Market makers, takers and fakers: Which exchanges are built to last?

Crypto exchanges are doubling down on their promotions, offering customers rebates and entitlements that seem impossible to maintain in the long run. With well over 200 exchanges now in existence, it’s becoming harder to discern between the viable, legitimate crypto venues and the platforms that are more akin to gambling than a marketplace.

Fakers taking from the makers?

These promotions are happening in jurisdictions outside of the US, expatriate Chinese exchanges now based in Hong Kong being most prominent. A report just released shows that trading volumes on reputable US exchanges Coinbase, Kraken and Bitstamp have plummeted 83% this year while volumes on Binance and OKEx have surged.

Source: Diar report, ‘State of the Digital Assets Industry‘

There are several points of interest here:
(i) the US exchanges are all fiat-to-crypto while Binance and OKEx are crypto-to-crypto
(ii) Binance is based in Malta, while OKEx has just signed an MOU to relocate to Malta, and;
(iii) both offer discounts on trading fees – as much as 50% on Binance using its BNB token while OKEx offers zero trading fees on all crypto-to-fiat pairs – and all the US-based exchanges charge flat fees.

The report notes that over 50% of overall traded volume on the crypto markets is around the majors: Bitcoin, Ethereum, XRP, Bitcoin Cash and Litecoin. The jurisdictions outside the US have more regulatory leeway and by all appearances have been making the most of it. This month, OKEx had to claw back millions of USD in BTC from its customers’ accounts after a single outsized trade on a bitcoin futures position went against a trader whose 4,168,515 contracts was worth over $400m, which he couldn’t cover when margin called. After OKEx liquidated his position there wasn’t enough buyers in the market to sell to all the contracts to which triggered its "societal loss risk management mechanism", which happens when there isn’t enough in the platform’s insurance fund to cover margin call "losses".

This cost OKEx traders – even those who had profited from taking the opposite side of the trade – a communal loss of around $9m from their accounts. Although this was legal at a Hong-Kong headquartered exchange, it is highly unlikely this would be permitted in a US jurisdiction.

However, in a bid to catch up with the alt-pack, Coinbase is pushing forward with its own decentralized exchange, Paradex, that currently has over 40 coins listed. Interestingly, they have also listed their competitors’ coins – Binance’s BNB and Huobi’s HT.

The network effect of trade mining exchanges 

The lines have become blurred between exchanges “aligning with customer interests” and the incentives becoming detrimental to the health of the overall economy. The recent trend of exchanges promoting transaction or “trade mining” schemes that reward users with rebates and with “shareholding” of their native tokens has become notorious for incentivising wash trading among users (more accurately, bots) who simply generate more tokens through spoof trades and hope that momentum carries the price upwards – until they dump it.

Below is a list of the zero-fee and trade mining exchanges that BNC has dropped from its spot and index pricing due to the nature of their irregular trading patterns. We stratify the exchanges by three main features – their fee structure, regulatory jurisdiction and their native token.

Replicating the Binance model?

The success of Binance’s BNB coin has spawned other Chinese imitators that have replicated their own micro economies and have brought to their exchange misleadingly high volumes of trading through bots and wash trading.

The Huobi Token (HT) is most similar to BNB, offering discounts on trading fees and buying back tokens on a regular basis to support the price.

"If an exchange doesn’t get revenue from transaction fees and solely profits from the price of its token. How would it survive without manipulating the token price? Are you sure you want to play against a price manipulator? The same price manipulator who controls the trading platform?" – Changpeng Zhao, Binance CEO

Zero fee and trade mining exchanges have surfaced in many variations and may not be immediately obvious; some like Hong Kong’s KuCoin charge fees but through their KCS coin redistribute 50% of the daily revenues generated from fees back to coin holders. On top of that, they claim to give 40% of the daily trading fees back to all users of the platform, apparently leaving only 10% of trading revenue for the company itself. The further you go down the market cap ranking of these exchange trade mining exchanges, the more incredulous the offers are.

From what we can tell from the brief history of zero fee and trade mining tokens in the volume chart below, the initial excitement has died down.

How does volume spoofing affect the overall economy?

Exchange operators have been vying with each other to build a network effect that will insulate them from a regulatory crackdown or a market clear-out. In the legal grey where many crypto exchanges operate there are practically no boundaries to what products or promotions they can offer customers. This is particularly the case in smaller jurisdictions. Almost in a rule of thumb, we could say the smaller the jurisdiction is, the looser the legal framework is going to be: Hong Kong, Malta, Gibraltar, Guernsey, Isle of Wight, Estonia, Seychelles etc.

While it sounds utopian aligning the interests of exchanges with their customers through the redistribution of company profits and showering them with “free coins” and discounts, the only way “zero fee exchanges" can give such generous offers is if they are market makers and control the payouts.

Going forward

The most salient indicator of an exchange’s intention is where it decides to set up its operations. With the great success Binance has had we will only see more blockchain companies and exchanges setting up in Malta.

Switzerland, the home of Ethereum, has lured many major blockchain startups and ICOs with its favourable regulatory climate but interestingly it has no major crypto exchanges based there, though there has been talk that Hong Kong-based Bitfinex intends to move its operations to Switzerland. Hong Kong is in a sort of a jurisdictional limbo which is governed under the principle of “one country, two systems”, where it is an autonomous state but under Chinese rule since 1997.  The relationship has grown more ambiguous as China encroached on its sovereignty in recent years.

This ambiguity could create uncertainty going forward for exchanges based in Hong Kong as China has closed off every avenue for its citizens to purchase cryptocurrencies by outlawing ICOs, shutting down exchanges, clamping down on miners and even closing the remaining loophole left for Chinese citizens to get their hands on crypto – overseas exchanges.

This year, Chinese regulators are planning to scrutinize the Chinese bank and online payment accounts of businesses and individuals suspected of trading or facilitating trades on offshore platforms. This could present a threat to the customer base of Hong Kong-based exchanges, many of which – including Huobi and OKEx – migrated from China in late 2017 after the government introduced the ban.

The Swiss national exchange, Six, has announced that it will launch its own fully-regulated crypto exchange, that will offer custodial and settlement services and it wouldn’t be surprising to see the country attracting more exchanges with its crypto-friendly climate and its financial prestige.

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The great ETF debate rages on and there’s a lot of conjecture as to why the SEC should or shouldn’t approve one. But what needs to be addressed foremost is the immaturity and unreliability of many of the exchanges that bitcoin derives its "global spot price" from – that numbernow over210 – and the obstacles they may encounter going forward. Where would you put your money?