OTC desks, brokers and prime brokerage

A large share of institutional crypto volume never touches a public order book. It is negotiated with over-the-counter (OTC) desks, routed through brokers and financed by prime brokers. These relationships solve real problems of size and capital efficiency, but they also create credit exposures that were at the center of the 2022 failures, so the professional's job is to know exactly who owes what to whom, and when.

Why trade off-exchange

Suppose a fund wants to buy 500 BTC. If the visible order book holds only 150 BTC of offers within 1% of the mid-price, a market order would walk the book and pay several percent more than the screen price, and everyone watching would see the buyer. An OTC desk quotes the whole block at one price and absorbs the trade into its own inventory or works it out over time.

The main reasons to trade OTC are:

• Size: blocks too large for the visible depth on any single venue.
• Discretion: less information leakage to other traders.
• Convenience: one counterparty, one price, settlement in fiat or stablecoins, often outside exchange hours.
• Access: assets, currency pairs or settlement methods not available on exchanges.

Request for quote and block trades

The standard workflow is the request for quote (RFQ). The client asks one or several desks for a price on a given size and side, receives firm quotes valid for a few seconds, and accepts one. Many desks also stream executable prices for standard sizes through an electronic interface. For very large orders, a desk may instead work the order over hours with an algorithm such as a time-weighted average price (TWAP), or agree a price linked to a published reference rate.

Two terms matter in any OTC agreement. Last look is a short window in which the desk can reject a trade the client has accepted, usually if the market has moved; it should be disclosed and limited. Trade confirmation fixes the economic terms in writing (asset, size, price, settlement date and method), because a chat message agreeing a price is not enough when a dispute arises.

Principal or agency

Many firms do both, so the client should know in each trade which capacity the firm is acting in. A desk that is part of a group running an exchange, a market maker and a fund raises the conflict-of-interest issues discussed in the lesson Market participants and their roles.

Settlement risk and pre-funding

In traditional markets, a central counterparty and delivery-versus-payment (DvP) systems make sure that the securities and the cash change hands together. Most crypto OTC trades have neither. One side must send first, and the side that sends first is exposed if the other fails to deliver. This is settlement risk, sometimes called Herstatt risk after a German bank that failed in 1974 in the middle of settling currency trades.

Desks manage it in three ways:

1. Pre-funding: the client deposits cash or crypto with the desk before trading. This removes the desk's risk but transfers all of it to the client, who becomes an unsecured creditor of the desk for the deposited amount.
2. Sequential settlement with limits: the party judged stronger receives first, within a credit limit for the other side.
3. Escrow or custodian-based settlement: both legs are delivered to a neutral custodian or settlement network, which releases them only when both have arrived, a form of DvP.

A worked example: a client buys 10 million dollars of ETH and the desk's policy is "client pays first, desk delivers within two hours". For those two hours, the client has a 10 million dollar unsecured exposure to the desk. A client doing this daily with three desks should measure that exposure like any other credit line.

Credit lines and prime brokerage

Large clients rarely want to pre-fund. Desks therefore grant credit lines: the right to trade now and settle later, or to carry a negative balance up to a limit, usually backed by collateral and a margin agreement.

A prime broker bundles this credit with other services in one relationship:

• Custody of client assets, often through an affiliated or third-party custodian.
• Financing: margin loans in fiat or stablecoins against crypto collateral, and borrowing of tokens for short sales.
• Cross-venue execution and margining: the client trades on many exchanges through one account and posts collateral once.
• Consolidated reporting of positions, profit and loss, and risk.

The weakness is concentration: the prime broker becomes a single point of failure holding the client's assets and its credit. The 2022 crisis showed it from the lender's side. The crypto lender Genesis had lent about 2.36 billion dollars to the hedge fund Three Arrows Capital, which defaulted when markets fell in June 2022; Genesis suspended withdrawals that November and its lending business filed for bankruptcy in January 2023. Its losses passed through to the clients, including retail users of an exchange "earn" program, whose assets Genesis had borrowed.

Off-exchange settlement and tri-party collateral

After FTX, institutions became reluctant to leave large balances on exchanges. Off-exchange settlement (OES) networks let them trade on an exchange while keeping assets with a separate custodian.

The client locks collateral in an account at the custodian under a tri-party agreement between client, custodian and exchange. The exchange gives the client trading credit equal to the collateral value minus a haircut. Trades accumulate as a net balance that is settled at fixed intervals, for example daily, by moving assets between the client's locked account and the exchange. If the exchange fails, the collateral is still at the custodian; if the client fails, the exchange can claim the collateral under the agreement.

OES reduces exposure to the exchange but does not remove all risk:

Custody structures and bankruptcy remoteness are covered in the lesson Custody models and the legal side of holding assets.

Lending desks and rehypothecation

Crypto lending desks borrow assets from holders, paying interest, and lend them to traders, market makers and funds, often against less collateral than the loan value. Rehypothecation means the lender re-uses collateral it has received, for example lending it on or pledging it to its own creditors. It is common and legal in traditional prime brokerage within limits, but it creates chains: if each link re-lends the same coins, a single default can travel along the whole chain.

The 2022 failures showed what happens without limits. Celsius took customer deposits under terms that transferred ownership to it, then deployed them in loans, decentralized finance strategies and purchases of its own token. When withdrawals froze in June 2022, customers learned they were unsecured creditors.

Controls a client should require:

• Title transfer or security interest: does ownership pass to the desk (title transfer) or does the client keep ownership, with the desk holding only a security interest?
• Rehypothecation limits: none allowed, or a cap such as a percentage of the loan value, written into the contract.
• Haircuts and margin calls: collateral discounts by asset, daily valuation, and clear timelines for top-ups and liquidation.
• Disclosure: who the ultimate borrowers are and how concentrated the book is.

Exam focus: why institutions trade OTC (size, discretion, access); the RFQ workflow, last look and written trade confirmation; principal versus agency capacity and the conflicts of each; settlement risk without DvP and the three ways to manage it (pre-funding, sequential settlement with limits, custodian or escrow settlement); prime brokerage services and the concentration risk it creates (Genesis and Three Arrows Capital); how off-exchange settlement and tri-party collateral work and their residual risks; rehypothecation, title transfer versus security interest, and the contractual limits a client should require.