The now-defunct BitcoinMarket.com launched as the first crypto exchange in March of 2010. It was followed by many different exchanges that aimed to carve out a niche in this emerging market. Due to the complete lack of rules, many exchanges were hacked for millions in crypto while others defrauded their customers and stole their money. Very few early exchanges took the path of full regulatory compliance, such as Coinbase. However, the market would undergo a major shift in 2017, just as the hype surrounding crypto was hitting a fever pitch. Binance, one of the best-known cryptocurrency exchanges of today, was launched and things began to change.
The Binance model was simple at its core: a focus on a user-friendly interface, plenty of liquidity, and an attractive referral program - one of the first of its kind. As history shows, this model proved wildly successful, transforming Binance from a small startup to a unicorn within less than a year. Many other exchanges took note of Binance’s approach and copied this model for their own launch. Referral programs, which essentially promise partners a share of the trading revenue from any traders that they successfully bring on, have become an integral part of most major crypto exchanges.
The majority of crypto exchanges have an identical core business model - they generate revenue by charging a small fee on every trade that is conducted on their platform. Many exchanges also continue to charge listing fees for new projects. These fees vary wildly across the industry, from $10,000 for smaller exchanges to $500,000 and more to list on the biggest players. Some exchanges have begun to explore new streams of revenue. Other exchange business models include transaction mining exchanges, which generate revenue by staking or mining tokens, and zero-fee exchanges such as Cobinhood, which generate revenue by charging interest on margin trading loans and for fees on ICO/IEO services.
As 2017 proved to be a turning point in the cryptocurrency exchange market, some new trends in 2019 are shaping up to create another major shift in the industry. Most of the changes set to be implemented stem from a need to respond to serious problems that continue to have a negative impact on the industry as a whole. In my view, the five biggest problems that plague the crypto exchange market today are oversaturation, non-transparency, illegal activity, non-compliance, and non-diversification.
Although the exact number of exchanges in the world is difficult to say with certainty (largely for reasons that will be discussed soon), estimates vary from about 500 to over 1,000. In comparison, the traditional exchange market features only several exchanges per country, but top traditional exchanges handle thousands of times more volume than top crypto exchanges. Further, most crypto exchanges offer many of the same trading pairs, a redundant and unnecessary service. Instead of aggregating buyers and sellers onto one platform, this situation dilutes liquidity, spreading out a portion of the demand over many smaller players. So many crypto exchanges exist because an unregulated crypto exchange can be launched with minimal investment, while the cost of launching a new securities exchange is in the hundreds of millions. There does not appear to be a business case for many of the smaller, unregulated players in this market, and yet new crypto exchanges keep coming, fighting for a slice of a pie that is hardly growing at all.
Bitcoin was born from ideals of providing all the people of the world with a way to transfer value while maintaining total privacy and anonymity. Many players in the crypto space have taken advantage of those ideals in order to defraud investors. However, it is perhaps because of these ideals that a certain degree of non-transparency continues to be tolerated in the crypto exchange market. It is an open secret that many of the cryptocurrency exchanges use various methods to fake their volume. Bitwise Asset Management filed a report to the US Securities and Exchange Commission (SEC) in May of 2019 claiming that 95% of all cryptocurrency trading volume was fake. Further, information about the founders, investors, and management team of some of the exchanges on the market is nearly impossible to find, even for exchanges that have operated for several years. Know-your-customer (KYC) procedures, custody solutions, insurance coverage, and other critical aspects of the business are nearly impossible to verify for many of the exchanges.
Allegations have surfaced that many cryptocurrency exchanges allow or enable a whole host of activities that are illegal in traditional securities exchanges, including wash trading, insider trading, organized pump and dumps, forced market making, and others. Actions like these are typical across many of the cryptocurrency exchanges and happen on a daily basis. Many groups organized in popular messengers like Telegram and WeChat are dedicated to providing “pump signals” and discussions about pump and dump timing between market insiders and large token holders. Projects looking to launch an initial exchange offering (IEO) on a major exchange often have to sign a contract that requires them to spend up to 90% of the funds that they raise on market-making activities in order to support the price of their token after listing. Exchanges position IEO as a marketing service, not a fundraising tool, but a lot of projects still think that IEO can help to raise millions, unfortunately for them, it's not true.
These problems continue to exist because many exchanges are able to operate in legal limbo, evading regulators and regulations by skirting the law. Part of the problem lies in the fact that many regulators have determined that the most commonly-traded digital assets, such as Bitcoin, are not securities, and thus are not subject to securities law. Further, many crypto exchanges have taken advantage of favorable conditions offered by offshore jurisdictions, which allow them to evade many requirements as well. Although these situations provide a great deal of opportunity for the cryptocurrency industry to grow, they also create opportunities for dishonest and incompetent players to put investor funds at risk. However, exchanges that aim to deliver any type of crypto-fiat trading are required to obtain certain financial registrations in every territory where they hope to conduct those types of operations. Institutional players in the crypto space are increasingly demanding a higher standard of security for their funds, desiring the same level of security that regulated exchanges in the traditional space deliver. This is why exchanges that secured compliance and registration early on, like Coinbase, continue to grow their business, while other leading market players, like Binance, are securing regulatory compliance when launching in new jurisdictions, such as the US.
As the exchange market continues to respond to the need for regulatory compliance and all that this entails, they will begin to incur new expenses. However, given the current competitive landscape, exchanges will face serious resistance to any attempts to raise trading fees. Regulatory compliance will also affect current revenue streams, including IEOs. Many exchanges will not be able to handle this financial pressure. In response, crypto exchanges will need to develop new streams of revenue. One of the most effective ways of doing this is to create solutions for actual customer needs. Binance certainly turned the market on its head when it launched in 2017, but the company’s product simply addressed legitimate pain points of everyday users. Cryptocurrency holders continue to experience several major pain points, including the inability to access quality banking services (cards, accounts, payment solutions, etc) for their digital asset holdings. Some exchanges are beginning to view crypto banking services, including government-registered bank accounts with instant convertibility to fiat and payment cards that enable crypto holders to spend their digital assets at brick and mortar merchants. This is one avenue that exchanges are exploring to diversify their revenue streams. Providing a complete and fully-regulated multi-level user experience, including crypto trading, digital banking, PoS solutions, custody, and OTC, will enable exchanges to increase user retention, stand out from competitors, draw in new customers from a range of business products, cross-sell existing customers, and diversify revenue streams.
Exchanges emerged as the most important players in the crypto market, but are continuing to evolve. The competition for customers is heating up while cost pressures are set to increase, setting the stage for another major disruption to the cryptocurrency exchange market. Needless to say, we expect the industry to consolidate and for many of the smaller players that offer redundant services to close their doors or sell their business to the top-ranked exchanges. Further, we expect more and more exchanges to seek out compliance with all relevant regulators, clamp down on illegal activity, and make significant efforts to boost transparency. Lastly, exchanges will look to diversify their revenue streams. One of the most obvious ways to do this is to offer customers complimentary services that address customer needs, such as by providing digital banking and crypto payment processing services. Launching a new exchange is still a good idea, but only if it can deliver a fully-compliant ecosystem of products built around the exchange and if you're able to attract enough customers (obviously). Unregulated mini-product exchanges are set to face increasingly competitive market conditions, which may force many of the smaller and less competitive players to close their doors.