Spot trading involves directly purchasing or selling financial instruments and assets such as cryptocurrencies, forex, stocks, or bonds. Delivery of the asset is often immediate. Spot trading occurs in spot markets, which are either exchange-based or over-the-counter (directly between traders). When trading on spot markets, you can only use assets you own - there is no leverage or margin.
Centralized exchanges for spot trading manage regulatory compliance, security, custody, and other factors to make trading easier. In return, exchanges take transaction fees. Decentralized exchanges provide a similar service but through blockchain smart contracts.
Introduction
Spot trading offers a simple way to invest and trade. With crypto investing, your first experience will likely be a spot transaction in the spot market, for example buying BNB at the market price and HODLing.
Spot markets exist across different asset classes, including cryptocurrencies, shares, commodities, forex, and bonds. You're probably more familiar with spot markets and spot trading than you think. Some of the most popular markets, like the NASDAQ or NYSE (New York Stock Exchange), are spot markets.
What’s a Spot Market?
A spot market is a financial market open to the public where assets trade immediately. A buyer purchases an asset with fiat or another medium of exchange from a seller. Delivery of the asset is often immediate, but this depends on what’s being traded.
Spot markets are also known as cash markets because traders make payments upfront. Spot markets come in different forms, and third parties, known as exchanges, typically facilitate trading. You can also trade directly with others in over-the-counter (OTC) trades. We'll dive into these later.
What’s Spot Trading?
Spot traders try to make profits in the market by purchasing assets and hoping they’ll rise in value. They can sell their assets later on the spot market for a profit when the price increases. Spot traders can also short the market. This process involves selling financial assets and repurchasing more when the price decreases.
The current market price of an asset is known as the spot price. Using a market order on an exchange, you can purchase or sell your holdings immediately at the best available spot price. However, there’s no guarantee that the market price won't change while your order executes. There also might not be enough volume to satisfy your order at the price you wanted. For example, if your order is for 10 ETH at the spot price, but only 3 are on offer, you will have to fill the rest of your order with ETH at a different price.
Spot prices update in real-time and change as orders match. Over-the-counter spot trading works differently. You can secure a fixed amount and price directly from another party without an order book.
Depending on the asset, delivery is immediate or typically within T+2 days. T+2 is the trade date plus two business days. Traditionally, shares and equities required the transfer of physical certificates. The foreign exchange market also previously transferred currencies via physical cash, wire, or deposit. Now with digitized systems, delivery takes place almost immediately. Crypto markets, however, operate 24/7 allowing for usually instant trades. Peer-to-Peer trading or OTC can however take longer for delivery.
Exchanges vs. Over-The-Counter
Spot trading isn't just limited to one single place. While most individuals will do spot trading on exchanges, you can also trade directly with others without a third party. As mentioned, these sales and purchases are known as over-the-counter trades. Each spot market has its own differences.
Centralized exchanges
Exchanges come in two forms: centralized and decentralized. A centralized exchange manages the trading of assets like cryptocurrencies, forex, and commodities. The exchange acts as an intermediary between market participants and as a custodian of the traded assets. To use a centralized exchange, you have to load up your account with the fiat or crypto you want to trade.
A serious centralized exchange needs to make sure transactions occur smoothly. Other responsibilities include regulatory compliance, KYC (Know Your Customer), fair pricing, security, and customer protection. In return, the exchange charges fees on transactions, listings, and other trading activities. Because of this, exchanges can profit in both bull and bear markets, as long as they have enough users and trading volume.
Decentralized exchanges
A decentralized exchange (DEX) is another type of exchange most commonly seen with cryptocurrencies. A DEX offers many of the same basic services as a centralized exchange. However, DEXs match buying and selling orders through the use of blockchain technology. In most cases, DEX users don’t need to create an account and can trade directly with one another, without the need for transferring assets onto the DEX.
Trading occurs directly from the traders' wallets through smart contracts. These are self-executing pieces of code on a blockchain. Many users prefer the experience of a DEX as it provides more privacy and freedom than a standard exchange. However, this comes with a tradeoff. For example, the lack of KYC and customer support can be a problem if you happen to have issues..
Some DEXs use an order book model, such as Binance DEX. A more recent development is the Automated Market Maker (AMM) model like Pancake Swap and Uniswap. AMMs also use smart contracts but implement a different model to determine prices. Buyers use funds in a liquidity pool to swap their tokens. Liquidity providers who provide the pool’s funds charge transaction fees for anyone who uses the pool.
Over-the-counter
On the other end, we have over-the-counter trading, sometimes known as off-exchange trading. Financial assets and securities are traded directly between brokers, traders, and dealers. Spot trading in the OTC market uses multiple communication methods to organize trades, including phones and instant messaging.
OTC trades have some benefits from not needing to use an order book. If you’re trading an asset with low liquidity, such as small-cap coins, a large order can cause slippage. The exchange often can't totally fill your order at the price wanted, so you have to take higher prices to complete the order. For this reason, large OTC trades often get better prices.
Note that even liquid assets like BTC can experience slippage when the orders are too large. So large BTC orders can also benefit from OTC trades.
