Why are we talking about Crypto Exchanges?
There is immense media as well as retail interest in cryptocurrencies like Bitcoin with celebrities capitalists like Elon Musk constantly creating news around it. While the older forms of trading assets like gold, stocks and even commodities, wherein investors speculated have matured and there is limited play for retail investors, cryptocurrency is a new investment option treating the old matured investor and new rookie alike. While the underlying currency provides immense opportunities for a new entrant and piques interest the trading platform which provides this opportunity is blindsided, by most investors.
These cryptocurrency exchanges can be sound businesses in themselves and this article will try and explore opportunities therein. The difference between these modern exchanges versus the earlier ones is that most of the modern exchanges are private companies, with a clear focus on profitability and value generation unlike the regular stock, commodity and derivative exchanges which started off as cooperative mutual organisations with self-regulation.
As these crypto exchanges are still nebulous, and sovereign states like to control capital flow especially in speculative investments, entrepreneurs will leverage the opportunity to create exchanges within each national boundary to adhere to the rules within each country. Some of the salient features of these currencies are;
- Digital Formats
- New Investment avenues
- Regulatory constraints
- Speculative assets
Cryptocurrencies can be traded in various ways
As cryptocurrency is still nebulous there are many exchanges popping up across countries especially after the big rally in bitcoins around 2017. As these exchanges are from the digital-first era, and yet regulated through laissez-faire methods, the evolution of these exchanges has been organic with protocols evolving as they have progressed. The exchanges offer features that have to cater to both the front end user type as well as the back engine which completes the trade and validates the currency.
Depending on the type of products exchanged, crypto exchanges can be as follows;
- Fiat – Crypto Exchanges
Standard Exchanges use an order book, in which a buyer and a seller place their buy and sell intentions. This order book then matches the price and quantity to complete the transaction. The whole process is anonymous to the buyer and seller. Similarly, fiat-crypto exchanges let a buyer buy a cryptocurrency by using regular cash or credit but do not allow crypto-crypto exchange. Executing transactions in these exchanges are simple, especially for basic investors.
2. Crypto – Crypto Exchanges
Transactions in these exchanges are delicately between two different cryptocurrencies or tokens. This works for experienced traders who already own cryptocurrency. A first-time buyer will have to buy crypto in a Fiat-Crypto exchange, load it into their wallet and then go to crypto exchange to swap it against another. Some exchanges generate their own tokens which are then used as a medium of exchange with other currencies.
3. Peer – Peer Crypto Exchanges
The concept of Bitcoin itself was peer-to-peer transactions. It was meant to be like a digital payment app or as a bank account to bank account transfer done digitally. Here the relationship is between the buyer and the seller and the parties know each other. The transaction gets executed through the bitcoin wallet address. Peer-to-peer exchanges are typically over the counter exchanges like NASDAQ OTC with a dedicated space for a buyer and seller to do bulk trades. Here the exchange only ensures protection for the buyer and seller to ensure that the deal is safe and clear. These exchanges provide services to large venture capital funds, hedge funds and cryptocurrency miners, who would like these trades to be discrete and not recorded on books, so as to not affect the price of the underlying asset.
The difference in peer to peer versus fiat and crypto-based exchanges is the elimination of the order book process. The peers negotiate and settle the trade, with the exchange ensuring that the trade is executed without any errors or misrepresentation by validating the currencies and accounts involved.
Brokers are alternatives to peer-to-peer as the process can be done by a middle party who finds the best value for both the counterparties or himself in case he is the buyer or seller. Advantages of using a broker lie in eliminating the process of holding wallets, doing the trade online etc; as the broker completes the process as well as guarantees its veracity.
5. Derivatives exchanges
Future trades are less riskier as compared to directly trading in the currency as the trade is limited to the anticipated change in price similar to trading in commodities and stocks. But understanding futures and options is a complex knowledge domain and needs expertise. They appeal to advanced and large-scale traders because they provide them with larger leverage and more investment avenues. These exchanges are also prone to more scrutiny because of the very nature of high-risk trades.
The technology behind Crypto Exchanges
1. Centralised Cryptocurrency Exchanges – CEX
Like traditional stock exchanges, centralised cryptocurrency exchanges bring buyers and sellers together and the exchange plays the role of a middle-man. The exchange holds the money of the buyer in a wallet and once the buyer executes the trade moves money out of the wallet and credits with equivalent coins. One of the main issues with centralised cryptocurrency exchanges is their vulnerability to hacks.
2. Decentralised Cryptocurrency Exchanges – DEX
Decentralised are conceptually peer to peer exchanges. A typical DEX doesn’t hold funds as the trade is directly concluded between the buyer and seller. Since the exchange doesn’t hold money or cryptocurrency they are tougher to hack, which is a risk with centralised exchanges. Currently, these exchanges lack volume as most of the trade is between fiat and crypto which these exchanges do not trade-in.
3. Hybrids – Different Types of Cryptocurrency Exchanges
Hybrids are the new exchanges that are trying to capture the best of both CEX and DEX exchanges. They intend to provide ease of trade and liquidity like CEX with the security of DEX.
|Centralised Exchange(CEX)||Decentralised Exchange(DEX)||Hybrid Exchange (HEX)|
|UI & UX||Easy to use||Hard to Use||Easy to use|
|Matching Speed||Very Fast||Slow||Fast|
|Custody||Users trust the CEX||Users own their funds||Users own their funds|
|EXCHANGE PLATFORM||MONTHLY VISITORS||$BN VOLUME (24 H)||# OF COINS||# OF FIATS SUPPORTED||TRADING COMMISSIONS|
Types of Crypto Wallets
Trading on crypto exchanges needs a wallet that will hold the trader’s currency or cryptocurrency on the account. Wallets are of two kinds; Hardware wallet and Software wallet with names exactly the opposite of the technique used. A hardware wallet is called a cold wallet as the keys to the value held in the wallet is stored in the hardware device and is held offline, while a Software wallet is like an online banking app, where all the details are stored in the software and can be used instantly when needed.
Both the wallets serve different purposes and depend on the type of user. A long term investor would prefer a hardware wallet as the data can be taken offline and stowed away safely, while a software wallet is always on tap for a regular trader to trade at any instance of time. The risks associated with them are that the chances of losing a hardware wallet are very high as these small USBs can be physically lost and there is no way to recover the money or coins stored in them. While the loss of the physical device is the risk of hardware wallets, online hacking of software wallets is a genuine risk. Many times investors use plain paper to print the private and public keys of information as a wallet.
Revenue for Crypto exchanges
The most prevalent technique across all forms of exchanges is to charge a percentage of the trade value as a commission by the exchange. But intense competition in a newly evolving digital-first sector like cryptocurrency pushes exchanges to keep these costs low and find new avenues to make fees, very similar to low-cost airlines. Some of the revenue-generating options are listed below;
- Trade commission/charges
- Exchange fees
- Deposit/withdrawal limits
- Payment methods
- Regional restrictions and regulations
- Verification requirements
A defined fee is charged as a percentage of the trade value. Even if the commission is less than 0.01%, giants like Binance, with its multimillion daily trading volume, make good money using this monetisation strategy. Some exchanges offer different commission rates for different slabs of trade.
The blockchain process involves transacting over an open network of powerful computers called miners. These miners are not just the source of cryptocurrency like bitcoins, but they are also the validator and bookkeepers for all trades. Whenever a cryptocurrency changes hands, the data information is routed to the network where the miners go about calculating cryptographic hash functions. These computers first validate the veracity of the currency and then add another block to record the transaction. The miners charge a fee, which is demand-driven and varies based on traffic at any point of time. Higher the transaction fee, the quicker the validation of the transaction.
Cryptocurrency needs to be held in a wallet which is mostly provided by the exchange. Since the exchange has an interest in making money as commissions for the trade they normally don’t charge valet fees, but do charge a fee on withdrawing/sending cryptocurrency from the wallet which is basically network fees.
Smaller exchanges, where the volume is low, cannot rely on commission-based revenue alone and hence ask the coin for a listing fee. This revenue option is limited as the coin would also be more interested in listing on a larger exchange as the option of getting noticed and at the least swapped against another crypto is higher.
Market making – A monetisation strategy that uses bid and ask limit orders to provide liquidity for a defined cryptocurrency on a crypto exchange. Market makers profit from the spread between bids and offer across multiple trades.
Located in London, CoinBurp has evolved from a P2P platform to a centralised crypto exchange which is now trying to merge the best parts of both the decentralised finance (DeFi) ecosystem and the centralised finance ecosystem. As stated earlier DeFi needs an understanding of the blockchain ecosystem and the capacity to take risks when dealing with completely anonymous parties. To merge these two ecosystems they leverage their own token called $BURP.
Funding: $6.05M (Seed)
Mintable, founded in 2018 in Singapore, is NFT focussed digital minting and trading platform expanding into ethereum based coins. Primarily, Mintable is a marketplace for next-generation digital products. It lets a new digital product owner create their own store or list their products for sale on this platform.
Funding: $13M (Series A)
Belfrics, founded in Malaysia in 2014, is an exchange from the larger Belfric group, which deals with all forms of blockchain led technology. An interesting feature of Belfrics exchange is the mandated KYC done using blockchain to identify and verify its users.
Funding: No Funding
Pastel, located in New York, has been one of the earliest innovators in the nascent NFT space since 2018 with a platform that allows trading in digital assets on a decentralised peer-to -peer protocol. They have a tool that also allows for the development of third-party applications to sit on top of the Network. Developers can build their own application or marketplace directly on Pastel.
Funding: $5M (Seed)
Geographically targeting the Latin American market, but headquartered at Kidlington, England, from 2019, is a cryptocurrency trading platform called Buenbit. The startup allows users to trade over 20 cryptocurrencies.
Funding: $11.1M (Series A)
Fumbi, founded in 2018, at Bratislava, Slovakia, allows users to own a portfolio of 28 cryptocurrencies directly as an individual portfolio even with as small a sum as 50 Euros. The application is designed with interesting GUIs to track portfolios on a daily basis.
Funding: $2.81M (Early Stage VC)
Started in 2018, in Newcastle, England, Bottlepay, is a cryptocurrency wallet and payments application that is looking to make money transfers even more convenient. It’s also integrated with social media, meaning that users can send money via tweets or messages. The startup is working on launching its enterprise solution by the second quarter of 2022.
Funding: $17.56M (Seed)
Open Ocean is the Trivago of cryptocurrency exchanges, aggregating information from centralised and decentralised exchanges, and provides a comparator. Founded in Singapore in 2019, the aggregation technique helps the startup get both segments, individuals as well as institutions, to come on their platform. This startup aggregates DEXes on Etherum, Binance Smart Chain, Tron and Ontology.
Funding: $2M (Early Stage VC)
Synapse Network is an investment ecosystem founded in 2021, which uses blockchain technology to help investors and fund seekers to come together. This will allow users to exchange most of the top-rated cryptocurrencies and bypass the borders caused by single blockchains by using the Crosschain method, linking together the digital market in a single platform. This will be where projects from our incubator will be listed, providing them with another layer of exposure.
Location: San Francisco, California
Funding: $2M (Early Stage VC)
Bitsika is a digital payment/wallet application, targeting the native currencies of Ghana, Nigeria and a few other West African countries, while it also accepts USD. They support Bitcoin (deposit and withdrawals), BNB (deposit), BUSD (deposit and withdrawals) and ABCD (deposit and withdrawals). The interesting feature is the capability to create a Visa card with deposits from cryptocurrency. This makes cryptocurrency fungible with regular visa online payments.
Year founded: 2016
Location: Accra, Ghana
Funding: $1.02M (Seed)
11. Derivatives Exchanges
Dedicated exchanges which allow traders to hedge their bets using futures are limited in number as the volume of users is fairly limited. The key advantage which futures trading sites like BitMEX provide is that it lets a cryptocurrency owner leverage the existing currency to hedge existing spot positions without additional currency as the exchange provides leveraged loans. While Bitmex allows futures only in Bitcoin, Kraken offers Ethereum, Litecoin, Bitcoin Cash, Ripple and Bitcoin futures.
Crypto Exchanges have been a recent phenomenon. Given the undefined nature of cryptocurrencies, many exchanges have been floated to manage country regulations as well as the plethora of new cryptocurrencies. Many of these exchanges have to not only compete but do immense work in educating customers as well managing regulatory maze.
The centralised model of Crypto Exchanges is easy for a user to understand as it is similar to a standard stock or commodity exchange; many exchanges follow this model to acquire consumers. With multiple currencies getting launched and the need for both retail and institutional transactions to be routed through the same exchange, the ones that provide a large scale aggregation like Binance or Open Ocean are startups that could see big traction.
Investment ecosystems like the Synapse Network which uses blockchain technology minted with proprietary bitcoins to invest in new businesses sound like a Private Equity opportunity for small investors. This seems to be conceptually a brilliant idea and works at the opposite end of the spectrum to the big private equity players like Blackstone.
I believe that an aggregator like Openocean which had its first round of seed funding of USD 2M, in March 2021, with the backing of investors like Binance is an excellent bet to capitalise on. OpenOcean has acquired more than 68,000 active addresses with a USD 23.7 million trading volume in the last 24 hours as per CoinMarketCap.
We have seen from earlier digital-only startups, the final winner tends to take away a disproportionately high market share. Given the large number of exchanges and new ones getting added every day, predicting a winner in this business is going to be tough as regulations and user penetration still seems a couple of years away. While there are multiple reasons as to why cryptocurrency feels like a ponzi scheme, and hence a risky investment, the exchanges which trade in them are sound businesses that can pivot to become trading desks for many other kinds of assets even if cryptocurrencies change their form and character in tyhe future.
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