Exchanges

Given that speculation is one of the, if not the, first mover use cases in crypto, we thought it might be useful to discuss the mechanisms for said speculation. Speculation is an exercise in price discovery and in order to facilitate it, there have to be markets for buyers and sellers. In the case of cryptocurrencies, these markets are mainly represented in the various exchanges that provide a facility for trading. Before we get started, lets briefly overview the legacy exchange markets.

Legacy Exchanges

It probably comes as little surprise that the highest volume exchange on the planet with a capitalization of $19.2 trillion is the New York Stock Exchange owned by Intercontinental Exchange (more on them later). The NYSE dates back to the Buttonwood Agreement from 1792 which was essentially a bargaining agreement where brokers committed to each other that they would not trade securities at a commission lower than 25 basis points and that they would give each other preference in negotiations. In case anyone was wondering whether Wall Street has only recently been constructing a system structurally skewed in their own favor, the terms of the Buttonwood Agreement beg to differ. The first securities traded on the NYSE: Revolutionary War Bonds.

Today’s markets are technological behemoths with all of the top 10 exchanges having market caps over $1 trillion and representing a mass of individuals, institutions, bots, and AI, trading stocks (equity), bonds (debt), and derivatives (options, swaps, futures, etc). Of course, these aren’t the only things you can trade since we have markets for commodities, FOREX, and other financial instruments all of which are defined by a single common thread: they are regulated, public, financial markets.

Enter Crypto

The first ever cryptocurrency exchange, BitcoinMarket.com, started operating in March of 2010 and is now defunct. Founded in 2011, the longest continously running crypto exchange is BTCC and the largest exchange by volume is a moving target, but usually cycles between BitMEX, Bitflyer and Bithumb. The largest American exchange is GDAX (owned by Coinbase) all the way down at #24 on the list. The existence of exchanges for cryptocurrency seems like an obvious and necessary part of market maturation, but there is nothing in the Bitcoin whitepaper that either directly or indirectly references the advent of Bitcoin as a speculative instrument. In fact, the Bitcoin whitepaper is oriented around BTC being a form of peer to peer electronic cash and there is no element of either the blockchain or the consensus mechanism that requires exchanges in order to operate. Exchanges, or centralized exchanges at least, are arguably antithetical to the purpose and ethos of cryptocurrency since they facilitate off-chain transactions where users do not hold their private keys. Nevertheless, exchanges serve an essential function in the cryptocurrency ecosystem in that they provide a venue for price discovery.

Famously, the first ever economic transaction using BTC was the purchase of two pizzas for 10,000 BTC. While that sounds expensive in today’s BTC terms, if BTC fulfils its promise of becoming a true store of value or, better yet, a world reserve currency, those two pizzas will probably equate to the GDP of a small country. Price discovery in pizza denominated transactions is hardly sound economic footing, however, so as the crypto ecosystem started to develop more cryptocurrency exchanges entered the market.

Early Exchanges

There are plenty of arguments to support the case that even the current “tier 1” exchanges for crypto have a ways to go in order to fully professionalize. The early exchanges, however, were much more like websites for trading collectibles than venues for transacting in financial products. The best, and worst, example of this was Mt. Gox. Initially a site for trading Magic the Gathering cards, it eventually became the preeminent cryptocurrency exchange, overwhelming both the expectation and capacity of its infrastructure and principals. At its peak Mt. Gox handled 70% of all crypto trading volume. In February 2014, Mt. Gox suspended trading and shortly thereafter filed for bankruptcy protection. Mt. Gox was forced to admit they had been subject to a multi-year hack wherein they lost approximately 850,000 BTC, most of which still has not been recovered, though some has and is held in a trust, the actions of which are closely monitored by the Bitcoin trading world. When Mt. Gox announced the hack, in what is to date the largest hack of cryptocurrency ever, it precipitated a financial bear market and a reckoning for the industry writ large.

Retail Maturation

Around the same time as the Mt. Gox fiasco, a new wave of financializaton ushered in exchanges with more sophisticated trading engines that looked more like Wall Street than their predecessors. While the upgraded exchanges, like Bitstamp, Bitfinex, and Bittrex did offer significant improvements, they were still oriented around retail trading. Part of the reason for this was the fact that even if the exchanges were able to provide the requisite security, custody, and regulatory environment to attract institutional investors, the crypto space was still too nascent for serious institutions. In addition to needing a greater level of maturity, and the existential threat to banking posed by cryptocurrency, very few institutional investors could defend a cryptocurrency investment to their risk committees in 2013, much less making said investment by purchasing or trading coins on a largely unregulated exchange like the ones mentioned above, even if they were domiciled in cozy jurisdictions like Luxembourg (Bitstamp), British Virgin Islands (Bitfinex), or Delaware (Bittrex). Barring the entrance of large-scale institutional accounts, the post Mt. Gox exchanges were and remain dominated by retail investors.

In fact, the first few tranches of crypto adopters have all been retail, which is unlike the standard adoption curve for financial instruments. Let’s take collateralized debt obligations as a counterpoint. CDOs are a purely Wall Street invention, which they packaged as products and foisted on the markets starting with a Drexel Burnham product in 1987 but really gaining traction in 2000. Wall Street kept the highest rated tranches (collateralized with the lowest default-risk loans) for themselves, and then marketed the lesser tranches to customers. When supply ran short, synthetic CDOs aka “CDO-squared” were created and sold as fuel to the what would later be revealed as the subprime mortgage crisis. In the case of CDOs, much like other financial products, the instrument had its origin with the institutions and eventually trickled down to retail. The opposite has been true with cryptocurrency where retail led as early adopters and institutions are forced to buy crypto from retail which until recently owned most of the circulating supply. It’s worth noting, however, that in both the CDO and crypto scenarios the bulk of the risk lies with retail. In the CDO case this is true because of the exposure to the higher default risk tranches and in the crypto case because retail adopted while the technology was entirely untested and before systemic ecosystem risk began to be mitigated.

State of Play

The cryptocurrency markets have been rapidly evolving as increasingly sophisticated players enter the space either as investors or as infrastructure providers. Perhaps most notably, both CME and CBOE, in 2017, announced and implemented Bitcoin futures markets on their platforms. While these markets are both cash-settled, their involvement still marked a major milestone for Bitcoin adoption into legacy financial markets. As discussed in a past newsletter, there is rampant speculation around the if/when of a Bitcoin ETF as a “next step” in Bitcoin adoption on legacy exchanges. More immediately, though, the market saw an equal if not bigger event in the announcement by ICE of the Bakkt one-day, Bitcoin settled, futures market. ICE, aka Intercontinental Exchange, you may recall from paragraphs such as the second one in this article, is also the owner of the NYSE. An exchange operator like ICE entering the cryptocurrency space signifies not only a massive leap in market maturation, it also provides a trading venue where investors, both institutional and retail, who may have been interested in trading crypto but were unwilling or unable to enter the market using even the more reputable exchanges organic to the crypto world, exactly the on ramp they need. Admittedly, the CME and CBOE markets do already represent a legacy venue for gaining exposure to crypto, but, they provide just that: exposure. Neither commodity market actually trades in Bitcoin since the contracts are, as we mentioned, cash-settled. This means that upon expiration, the contract holder is entitled to the value of the contract in USD terms, not actual Bitcoin. In opting for cash-settled markets, CME and CBOE avoided all of the issues around custody and settlement in Bitcoin. It was definitely a nod to the cryptocurrency industry, but hardly an embrace.

Bakkt, on the other hand, will offer Bitcoin settled markets. Moreover, they are one-day futures so those looking to purchase real BTC will be able to do so through an ICE operated platform where contract holders are entitled to the value of the underlying contract in actual Bitcoin within a trading day. (As an aside, there is an on-going conversation in the crypto world around whether Bakkt will rehypothecate the BTC held in their contracts, and the consensus is that they have the ability and perhaps the profit imperative to do so, but we will leave that as a topic for another conversation).

The Future

As cryptocurrency cheerleaders, we are encouraged by the improvements made by crypto exchanges and the entrance of legacy players into the crypto trading space since we expect that at least in the short-term, these market forces will drive up demand and price which will attract a new wave of investors, investment, and attention to the space. But, going back to the Bitcoin whitepaper for a moment, we believe that there is a need to protect or at least provide a venue for the peer to peer ethos of crypto. Without getting into a debate about the pros and cons of monetary sovereignty, we believe that there is a true need for censorship-resistant money. One way to facilitate cryptocurrency trading without forcing participants into a centralized platform is through decentralized exchanges aka DEXs. These exchanges already exist, but they are still fairly “illiquid” since they have yet to attract large numbers of users and they, by design, don’t provision for market making. DEXs do not take custody of any user’s coins in the traditional exchange sense, but rather, merely provide a venue for buyers and sellers to meet and negotiate prices. Generally, the DEXs do provide a trade settlement facility either through the issuance of a trade through a smart contract or by establishing the framework for a multi-sig wallet transaction, which is somewhat like having an escrow agent but more “trustless” since no single party to the transaction full control over settlement.

As elements of crypto trading gear up for institutional adoption and professionalization, DEXs will act as a hedge against the negative aspects of financialization against which Bitcoin formed its original rebellion. As is often repeated, the two elements required for monetary sovereignty in crypto are holding your own private keys and running a full node so you can validate transactions. We remain enthusiastic about the improving conditions around crypto trading exchanges, but if institutional financialization and government regulation wade further in to the cryptocurrency space, as we know they will, it will be increasingly important to have things like DEXs to facilitate transactions that don’t infringe on monetary sovereignty.