At the beginning of November, the Hong Kong Securities and Futures Commission (SFC) announced that it is introducing a new licensing system to regulate all crypto exchanges operating in Hong Kong. This paves the way for an influx of institutional capital into the space and highlights the pivotal moment that we are in, with digital assets exploding in popularity and governments looking to regulate the space. Exchanges are a key component of the ecosystem and have been growing rapidly, with crypto derivative markets doubling in size in the last year. Exchanges have evolved from limited platforms offering a small number of spot trading pairs, to expansive platforms offering spot and derivative markets, lending and borrowing products, and crypto-native “yield” products such as staking. This month we are going to dive into the developing exchange landscape and evaluate what might lie ahead as regulators enter the fray.
Exchanges are a vital part of any market, facilitating price discovery and allowing market participants to buy and sell assets. There are over 350 digital asset exchanges in operation, with at least 20 of these claiming to trade over USD1bn of volume every 24 hours. There are two primary types of market in the digital asset space; spot markets and derivatives. There has been a staggering growth in derivative markets over the last two years, with volumes in October 2020 reaching USD620bn (verifiable volume across top-tier exchanges). Conversely, we are seeing declining volumes in spot markets, with volumes falling 18% in October 2020 down to USD560bn across these same exchanges. This is a reflection of the growing sophistication of crypto traders, preferring to use derivative products for trading and risk-management as opposed to spot. It is also an indication of the mounting interest from institutional investors, who are more likely to invest in derivative products.
Exchanges benefit from a liquidity network effect; the more liquidity an exchange has, the more attractive its prices are, and the more people will want to trade there, further boosting liquidity. As a result of this network effect, of the hundreds of exchanges in existence, a small subset makes up the vast majority of trading volumes. Indeed, the largest three exchanges (Binance, Huobi and OkEx) make up 75% of all derivative volumes. Notably, all of these exchanges are unregulated and offer their users access to up to 100x leverage. It is tough for new exchanges to break into the market, with the long tail of low-liquidity exchanges tending to have a regional focus, appealing to local traders looking to transact in a local currency.
In terms of functionality, exchanges have been broadening their offerings. On top of spot and derivative markets, all of the top exchanges are offering the ability to trade with leverage as well as crypto lending and borrowing services. One of the more recent product offerings across exchanges is the ability for users to “earn yield” from assets held on an exchange. This yield can come from a variety of places including:
Given the rapid growth of digital asset trading, it is not surprising that we are seeing global regulators starting to take a serious look into crypto exchanges. In Hong Kong, the SFC will require all cryptocurrency exchanges operating in the city to be regulated. This will affect Huobi, OKEx, FTX, BitMex, and many more which all have operations based in Hong Kong. Hugh Madden, CEO of BC Group that operates OSL in Hong Kong, commented that:
"As a result, no doubt some firms may choose to relocate to avoid regulations. This game of regulatory arbitrage has a limited runway however, as the Financial Action Task Force’s June 2019 recommendations made it clear all 39 FATF member jurisdictions will follow Hong Kong’s path.”
There are four probable outcomes of increased regulatory scrutiny on digital asset exchanges. The first is that some exchanges will opt to comply with regional regulations. BC Group is a great example of this in Hong Kong, with the SFC issuing approval-in-principle to OSL (its exchange) for Types 1 and 7 licenses. Exchanges that go down this route can expect to have heavier reporting obligations, but the ability to continue operating legally in their jurisdictions. These exchanges can expect to onboard fresh capital from banks and larger institutions that are looking for regulated routes to participate in the digital asset ecosystem. The second outcome will be that some exchanges will look to avoid regulations entirely by domiciling in offshore jurisdictions like Malta. We are already seeing exchanges like Binance do this and it is likely that others will join them.
The third probable outcome is that we will see the continued rise of decentralized exchanges (“Dexes”). These are exchanges that live entirely “on chain” and that have no centralized entity supporting them. Ethereum has a number of high-profile Dexes, such as Uniswap, that are seeing daily trading volumes of over USD500m. Serum, built on Solana, is another high profile dex that is benefiting from the incredibly high throughput of the Solana network. The structure of these Dexes makes them extremely difficult to regulate, as they are not companies, but contracts running on smart contract protocols. There is no way to prevent a user from interacting with these contracts, once they have been deployed.
A final outcome is that some of today’s leading centralized exchanges will look to become decentralized in the future. One interesting observation over the last 6 months is that many centralized exchanges are starting to offer decentralized finance products to their clients, allowing users to sample the benefits of DeFi. It appears that centralized exchanges realize that they are in danger of being disrupted and abandoned if they do not offer DeFi functionality and returns. Centralized platforms are therefore becoming a gateway for users to access DeFi, seeing this as a way to retain users. It may also become a “way out” for centralized exchanges to permanently avoid regulatory restrictions, by entirely decentralizing their platforms. Binance, the world’s largest crypto exchange, is going down this path. Binance’s CEO, Changpeng Zhao, stated in a recent blog post that “We believe the future of the industry lies in decentralization, and with the momentum increasing, it’s time to go all in.”
At CMCC Global, we see two winning strategies for exchanges. The first is to comply entirely with regulatory frameworks, as BC Group is doing in Hong Kong. Few exchanges will manage to meet the regulatory requirements and the ones that do will gain access to large pools of retail and institutional capital. The second winning strategy will be to become entirely decentralized and operate in a world of code. Peer-to-peer trading will monopolize liquidity in the long run and benefit from global network effects. This will take many years to play out and there will be many regulatory hurdles along the way. However, it will be difficult for any centralized exchange to compete with peer-to-peer markets that have little to no trading fees.
CMCC has exposure to the digital asset exchange space in a number of ways. Our digital asset funds hold BNB, the token linked to the Binance exchange. We believe that Binance is a remarkable company and its decision to entirely decentralize over the coming years is hugely progressive. We have a position in Serum, the dex operating on Solana and are also invested in underlying smart contract protocols, like Ethereum and Solana, that enable decentralized exchanges to operate.