Many traders forget or turn a blind eye to the practices that crypto exchanges utilize during trading. Before we jump into how exchanges use internal market makers to generate revenue by taking the other side of your trades, let me share my experience from working at one of the top forex brokers.
In forex, it was and still is a common practice to provide pricing for pairs by making the market. Many traders focused on commission costs and forget that brokers take the other side of their trades which generates a significant portion of their revenue. Dealing desk is a common term used in the industry, which indicates that brokers will provide liquidity and execution themselves, ie. take the other side of your trades. They are basically running two books on their end; a book where all traders are offset right away with LPs (limited partnerships, i.e. banks) and a "B book," where trades are kept internally.
Why would a broker avoid offsetting your trades?
Well, it's simple. They make a lot of money from your losses. It's no surprise to anyone that most traders lose money trading. Therefore, if an exchange can identify a book of clients who have consistently failed to time the market and lost money, they end up being part of the B book and thus generating revenue for the broker. This practice creates a conflict of interest between the price provider (the exchange) and their traders.
Exchanges will make more money by taking the other side of trades from these clients than the commissions they charge. Simply put, exchanges would prefer for you to lose money on trades. Since they control the price feed in this highly leveraged market, they’re often accused of “stop hunting.” Exchanges have the ability to see pending orders like stop losses. If they see a significant saturation of these orders at one price, they can “move” their prices to trigger them. And since they are on the other side of your trades, you lose and they win.
This practice became a big concern for traders. Keep in mind, this practice is completely legal from a regulatory standpoint. Brokers use this strategy to provide liquidity.
Now, you may ask, how does this relate to crypto exchanges?
Well, even though you can see the liquidity book, it's fair to say that multiple layers of that book are saturated with internal market makers that act as a “dealing desk.” These market makers have similar access to seeing stop-loss orders, and the weight of leverage behind them. We often see prices differ between exchanges, and traders can often find themselves stopped out of a trade because the price went to their stop loss on that particular exchange. However, other exchanges might not show a price reaching your stop loss, in which case your trade could still be open. This practice can trigger predatory trading from the exchange. It's important to keep this in mind when selecting your trading platform and LP.
How do we remedy this issue?
In forex, my company took a different approach. Instead of us making the price and being the LP, we provided access to 12+ liquidity providers (banks) that can’t see your orders. Meanwhile, LPs would compete to provide the best competitive market price for traders. This helped to protect traders from predatory stop-loss hunting. I have still yet to see a reasonable platform that gives access to multiple exchanges and protects your orders.
I have seen projects in the past that tried to make it possible, which made me very excited about the future of crypto trading. However, most of these projects failed to deliver the product. A great amount of these projects lost the money they raised because they did not hedge the risk of market volatility. I’m looking forward to seeing a platform with at least 12+ exchanges that aggregate pricing and hide your orders.
Eventually, this will help all exchanges to sync prices and have less arbitrage.