Benjamin Bommhardt At Bitcoin South: Generations of CryptoExchanges

Benjamin Bommhardt: Generations of Crypto-Exchanges

Presented at Bitcoin South; Speakers list and videos

Bommhardt: Generations of Crypto-Exchanges

Bommhardt started Bitcoin trading in early 2013 and was able to gather some experiences and observation of the fast-evolving trading landscape. These observations allowed him to cluster the exchanges that were traded on into generations and evaluate the strengths and weaknesses of each generation. The weaknesses led to the forming of the following generation.

The talk started with a quick introduction about himself: lots of studies, experience in process and customer relationship management at bigger German corporates, co-founder and director of sales at Draglet.

He then dove right into the early beginnings of trading – focusing on the trading of money versus Bitcoin and vice versa, which facilitates the entrance to the Bitcoin economy.

Generation Zero – Manual Trades

An exchange is defined as "an act of giving one thing and receiving another in return". The early tradings were done over simple escrows and trust based systems on chats and forums. Because Bitcoin had virtually no value in the early days, these type of trading facilitated the only feasible option to buy Bitcoins. The pizza trade perfectly represents this generation, as a user desperately tried to get some value for his Bitcoin – resulting in a trade of 10.000 Bitcoin for 2 Pizzas.

Those Bitcoin now worth are around 3.7 M US$ and this make it the most expensive pizza ever sold when revaluing this trade today. The weaknesses of the Zero Generation were obvious – the process was very inconvenient and the chances of getting scammed were persistent. It scared people that were thinking of getting into the Bitcoin economy. A new generation had to be formed so users could buy and sell Bitcoin with higher convenience and security.

Generation 1 – Business-Enablers / Pioneers

The first generation was being formed; MtGox is the best example for the first generation, which we call the ‘Business Enablers’. They allowed the users to register on an exchange website and to easily get in and out of the Bitcoin economy. This propelled the process of buying and selling Bitcoin and MtGox was largely responsible for 80-90% of all Bitcoin trades. It did not matter that it was once an exchange for ‘Magic the Gathering’ game-cards and the weaknesses of this exchange were horrible on the technological side. Down-times of hours and sometimes days, as well as immense lags of trading did not demotivate people to trade on this platform.

As a pioneer, MtGox had also severe problems on the legal side – banking problems, seizures and being sued hit the MtGox marketplace hard and resulted in delayed withdraws. Delayed withdraws resulted in a deviated exchange rate and after Bitcoin withdrawals were also completely shut down, the price crashed down and MtGox died. The problems on the legal side were finally bringing down the once huge giant of Bitcoin exchanges.

Generation 2 – Diversification

Mt.gox was one of the only exchanges out on the market, people had no choice but to go to this website and trade there. As more and more exchanges streamed on the market and people had suddenly a choice to make. It led to the forming of the Second Generation, as exchanges now needed to diversify so they had USPs (unique selling propositions) that made people come to their exchange. One example was McXnow, one of the first online exchanges that allowed the trading of Alt-Coins as well as giving 25% of the transaction fees generated to their exchange users as dividends.

Another example was Bitcoin-24.com, a website that served the European Market and had no KYC (Know Your Customer, mandatory identification before users were able to start trading), instant deposits as well as 0% trading fee. This motivated people tremendously to trade on this platform, so it came that Bitcoin-24.com had more EUR trading volume than MtGox. But the problems of this generation could pretty well be explained at the example of Bitcoin-24.com, which was not secured by a license for operating this exchange – or having a bug in the exchange software. This bug allowed to people to make market sells (when transaction volume on this exchange got higher) and receive 3 times the value for their Bitcoin. Exploiting this bug, people could extract tons of Bitcoins from this exchange. When this could be exploited in April 2013 (when the second spike occurred), the exchange was hit hard by the closure of the German and Polish banking account that was used to manage the user funds. This exchange came to a bitter end and showed us how important technological and legal factors are for the operation of the exchange business and led to the forming of the third generation.

Generation 3 – Solid Exchanges

After the failure of the First and Second Generation, it was obvious that a lack Legal and Technological consideration leads to immediate failure of an exchange. The time for one man shows – single individuals that were able to operate an exchange was definitely over. Now, additional security precautions like two factor authentication was a complete must have and a license to operate the exchange was also a base line for further exchange activities. The trustworthiness of the exchange needed to be increased with audits and transparency of the exchange management and operations so people could trust this entity.

It was no coincidence that in April 2013 (the time Bitcoin-24.com, the Second Generation was being closed down) a study emerged that stated that 45% of all Bitcoin exchanges end up closing down and result in a failure. After that, trustworthy and solid exchanges like Kraken emerged and showed the Bitcoin community that there is a shining beacon of light for trustworthy exchanges.

The Third Generation exchanges are doing pretty well so far, although they need to be able to deal with the technological side as well as with the legal side, as both are the main pillars of operating an exchange business. This gave room for another, fourth generation.

Generation 4 – White Label Exchanges

It was clear that a risk distribution had to happen and a co-operational structure had to be formed that allowed either side to focus on their part. This facilitated the White Label exchange, a recent trend in the Bitcoin exchange scene.

White Label exchanges work like the following: there is a Technological service provider that offers an already developed exchange Software as a Service (SaaS, or as a product for self hosting) and a co-operational partner that has a license, compliance and the resources to operate in the market and run a Bitcoin or Crypto exchange. The White Label aspect helps the exchange operator because customers do not notice that he is not the one that hosts and provides the technological foundation for the trading for his customers. This allows interested exchange operators a much shorter time to market (days compared to years when trying to develop the software from the scratch) and gives risk distribution as well as a much better scalability. In terms of Draglet, the White Label exchange I co-founded, it means that our customers need to take care of marketing, business develoopment, operative support as well as legal and compliance, while draglet sets up and customizes the exchange according to the customers CI and desire, further develops the exchange software depending on what the customer wishes, offering reliable B2B support and industry grade availability for the exchange.

Amongst its competitors, Draglet is a self funded company that can offer Service Level Agreements (SLA’s) right of the beginning (competitors rarely seem to have those) and offers exchange software as a modular, customizable and extendable service for customers on 4 different continents. This allows our customers to have a bleeding-edge Crypto exchange as strategic base for further business developments. Since Draglet built the software from scratch, it has some unique features like optimistic fund locking (user funds do not get locked, users can create orders without having actual account balance) and encrypted user access (an encryption process that protects the user funds in the wallet from external and in house attacks, a feature that already has been applied for as a software patent). With our shared liquidity, also known as re-marketer ability, we want to help exchange operators to overcome the negative thresholds when starting the exchange by providing already filled order-books. Also, draglet has a unique pricing – not working with the usual fee depending model but offering ticks pricing: exchange operators do not have to give 30-50% of the transaction fee to draglet, but can buy ticks (executions on the exchange that do not expire over time) and control their budget quite better, while receiving full transaction fees of their exchange business.

Outlook

Margin trading platforms (as well as more streamlined user experiences to attract more people to Bitcoin) will dominate the market for the next time. Altcoin specific exchanges or asset backed exchanges might be another alternative for users to trade on and Benjamin is confident that there is going to be a huge flood of exchanges across the planet. Every exchange needs to compete against other exchanges, users have only two opportunities to make up their mind on which exchange they want to trade at the end of the day: use case (what can I do on this exchange?, i.e. what can I trade or how is the experience?) as well as price (quantitative opportunity to evaluate exchange alternatives) manifested by the transaction fees of the exchange. A logical conclusion would be that the transaction fee will compete so intensively that the transaction fees on all exchanges that are in direct competitions will drive towards 0%.

Lastly, decentralized exchanges are coming into play, but Benjamin’s eyes, they still do not facilitate a convenient and understandable way of trading Crypto assets. Draglet tries to support their exchange operators with well developed software as well as a flexible, tick based pricing, that gives our customers the ability to freely decide their transaction fee structure so they are able to compete on the local market.