:

• Liquidity Built on AMMs: Between 2017-2018, building liquidity in emerging assets required collaboration with exchanges and market makers. However, through automated market makers (AMMs), these assets can be listed without permission, allowing passive retail liquidity providers to establish market depth before professional liquidity providers hold inventory. Global mainstream exchanges were once the starting point for liquidity, but now they are latecomers.
• On-Chain Interaction for Best Execution: AMMs like Curve now hold nearly $1 billion in stablecoin markets. The direct implication is that brokers unable to access on-chain liquidity are at a disadvantage compared to those who can. The transition happened quickly, with AMMs starting to impact centralized liquidity significantly in March 2020. For many market makers, this has become the real balancing ability of DeFi.
• Crypto-Native Cross-Margining: Margin positions in DeFi were tokenized from the start, such as LP shares on Uniswap, cTokens on Compound, and synthetic assets on Synthetix. DeFi margin tokens are fully collateralized, callable on-chain, and enable transparent rehypothecation when used in combination (e.g., using Uniswap's LP shares as collateral for Maker's CDPs). While FTX pioneered tokenized margin on centralized platforms, the design interface is just beginning.
• Seamless User Experience in DeFi: DeFi's user experience surpasses CeFi in many ways. Although critics often focus on gas fees, DeFi provides outstanding security experiences, non-custodial and seamlessly integrated user experiences. Scanning QR codes and signing transactions with MetaMask is as simple as using Snapchat, making it easier than traditional brokers.

Although DeFi has depth in spot and lending markets, DeFi has not "swallowed" CeFi. Throughput and high fees remain significant structural obstacles. With L2 solutions entering the market, DeFi applications like Synthetix pose a real threat to centralized platforms, offering a user experience similar to FTX, enabling people to replicate Bitcoin collateralized synthetic assets.

What does this mean for CeFi participants? It implies:

• Better DeFi Interfaces: Centralized exchanges will rely on DeFi for efficiency extensions, acting as intermediaries between users and DeFi, like the staking services they currently offer. Providing an entry point to using DeFi is a natural way to prevent off-chain fund outflows. Exchanges can encourage users to use DeFi through their interfaces, providing locked asset liquidity, lower fees through fundraising, and additional off-chain collateral. For many users, the exchange account as the default wallet may be the most convenient way to visit on-chain protocols.
• Normalization of Non-Custodial Trading: Non-custodial trading products are another natural "defense" against fund outflows. Binance and FTX have fully embraced the challenge, establishing non-custodial DEX Binance Chain (a Comos domain) and Serum (based on the Solana blockchain). Protocols like Arwen can enable non-custodial trading for exchanges using a hybrid approach. Newer projects like dYdX and DeversiFi are building scalable, initially through Bitfinex, based on StarkWare's ZK L2 solution, to compete with centralized user experiences.
• "CeDeFi" Exists: Besides non-custodial veneers, every major CeFi participant will ironically attempt to use "CeDeFi." Turnkey solutions may attempt to mimic the structural products of on-chain yields, and more comprehensive solutions might include a fully Ethereum Virtual Machine-compatible blockchain for portable DeFi, such as Binance Smart Chain.
• DeFi Support for Institutions: Due to compliance and regulatory barriers, large institutions have less friction using DeFi compared to retail. As larger companies start to view the DeFi market as a first-class object, service providers will seek ways to allow their clients to seamlessly participate without compromising existing operations. As development progresses, we may even see projects launching whitelist (KYC) liquidity pools. Offline DeFi insurance can mitigate mechanism and contract risks in the absence of collateral or insufficient collateral, providing more security.

As scalability improves, on-chain financial infrastructure will begin to compete with centralized infrastructure. However, user diversity and the importance of fiat channels still mean that centralized platforms will not disappear quickly. The long-term winners are users who can try various choices in trust, pricing, risks, and user experience.

Conclusion

Over the first decade, the cryptocurrency market structure has undergone two significant developments. Despite rapid innovation, the market is far from reaching the maturity or scale needed to support a market value of hundreds of billions of dollars.

Driven by entrepreneurs and user demand, the changes in the crypto market have always been community-driven. While this has led to some unexpected re-innovations, the optimistic view is that innovation will achieve long-term victories—today's crypto sandbox is equivalent to the design of every major market in the future.

Historically, the cryptocurrency market has been unknown, with little knowledge among people. We hope that as we build an open, efficient financial system in the next decade, this article provides a useful starting point for future discussions.

If you focus on Market Structure 3.0 (or 4.0+ as we do not exclude), we are happy to explore together. Please feel free to contact us at your earliest convenience: [email protected]