Why Are Digital Currency Exchanges Making a Great Fortune Easily Yet Involved In Controversy?

Before we cut to the chase, we will have to talk about exchanges.
After all, in blockchain community, the most profitable area includes the R&D and production of “mining” equipment, and digital currency exchanges. In this community, what gains the most popularity among the public would be anything related to the “coin”. “Mining” is associated with the generation of “coin” while exchanges are involved in the transaction of “coin”. In one word, this field is where the money is.
On February 7th this year, Forbes’ First List Of Cryptocurrency’s Richest is released. The founder of Binance, Changpeng Zhao ranked the third on the list, with a personal fortune as much as $2 billion(as of the end of this January), which reflected wealth-generation effect of exchanges. Once the space matures and people are ready for a more regulated market, Nasdaq is open to becoming a platform for trading cryptocurrencies, according to the company’s CEO Adena Friedman.
Speaking of transaction volume, so far in domestic China, we have some large exchanges such as Binance, Huobi and OKCoin, all of which entered top ten of the most active exchanges in the world. There is no doubt that the large population of China contributes a lot to create these world-class exchanges.
According to the statistics released by CoinMarketCap, a crypto-currency data analysis website, the top ten exchanges in terms of transaction volume included BitMEX(registered in the trading platform in the Republic of Seychelles, focusing on highly leveraged transactions), Binance, Huobi, Upbit(the largest digital currency exchange in South Korea), and international trading platforms subordinated to OKCoin, including OKEx, Bitfinex, Bittrex , Bit-Z and HitBTC.
There are two types of exchanges: centralized exchanges and decentralized exchanges. The large-scale exchanges mentioned above are centralized exchanges that operate in conventional mode. They are centralized Internet platforms on which tokens of decentralized blockchain projects are traded.
A decentralized exchange is a token trading platform based on blockchain, yet still at the initial stage.
Centralized Exchange
The well-known Shanghai and Shenzhen Stock Exchanges is a centralized exchange. Security companies take orders from clients and trade through the exchange by buying trading desks and marketing units while exchanges match the orders. Binance, Huobi and OKCoin, however, are centralized platforms for trading tokens. Users can participate in trading directly and get matched on the platform once they register. OTC transactions are also available.
In terms of trading size, the main domestic Chinese centralized trading platforms include Binance, Huobi, OKCoin and etc.
Binance
Binance was a little known platform until September 2017. On September 4th, after Chinese domestic regulators defined Initial Coin Offering(ICO) as illegal, the three major exchanges — Huobi, OKCoin and Bitcoin were required to stop trading in China, giving Binance an opportunity to grow rapidly.
Changpeng Zhao, the founder of Binance, holds Canadian citizenship. After September, he moved the platform offshored, in advance of any other exchanges. Afterwards, Binance gradually outperformed the three major exchanges. There are several reasons for the success. First of all, despite that Binance was founded later than the others, it offered token-to-token transactions earlier and forbad transactions between fiat money and tokens. Besides, the platform claimed that it prohibited Chinese domestic IP participate in tradings. It also updated its server in advance regarding regulation policies. From marketing and operating point of view, the joining of Yi He, a leader in token community, brought lots of new ideas. Strategic special events such as rebates for invitations on social media and chances to win luxury cars or gifts worth millions have gained great popularities.
So far, 290 types of tokens are traded on Binance. According to the data by March 26th 2018, the 24-hour trade volume had been more than ¥9.8 billion, ranked first among all the exchanges that charge transaction fees, and second among all exchanges, following BitMEX. Based on a transaction cost structure of 0.1%, Binance made an income on 24-hour transaction fee of almost ¥10 million.
The founder Zhao worked to establish Internet trading systems in his early years. In 2014, Zhao joined OKCoin to serve as co-founder and Chief Techonology Officer(CTO). In July 2017, he established Binance and undertook ICO. He also issued his own blockchain token BNB, with a total quantity of 200 million. The founder team, including Zhao, held 40% of the total quantity. On September 1st, shortly before the “9.4” ICO supervision storm, Binance acquired $10 million in angel rounds from FunCity Investment and BlackHole Investment. As of March 16th 2018, Binance owned 7.9 million users.
In April this year, Binance officially released its quarter report, showing that the quarter profit reached $150 million, almost ¥1 billion. Blockchain is still far away from making a profit while the exchanges in which blockchain assets are traded have made a great fortune.
Despite that Binance has been a top-class exchange, its capacity to protect transactions was threatened several times. During operating period, Binance has been through times of network attacks and DDOS attacks, resulting in failures on transactions. In early March, the news that Binance was attacked again brought crypto-currency community into chaos and made it a bear market to the public. Anonymous hackers collected 31 of Binance users’ information through network deception and special API key. They trade ViaCoin, driving the price up from $2 to over $10.
Huobi
In May 2013, Lin Li established Huobi. It once made over 50% market share of BitCoin worldwide. At present, the trade volume is ranked third, slight lower than Binance. According to the data by Monday March 26th 2018, the 24-hour trade volume went over ¥5.3 billion, and the quantity of crypto-currency and tokens in trading had been 200.
The founder team of Huobi included Jun Du, Jiawei Zhu and etc. Du has gradually faded out. He then created a program called Golden Finance and an investment institution called Node Capital.
When Huobi was firstly founded, it used to charge no transaction fee for Bitcoin transactions, which attracted a large number of users, resulting in a rapidly expanded size. In 2017, Huobi began to charge transaction fee.
In November 2013, Huobi acquired joint investment from ZhenFund and angel investor Zhikang Dai. In April 2014, it again acquired over ¥10 million from Sequoia Capital in the first round of financing. At present, Huobi is not only running a trading platform, but also investing in digital currency, blockchain information platforms such as Coin World and Golden Finance, and Coldlar, a solution provider for digital assets storage security.
OKCoin
OKCoin, founded in October 2013, was one of the earliest Chinese domestic digital assets trading platform. The founder, Mingxing Xu, was a co-founder of DocIn. According to the data on CoinMarketCap by Monday March 26th 2018, the 24-hour trade volume exceeded ¥4.1 billion. So far, more than 400 types of tokens are in trading.
On March 23rd, Giant Interactive Group Inc. announced that it would transfer the 14% shares of Oukai Joint Network Technology Co., OKCoin parent company and OKC, VIE offshore company, at a price of $2.85 million. Thus, OKCoin was estimated to worth $200 million. OKC was registered in Cayman Islands. It controls Oukai Joint which is located in China, through VIE structure. Oukai Joint is the only shareholder of OKCoin. Xu holds 78.92% of Oukai’s shares. OKC had an annual operating income of $44.77 million in 2017 and an annual net profit of $26.58 million.
In May 2017, OKCoin launched OKex, a platform of virtual assets contractual dealings. On this platform, token-to-token transactions and leveraged token futures tradings are possible. It is worth mentioning that because investors’ accounts were somehow burned with no reason when participating in futures tradings, there were several times that investors of OKCoin tried to fight for their rights and interests.
Besides the three exchanges mentioned, there are other Chinese domestic exchanges including Coinw, BiKu, ETCWin, BigONE and etc. Although the policies regarding exchanges are still ambiguous, in terms of fundamentals, exchanges are still a hot issue. After all, projects on blockchain are springing up yet there are not so many investors. It is going to last for a while when exchanges can make a fortune easily because we are not getting closer to running out of new ideas on blockchain.
But the industry structure is not solidified yet, and not a single exchange has built a real barrier. Popular projects are available at any exchange and any exchange offer air coin that fell below debut. Besides, there is no such high barrier that impedes users from switching between platforms.
Business Features of Centralized Exchanges
In terms of operation, the main exchanges are quite similar on business pattern. All of them launched international trading platforms; all of them focus on token-to-token transactions and OTC C2C transactions; all the them issued their own tokens(BNB, HT, OKB). Besides, both Binance and Huobi decide whether or not to list a token by voting using their own tokens. Previously, however, a proportionate listing fee was required for any project. After the change, users need to purchase a large number of tokens on the platform in order to get publicly traded. And it usually costs over $10 million.
Meanwhile, this voting mechanism has been controversial. For exchanges, more tokens mean more transactions. However, if there is any big yet bad project that results in investors suffering heavy losses, the platform is likely to lose good reputation and trade volume. The main exchanges of today all claim to have their own regime of tokens going public, taking into account project prospects, the necessity of applied blockchain, team background and policy environment. But the public never knows how they actually practice.
Zhao of Binance once released an open letter, stating that the bottleneck for a token listing is how fast the auditing would be. Before a token goes public, Binance needs to go over the white paper, seek for industry professions’ opinions, download and use the product, install token wallet, study community discussion of the token, examine how the project’s code is submitted on GitHub, and under most cases review the source code of the project. However, Yinhai Zhang, the CEO of Dianfu Technology Ltd. in a group chat named “3am sleepless blockchain” claimed that he could not find the token he wanted on OKEx, HuobiPro and Binance. He found that there were many exchanges that decide which token to list based on whichever they receive most money from and whichever they have a good connection with. He also doubted the standard according to which Binance list their tokens.
The top exchanges are basically trying to carry out an “Exchange+Blockchain Media+Investment Funds” layout. OKCoin set up OK capital, s blockchain community venture capital fund, while Huobi established a global eco-fund of $200 million, using platform pass HT as circulation medium, aimed at integrating all upstream, midstream and downstream business of the industry chain. Yi He, the co-founder of Binance created a program called BABI Finance; Huobi used to be a leader in digital currency investment community Coin World and holds some shares of Golden Finance. Nowadays there are hundreds of medias of blockchain. Most of their investment status is unknown. Exchanges might have played a role in their investors. The layout of “Exchange+Blockchain Media+Investment Funds” is enhancing the top exchanges’ control over industry resources.
Besides, probably in order to develop blockchain business, or to avoid rumor on regulation and the down time on public opinions, both OKCoin and Binance are developing their own blockchain products.
In February 2018, Xu, the founder and CEO of OKCoin resigned from the executive team. And the overseas team would be taking charge of the exchange Okex and Xu would be in charge of the development on OKchain blockchain business. But OKchain did not release any detailed information yet. On March 13th, Binance issued a statement claiming that they are developing a public blockchain to establish a decentralized trading platform. On the platform, users can transfer and trade blockchain assets through Binance Chain. But what stage the project is at and what time it will come out still remained unknown.
Overall, the major exchanges are winners in this recent wave of virtual currency and digital token. They stood on the peak of the wave, making profits through token listings and commissions on transactions. Regardless of business ethics and law, the business model those exchanges are conducting are definitely one of the few mature models of blockchain economies today. The way they make profits is simple yet effective, meeting the core needs of both token issuers and investors.
On the other hand, regarding the huge number of transactions on these platforms, some voices point out that the number might have been fake as a result of deliberately boosting transactions. In March, Sylvian, a foreign author published an article on media platform Medium based on his conclusion from a data analysis. He claimed that counterfeiting transactions did exist in OKEX exchange, and 93% of the trade volume was counterfeit. Counterfeit on trade volume exists in Huobi, Binance and Lbank and etc., which made up 70%-90% of the their total trade volume.
Regarding the problem, OKex responds that there are many users doing quantitative tradings and derivative hedgings on OKex. Thus there are many program tradings. Also most users tend to be active during daytime and not so much during nighttime. OKex never intervene data and would not bother to make any so called “fake data”. No one knows who is telling the truth. In the industry competition, however, “boosting” volume might be a problem of not “yes or no”, but rather “more or less”.
Decentralized Exchanges
The main concept of blockchain is decentralized P2P transaction. Yet the exchanges mentioned above with large trade volume are centralized exchanges. They have advantages of faster transactions, out-of-chain orders match and out-of-chain settlement. But the concerns are capital security problem and potential problems raised by information asymmetry, such as price manipulation and fraud.
A decentralized exchange is where token transactions are run on blockchain to realize P2P transactions and transaction data are recorded on every single block. In a decentralized exchange, users do not need to provide personal information to the exchange. They trade through public keys and wallets, and trust funds to smart contracts. Fund trust, order matching, assets liquidation are all conducted on blockchain. Yet in a centralized exchange, there is an account system for users. An exchange system for fiat money and token is also necessary. Fund trust, order matching and assets liquidation are conducted on centralized Internet framework.
At present, large-scale decentralized exchanges include DEW, IDEX, Bancor, Bitshares, Etherdelta, Ox, Kyber, Airswap, Stex, Loopring and etc. These exchanges tried to run blockchain assets on blockchain in order to realize decentralized transaction. Since they do not have mature technology and mode yet, there is only a low trade volume.
So far, only DEW, IDEX and Bitshare stepped into world’s top 100 decentralized exchanges, with their rankings after 50. EtherDelta(also named Yide), who used to have a high trade volume, is now closed.
EtherDelta established a trading system based on Ethereum smart contract to realize distributed decentralized encrypted signature transactions. Users do not need to log in. They just have to set up or lead in wallets and trade through public keys. Users operate on EtherDelta web interface and transactions are conducted through EtherDelta smart contract. The contract contains a list of user assets and a list of orders. The order list shows present traded orders and pending orders. The user assets list serves as a deposit to protect token assets and to guarantee an asset settlement for traded orders.
In early 2018, because of ownership problems and internal conflicts, EtherDelta had to close.
DEW, subordinated to British DEW Foundation, is a distributed asset exchange based on Ethereum. Besides transactions on BitCoin, ETH and etc, there are also transactions on stocks, foreign exchanges, ETF, quiz contracts, blockchain index and etc. According to the transaction process, these traditional assets are traded for DEW, and the DEW are then exchanged for other investment targets. On DEW platform, inflows and outflows of capital are conducted through smart contracts. Users need to bind a withdrawal address to generate a smart contract deposit address. They deposit to the address before they make transactions.
Bancor project was launched in 2017 and managed by Bprotocol Foundation. In June 2017, it raised $153 million of ETH through ICO and broke industry record.
Bitshares is an elder decentralized exchange. Besides digital token trading, it also issues assets and manage assets. Bitshare is a representative of Graphene Ecology. Compared with BitCoin Ecology and Ethereum Ecology, Graphene adopted consensus mechanism from DPOS, with a generation speed of 1.5s,resulting in a larger transactional throughput in blockchain application. BTS can process 1 million times as much as TPS does.
Ideally, decentralized exchanges can prevent transaction information being tampered. They can also enhance trust mechanism, consensus mechanism and smart contract to guarantee that transactions are done under a set of rules. At present, however, the technology is not perfect yet. How fast a transaction is confirmed is subject to the performance of blockchain. It is hard to conduct large transactions. In addition, regarding how a decentralized exchange should operate, there is no experience to learn from. How to balance between a decentralized transaction and a centralized team? How to allocate tokens after issuance? All of these are potential problems. Moreover, the security problem of the platform still remains concerned. Although blockchain helps prevent information from being tampered, technical protection is necessary to guarantee the security of users’ public keys.
Will decentralized exchanges take place of centralized exchanges? So far we do not see any superiority on decentralized exchanges.
Due to limited node scale, insufficient encryption technique and lack of system stability, decentralized exchanges often suffers from hacker attacks. The feature of safety is not obvious yet. To users, they do not see anything special on decentralized exchanges.
Problems
Virtual currency and token exchange are discouraged by not only supervision but also public opinions. After all, to those exchanges, there are still a lot of problems waiting for solutions.
The core problem is how to respond to supervision. Exchanges are making money quietly, yet the uncertainty of government supervision is still a sword of Damocles for them. In China, ICO was forbidden in September last year and transactions on digital currency such BitCoin were banned. Exchanges had to move towards overseas market. In fact, Chinese users can still participate in investments through VPN or OTC C2C trading.
In other countries, governments are not so easy with exchanges either. Binance tried to headquarter in Japan, but failed to acquire license. On March 23rd this year, Japanese Financial Services Agency(FSA) who has recently strengthened supervision on digital currency, warned Binance for operating while unregistered. The headquarters of Binance has been moved to the Republic of Malta.
In general, even if governments do not oppose transactions between crypto-currency such as BitCoin, they are most likely to reinforce the managements of ICO gradually. Policies tend to be stricter for sure. This is a constraint for exchanges since token issuance fee and transaction fee contribute a lot to their operating income.
Domestically, Chinese financial supervision focus on capital inflow towards the real economy while exchanges are more likely to encourage asset bubbles. To be honest, so far there is not much evidence that exchanges support innovation. Projects on token issued were mostly not decent and reliable. Even fewer were put into action. Thus we cannot tell how much they contributed to the real economy. From this perspective, it is hardly possible to restore transactions of virtual currency and tokens. In other words, those domestic exchanges have to operate overseas or to get around the ban to attract domestic investors.
But recently policies seem to be eased. The central bank claimed that after a thorough searching, all the ICO platforms and exchanges for virtual currency such as BitCoin have quitted with no risk. It is most likely that a stricter policy would not be enacted.
Moreover, those exchanges are concerned by information security problem.Although called an exchange, its performance on protecting transactions is quite poor comparing to a traditional stock exchange. Frequent security bugs happened in several exchanges resulting in losses for investors.
At the end of September 2017, several users of OKEX and OKCoin disclosed that their accounts were hacked and the losses ranged from $10 thousand to over a million. In late night March 7th this year, the trading system of Binance suddenly failed and numbers of users lost their accounts. More than 20 types of token in their accounts were secretly sold at market price and changed to BitCoin. And websites of platforms such as Huobi and OKEX were unavailable. In other countries, Bitfinex was once hacked and almost 119,756 BitCoin, which are worth $75 million, were stolen. Youbit, a Korean exchange, had 4000 of their BitCoin stolen. It was hacked again afterwards and lost so much that it had to file for bankruptcy.
A more classic case was that on February 28th 2014, Mt.Gox, the largest BitCoin exchange at that time announced that because 850 thousand BitCoin on the trading platform were stolen, it seek for bankruptcy protection from Tokyo District Court in Japan.
Obviously, even as normal platforms for investment and speculation, these exchanges have a lot to work on. It is fundamental for an exchange to guarantee a smooth trading process and to ensure users account security. If they were frequently hacked resulting in transaction failures or even users’ loss, they would be unqualified.
At present, the exchanges are not yet qualified infrastructure for digital currency.
One of the key factors affecting the development of exchanges is that a large number of token prices fell below their issue prices. Once investors suffer a loss, they must walk away from exchange platforms. Realities are that there are lots of projects in which market price of the token falls below debut and the possibility of such situation is quite high. According to Synchronized Finance, a blockchain media, in the 247 virtual currencies listed in exchanges after 2018, 87.5% of them have their market prices under the issue price for a long time. Investors are going to be negative about tokens and exchanges if they do not see an apparent wealth effect.
Whether a mature token issuance system is to be formed and whether a correct decision is to be made in between projects is probably a key factor in deciding future industry structure. Theoretically, exchanges would carefully select good projects for their long-term development. However, it is not guaranteed that they would not sacrifice their integrity if provided good compensations from bad projects. In addition, it does take time to develop mature project evaluating skills.
