Bitcoin OTC: overview of a nascent (and sometimes scary) market

Buying or selling Bitcoins (BTC) or other popular cryptocurrencies does not take place only through publicized exchange platforms like Coinbase or Binance.

Large amounts of BTC transactions are executed in more discreet environments, the so-called “over the counter” (OTC) transactions, where the parties don’t want to disclose their identities or influence the market value, or simply believe they will benefit from better conditions.

Based on our own experience of this new market, we believed an overview of the main practices we have observed so far would be helpful for a number of persons willing to get involved in those particular transactions.

We should start by noting that there is rampant fraud in this space. There are lots of people offering coins for sale which do not exist, and lots of false buyers who have no funds. There are also lots of intermediaries pitching deals which do not exist. In most cases, these individuals are seeking some sort of value from the parties. They could be hunting legitimate counterparties to then pitch to a client, or they can be committing fraud/theft attempts as they attempt to extract information from a counterparty. We have seen people defrauded of large amounts of money, and lots of people have wasted time and money on seemingly legitimate transactions that collapse at a late stage. Please be extremely careful.

In 99% of all discussions we have observed to date, Bitcoin is the sole instrument traded OTC at scale. It is interesting to note that in any general conversation around OTC trading, people in some cases do not even mention the instrument in question, as it is so fully expected that it is solely Bitcoin. Only Ether has come up as an alternate, and only in very unique situations.

There are three key items that have to be solved in order for a deal to be likely to be formed. In practice, the two forms of proof quoted below are far more important than price.

Price 

OTC offers are usually quoted as percentage points of discount to the market price of BTC. Typically this can be shown as something like -6/-3, where the seller is offering their BTC at 6% below par, and the buyer being offered to buy at 3% below par. Any spread, in this example 3% is expected to be distributed to any intermediating parties to the transaction as compensation. What is important to note here, which I personally find to be a major deficiency in this market, is that almost nobody specifies what price they are benchmarked against. I.e. coinmarket cap, or another source, and rarely is it discussed if a transaction is to be completed with a price from a specific snapshot in time, or on a weighted average etc. For Quantex we have already designed price solution concepts to address this.

Proof of Funds (POF)

Where the buyer proves to the seller that they have sufficient funds available in order to complete the transaction. Precisely how the buyer is able to show the funds can vary greatly between buyers, and how the seller wishes to see the proof of funds can also vary substantially. In some cases a seller will demand something as simple as a screenshot of a bank balance showing at least a specific amount of money. In other cases, the seller demands the buyer complete a SWIFT message (usually MT199/799) for delivery to the buyer’s bank. These messages confirm an unencumbered total balance of funds at a given account, and are extremely good proof of fund availability.

Risk note

If a buyer provides a POF in a Swift message, and also provides sufficient identity info the seller, it is possible for a seller to commit fraud and either steal the identity of the buyer, take a lien against the MT messages from the bank, or other fraud. It is very important to be hyper vigilant in providing only as much information as seems safe given the counterparty.

Proof of Coin (POC)

The mechanism through which a seller demonstrates to a buyer that they genuinely possess a certain balance of coins to sell. This can be done in a few different ways, and often the buyer or seller will have a personal preference regarding how to do this. Often this is the most contentious aspect, as a buyer who is unable to see POC in a format they prefer may decide to not partake in a trade at all.

As you know, providing a simple public address with a balance is insufficient. A proof of the ability to manipulate coins is mandatory to show you genuinely own them. Thus, the simplest and often highest valued form of POC is the “Satoshi test”, where the seller sends the buyer one satoshi from an address they control, to the address of choice provided by the buyer. The intent is that a large wallet balance at the sending address should provide proof the seller has lots of coins available. Often this can still be impossible to know for sure, as a large position is almost always split amongst many individual addresses.

Letter of Attestations are also often offered, where a seller has an attorney or other official provide an attestation that they have observed the seller demonstrating true ownership of the coins. This can for example be through a technical demonstration of manipulation of wallets, or something else satisfactory to the attorney. Note, many attorneys still do not really understand what they are observing with bitcoin/blockchain assets, and are at risk of being fooled by a fraudulent proof of coin.

The Transaction:

When a buyer and seller have sufficiently proven to each other that the coins and money are real, and the price is reasonable, they draw up a sales contract which specifies precise mechanics of exchange, such as amounts per transaction (f split into multiple batches), bank details, if the deal is face to face, or over the internet only, etc. At the same time an Irrevocable Master Fee Protection Agreement is written that defines the compensation to each seller/buyer representative and intermediary.

Escrow platforms

An emerging offering is the arrival of escrow services for both fiat and crypto sides of a trade to minimize the risk involved in bilateral trades to counterparty risk of failed completion, or any concern about the actual funds/crypto available. Etana, Volantis, and others exist which provide this service. A user can upload coins to their account on the platform, and wire money in as well. Users can find each other on the platform and create an agreement online, which moves the money/crypto in an off-chain transaction between the users. Fees are in the 1% per deal range. These platforms are often still not showing very large deal size, best for 100-1000 BTC.

Parties to a deal

Here are the general types of parties you are likely to encounter who are part of a transaction :

Seller Mandate: the brokerage/lawyer/trusted agent who is actually tasked with selling the coins, and has the legal right to act on the seller’s behalf to execute a deal. They also enable privacy for the actual seller who almost never reveals their identity. These people usually take about !% of a deal as a fee, and cover the costs of escrow, legal, etc out of that fee.

Buyer Mandate: the brokerage/lawyer/trusted agent who is actually tasked with buying the coins, and has the legal right to act on the buyer’s behalf to execute a deal including holding the money with power of attorney.. They also enable privacy for the actual buyer who almost never reveals their identity. These people usually take about !% of a deal as a fee, and cover the costs of escrow, legal, etc out of that fee.

Intermediaries: The agents, usually individuals doing this professionally or semi-professionally, who have an interconnected web of contacts on either the buying or selling side of the equation who play matchmaker for deal flow they see where they can find the right combination of characteristics between a buyer/seller’s desires (price, terms to complete deal, size, etc). This can often end up being a long chain with several introducers until you ultimately see the full list of people connecting the buyer/seller mandates together. Compensation here is a split of whatever spread is left after the buyer/seller mandates take their fee first. It can range from 10bps to 50bps depending on those factors.

Regulatory framework

We will address the regulatory issues around Bitcoin OTC in our next article.


Written with John Willock, CEO Quantex.io

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