How market fragmentation impacts OTC trading: Report

The crypto market is one of the most fragmented financial ecosystems in history. Unlike traditional markets, where liquidity coalesces around a few dominant exchanges, crypto trading occurs across over 700 exchanges worldwide. This fragmentation presents opportunities and challenges, but it poses greater concerns for institutional players, as it complicates price discovery, degrades execution quality and reduces market efficiency.

In this report, Finery Markets analyzes how fragmentation affects market liquidity, transaction costs and execution efficiency. The report examines the structural differences between centralized exchanges, decentralized exchanges and OTC markets. It particularly covers market fragmentation in OTC markets and how institutions navigate these complexities.

Fragmentation: A Paradox of Competition and Inefficiency

Market fragmentation in crypto is a paradox. In contrast to consolidated markets, where traders compete for the best price at the same venue,  the competition shifts venues in fragmented markets. This forces exchanges to compete through cost structures, incentives and better liquidity. While fragmentation drives innovation, it also spreads liquidity across multiple venues, which makes execution more complex and costly.

The impact of market fragmentation is especially evident in OTC markets, where it affects both execution models and post-trade settlements. Compared to centralized and decentralized exchanges, which use order-driven models for price discovery, OTC markets rely on a quote-driven system through bilateral agreements, electronic communication networks (ECNs) and smart order routers (SORs). ECNs facilitate direct trade execution by matching liquidity takers with liquidity providers without intermediaries. Meanwhile, SORs scan multiple venues to optimize execution and direct orders to the best available liquidity sources.

The lack of centralized reporting in OTC markets complicates liquidity aggregation and forces market participants to rely on liquidity providers (LPs) to absorb order flow imbalances. LPs, in turn, offer firm or indicative pricing, which deepens liquidity but reduces transparency compared to traditional order books.

Hybrid execution models are emerging to mitigate this. They integrate order book depth with private request-for-quote (RFQ) mechanisms. These models combine the transparency of order-driven markets with the efficiency of RFQ systems to improve execution quality and liquidity sourcing.

Post-trade settlements in OTC markets also remain underdeveloped. Unlike exchanges that internally match and settle orders, OTC transactions depend on external custody solutions, which extend settlement times and increase counterparty risk. The absence of standardized clearing mechanisms leaves bilateral settlement as the default and adds complexity to post-trade operations. These inefficiencies discourage institutional participation, heighten operational risks and reduce capital efficiency. As market participation expands, establishing a standardized execution protocol across venues will be essential to minimize fragmentation and improve market scalability.

Impact of regulatory developments and institutional adoption on market fragmentation

Beyond technological inefficiencies, market fragmentation has also been influenced by the regulatory divergence across jurisdictions. The uneven regulatory landscape raises operational costs and forces firms to navigate complex compliance requirements. In response, many crypto companies are proactively seeking additional licenses to align with evolving regulations. For instance, under the leadership of CEO Richard Teng, Binance has expanded its regulatory approvals to 21 countries, which signals a broader industry shift toward compliance and institutional market maturity.

This shift is expected to accelerate as policymakers clarify their stance on crypto. Regulatory developments will also influence institutional capital flows in the coming years. The pro-crypto stance of US President Donald Trump’s administration and Europe’s MiCA framework are two such examples. Major firms such as BlackRock, Fidelity and JPMorgan Chase have already launched crypto-related services and products. At the same time, M&A activity in crypto is increasing, with Q1 2024 deal activity up 22%.

As more firms enter the space, market infrastructure must evolve to reduce inefficiencies and improve execution quality. 

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