Crypto exchanges should STOP internal market-making and prop trading against clients

The crypto industry has been plagued by exchanges doing internal proprietary trading and market-making, where they trade tokens for a profit, raising concerns about potential conflicts of interest.

With 10+ years of experience in the crypto industry under my belt  -  running both an exchange & market maker  -  I want to provide a bit of historical context to the whole concept of exchanges doing market-making themselves.

First, to mention, every exchange operator learns on the first day of running a trading venue  - usually the hard way  -  that liquidity is the key ingredient of growing and scaling an exchange.

I saw that first running Lykke, where we struggled quite a lot since there were not a lot of reliable crypto liquidity providers.

In the early days, it was really really difficult to find a good market-making partner, hence crypto exchanges resorted to being also their own market maker, more from necessity than opportunity.

Sometimes the market-making of the exchange was done on an “arms-length” basis with an external, though closely tied trading firm to the exchange, but a more common approach was to have an internal proprietary trading desk, that was the initial & last provider of liquidity, at all times. Just think of FTX and Alameda Research!

Today, the situation is very much different and an up-and-coming exchange can ring up many crypto heavyweights, such as Wintermute, GSR, Jump Crypto, Jane Street, and Amber Group to name a few, and get the ball rolling from the first days of launching!

While there is a strong & convincing argument that internal market-making will be phased out over time, I still see pretty much every exchange out there doing prop trading against clients, and it’s not obvious that “self-regulatory” efforts would change that.

Especially, if we consider DEXs, where Automated Market Makers (AMMs) by definition are both trading venues & market makers, packaged and glued together via smart contracts.

Liquidity is the name of the game in the crypto industry, and whatever it takes for a trading venue to achieve that — including doing market-making themselves — will continue being the rule, rather than the exception.