Crypto Exchanges: a Growing Divide
As cryptocurrency speculation has increased along with the hype about the potential of blockchain technology, cryptocurrency exchanges have been incredibly successful. However, there’s a growing divide amongst exchanges. Some exchanges are moving towards improved standards and heightened regulatory oversight as increasingly “legitimate” players from the traditional financial world enter the space. Meanwhile other exchanges play regulatory arbitrage or push for decentralized alternatives. Worryingly, many exchanges continue to engage in questionable practices that threaten to have long-lasting negative impacts on the crypto community.
The growth in the crypto exchange industry has been phenomenal. Just two years ago, Coinmarketcap listed about a hundred exchanges, with the vast majority seeing only minimal trading volume. In August 2016, the top 10 exchanges accounted for around $1 billion in cryptocurrencies traded per day.
Today Coinmarketcap lists over 200 exchanges, averaging a total of more than $10 billion in volume per day. Of course, Coinmarketcap doesn’t include derivatives markets like the hugely popular BitMEX, which, on its own, has been averaging around $1 billion in daily volume. Some estimates have put the total number of exchanges at closer to 500 with the daily volume exceeding $20 billion.
As for users per exchange, the rise has been meteoric. In January 2018, it was reported that exchanges were signing up more than 100,000 new users each day. Popular US exchange Coinbase’s user numbers went from less than half a million at the start of 2017 to over 4 million by the end of the year, making it twice as popular (by user numbers) as US brokerage giant Charles Schwab.
Exchanges are currently by far the most profitable segment of the crypto industry, where speculation remains the only use-case that has so far gained significant traction.
Binance represents the quintessential unicorn in the space. Rising from nothing to most used global crypto exchange in a matter of months, Binance expects to bring in $1 Billion in profits this year. The crypto-only exchange claims to have 10 million users and the capacity to handle 1.4 million transactions per second.
While top exchanges like Binance, Coinbase, Kraken, and Huobi were all started by “crypto outsiders” the incredible profits they’ve been posting have finally attracted “Wall Street insiders.”
In Japan established public companies like SBI Group, Line Corp, and Yahoo! Japan are just a few of the more than 160 entities that have announced plans to create exchanges, according to the Japanese Financial Services Agency. The value of an approved crypto-exchange in Japan is so great that when Japan based Zaif Exchange got hacked for over $60 million in September, there was an immediate offer of $44.5 million from rival exchange FISCO to acquire a major stake in the platform.
The trend of established traditional players entering the crypto exchange business is the same in Europe. The Gibraltar Stock Exchange (GSX) launched the Gibraltar Blockchain Exchange (GBX) in June aiming to become one of the first licensed and regulated digital asset exchanges operated by an EU regulated stock exchange. Other new entrants to the space such as Blocktrade, which launched this summer, are focusing on strict adherence to regulation in order to attract institutional investors.
In the US, the trend is similar, with Wall Street joining the crypto exchange space in a big way. In August Intercontinental Exchange — the trading colossus that owns the New York Stock Exchange and other global marketplaces — announced that it is forming a new company called Bakkt that will create an integrated platform to enable consumers, merchants, and institutional clients to buy, sell, store, and spend digital assets in a “seamless global network,” according to a press release. In September Bakkt, which is partnered with Microsoft and Starbucks among other heavyweights from the worlds of technology, consulting, and retail, announced via Twitter its first product would be futures against at least three fiat currencies: the U.S. dollar, British pound sterling and euro.
Clearly crypto exchanges have a bright future amongst global financial giants, but there’s a dark-side to this fast-emerging, sometimes-regulated industry.
Not all Exchanges are Created Equal
Of the hundreds of crypto exchanges now in existence, this is a huge gap in quality between the top let’s say 30, and the bottom 100.
With so many players in the space, it’s inevitable that some are either just half-hearted attempts, or perhaps operated by startups that don’t have the technical skills to compete with the top exchanges. If you’ve ever tried using a low-tier exchange to trade that diamond-in-the-rough small market-cap coin you love, you’ll know user experience often leaves a lot to be desired. The problems range from being merely annoying — such as confusing layout — to disastrous, such as downed servers.
In many exchanges the fees are far from transparent. A commonly reported experience is getting slapped in the face with a huge withdrawal fee when trying to move coins off the exchange (before it gets hacked).
By far the biggest problem faced by the smaller exchanges though, is the lack of liquidity; and it’s here where the real “fuckery” begins.
Every trader knows that you need decent liquidity to smoothly make trades and prevent slippage, so naturally trading volume tends to accumulate on just a few of the biggest exchanges. Therefore in an effort to attract users — as has become a widely known “secret” — exchanges misrepresent the amount of volume they process. This is done either through outright manipulation of the numbers or, more commonly, through so-called “wash-trading” — a process of pointless trading back and forth between multiple accounts all setup by the same entity, that gives the illusion of high trade volume.
While exchange operators are not likely to be directly involved in wash-trading themselves, they tend to turn a blind eye because, as mentioned, high-volume begets high-volume, plus exchanges earn trading fees based on volume.
Wash trading appears to be the most rampant among Asian-based exchanges. A phenomenon that has come to be dominated by the so-called “Market Makers,” which — according to founder and CIO at US-based crypto hedge fund Ikigai Asset Management, Travis Kling — consists of about 10 big players. In a September podcast interview with Anthony Pompliano — well-known crypto commentator and founding partner at investment firm Morgan Creek Digital — Kling noted that the Asian Market Makers have been known to engage in actual written contracts with new ICOs to guarantee a certain volume and market price through wash-trading. According to Kling, the contract typically consists of the market makers being giving a significant portion of the newly issued tokens — as high as 10% plus a payout in ETH — then using those tokens to manipulate the market. Observing WeChat groups, one can watch as the market makers discuss deliberately painting technical indicators like bull flags and rising wedges, according to Kling.
“The more retailish you are, the more you are guaranteed to lose money in this process,” said Kling in the discussion.
“It’s psychological warfare against retail investors,” added Pompliano.
Wash trading is illegal in most jurisdictions but the laws are hardly enforced outside the US and Europe. In the US, top regulated exchanges have made a serious effort to eliminate it. Coinbase Pro (formerly GDAX) and CFTC regulated bitcoin swaps facility LedgerX both have a zero tolerance policy on wash trading and have been known to ban accounts suspected of even small amounts.
One recent study suggested that London based HitBTC and Hong Kong based OKex have the highest levels of wash trading. South Korean based Bithumb also recently came under fire for supposedly allowing $250 million/day in wash trading.
Binance is also one of the exchanges that has been criticized for not doing enough to stop it. In a September interview, Binance Founder and CEO Changpeng Zhao addressed the issue, claiming it’s hard for exchanges to stop it. “It’s very hard to define quantitatively what it is without them being able to go against the rules. Let’s say if you trade over $100K in five minutes against each other, that we define that as wash trading: guess what’s going to happen? They are going to trade $99K every 5 min and they are going to have three or four accounts trading against each other.”
Binance and other top exchanges have additionally been accused of questionable practices surrounding their procedure for the listing of coins, with many blockchain startups complaining of unreasonable listing fee demands and favoritism. According to Christopher Franko, co-founder of blockchain platform Expanse, Binance requested in August 400 BTC (worth $2.6 million at the time) to list the Expanse coin.
In October there was widely retweeted tweet-storm from Digibyte blockchain founder Jared Tate alleging Binance attempted to extort fees from Digibyte despite the decentralized payment network and digital currency winning a Twitter poll for a DGB listing and having the listing “promised” by Binance.
To its credit, in a Medium post seemingly written in response to mounting criticism, Binance said moving forward it would disclose fees that arise in the process of getting a coin listed on the exchange and donate all listing fees to charity.
The Regulators are Coming
The freewheeling days of questionable practices have been allowed largely because crypto-exchanges have flown under the radar for much of their brief history, but that’s about it to change in a big way.
In Europe several top exchanges have been operating using licenses obtained under the EU Payment Services Directive and the EU Electronic Money Directive, but the adequacy of such licenses for the legal operation of a crypto exchange has not yet been judicially tested. In response to this the European Council and the European Parliament have announced that they will issue regulations to impose stricter rules targeting exchange platforms.
Similarly strict regulation is coming in the US. In 2018, the US Securities and Exchange Commission maintained that “if a platform offers trading of digital assets that are securities and operates as an ‘exchange,’ as defined by the federal securities laws, then the platform must register with the SEC as a national securities exchange or be exempt from registration”.
Is Decentralized the Future?
Existing decentralized exchanges such as Etherdelta, IDEX and HADAX do not store users’ funds on the exchange, but instead facilitate peer-to-peer cryptocurrency trading through the creation of open-source protocols. Decentralized exchanges are resistant to security problems that affect other exchanges, but as of yet suffer from low trading volumes and, frankly, poor user experience.
For crypto revolutionists, decentralized exchanges are the future because they are the only way to guarantee facilitation of trade without being at the mercy of financial regulator overlords.
Binance, KuKoin, and a number of other top exchanges all have decentralization in their roadmap (and so do we at Xtech).
It’s likely just a matter of time until decentralized exchanges can offer smooth enough UX to compete with their centralized counterparts. The real question is whether the rise of decentralized exchanges will curtail the questionable practices that have been rampant in the industry so far or if they will simply act as an outlet, pushing the “fuckery” down the line.
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