Max Pacella
Investment Analyst
Macro & Markets
7 Sep, 2021

Many of us are trying to better learn and understand the emerging world of cryptocurrencies, out here on the frontier of a new asset class.

Like the old frontier of the wild west, crypto is undergoing constant change, both evolutions and setbacks, which we must adapt to and understand the long term mechanics of what will undoubtedly be a crucial part of our financial infrastructure in the years to come.

One key piece of technology that benefits from the growing participation in cryptocurrencies is that of the crypto exchanges themselves; unable to work off the traditional stock exchange model, these are impressive technology pieces which themselves warrant a note or two to explain their mechanics and difference to the “old world model”.

Without further ado, let’s touch on the first type of exchange today: the centralised model.

The Exchange Structure

What we know today as a normal securities exchange structure can trace its roots back to the turn of the 17th century, when the Dutch East India Trading company established the Amsterdam Stock Exchange.

Traditional exchanges hold sway as a cultural and financial touchstone, they are and will continue to be integral to the healthy functioning of our global capital markets.

Their model has evolved slightly over time, particularly with the advent of algorithmic trading, but the key component stays the same: exchanges operate as a matching engine, providing a venue for buyers and sellers to create liquidity for each-other.

To the side of this there are many different functions which are complementary to the matching engine, which are necessary to efficiently execute and settle orders within the market. To name two of the main functions essential to a smooth securities exchange:

  • Clearing house; a financial intermediary providing a facility to ensure traders have sufficient funding in their account to fund the trades they are taking, be it through cash or margin
  • Prime brokerage; a broad term referring to intuitions which facilitate large trading operations, for instance a global bank providing liquidity and execution to a large hedge fund

Due to the nature of a cryptocurrency and the blockchain it sits upon, a centralised cryptocurrency exchange needs to provide market participants with all the direct and ancillary functions mentioned above bundled into one.

We won’t cover old ground by touching on the nature of cryptocurrencies here, however Mike has written several comprehensive notes which you can find below:

Essentially, a centralised cryptocurrency exchange has to re-create the entire financial infrastructure we experience in stocks or bonds, all within one service. This is the price you pay when your market is built upon tokens which in themselves look to create entire financial ecosystems in their own operation and code.

Under this model, the exchange handles every step of the consumer experience, from account opening to trading to clearing and providing margin. To draw a comparison between the two:

FunctionStock MarketCrypto Market
Account OpeningBroker or BankExchange
AML/KYCBroker or BankExchange
CUSTODYBroker or BankExchange
MARGINBroker or BankExchange
ORDERING/TRADINGBrokerExchange
MATCHING/EXECUTIONExchangeExchange
CLEARING/SETTLEMENTIntermediaryExchange

Source: Mason Stevens

Benefits of Centralised Exchange Structure

There are some interesting benefits to having exchanges operate as a “full stack product”, as opposed to dealing with potentially half a dozen different parties within the one process, within a developing financial market.

  1. Counterparty Risk: this is a risk that is often unspoken in securities exchanges, but the more hands which are touching your order, the more risk that an error in process or execution may occur.

    This is not as evident when dealing with experienced institutions, but this risk would be magnitudes higher if applied to an industry still in its infancy, like crypto.

    I would caution this does carry its own risks with the entire process being centralised, which was mainly evident in the early stages of exchanges when security infrastructure was less robust – many investors will be aware and wary of Mt Gox, an infamous hack of a Japanese exchange which resulted in the theft of $460 million USD of cryptocurrency. (Side note: those stolen coins are now with ~$44 billion USD).

  2. Risk Engine: when you place a trade through Mason Stevens, we have our own in-house risk and compliance policies/systems which review your trade, before going on to a broker who has their own risk systems, who execute on the exchange (who have their own risk systems).

    For crypto, where there is a fraction of the history and therefore a fraction of experienced counterparties, having an inbuilt 24/7 risk engine removes the need to rely on any other parties to handle the risk management of the exchange’s clients.

  3. Customer Experience: crypto is still a growing market, where the first mover advantage has not yet solidified and many exchanges continue to compete for market share – albeit its almost certain that in the coming years there will be significant amalgamation.

    To that end, being able to fully control every aspect of the client trading experience allows exchanges to develop a loyal base and a reputation for security and best practice to grow their market presence… or they won’t, and they won’t.

There’s another key benefit which is relevant to us as investors, looking for potential opportunities in the market – and that is the ability for these exchanges to earn revenue from trading.

To discuss this point, first let’s establish that we need to look at the crypto exchanges through the lens of being technology companies first, and exchanges second – rather than a more traditional corporation which has adopted technology as times have progressed (think stock exchanges evolving from brokers yelling in pits to algorithmic execution).

As a technology company, cryptocurrency exchanges can rapidly scale up their operation, capacity and services. This is the very foundation that allows them to be “full stack” in the first place.

Consider then that you have only one company executing the entire client experience, and taking the entire share of the revenue per trade.

That is a massive advantage over something like the ASX or NYSE, who have to apply a discount factor to any increased trading volume – if you increase trading volume by 100%, but pay 85% of the trading fee away to various counterparties to help you execute, settle and custody the security, the growth is much slower.

This is one reason supporting why cryptocurrency exchanges won’t fail if crypto doesn’t keep making new highs – rising prices help, but capturing 100% of the upside from a trade provides a compelling business model regardless of if BTC is trading at $30,000 USD or $100,000 USD tomorrow.

Buying the Frontier

Where do we go from here, as investors seeking opportunities?

It’s important to remember that this is still a budding industry, so much like the tokens they trade, these exchanges are yet to establish the true winners and losers.

Does that mean you shouldn’t go buy Coinbase (COIN:NASDAQ)? Not necessarily.

But there is still a hierarchy of technology being sifted out between the players in this space, there are doubtless exchanges with better offerings than Coinbase, just as doubtless there are exchanges with worse.

There will be significant M&A and listing activity in this space, at all levels and sizes – albeit there are only a handful of companies who could try to buy a large player like a Binance or Coinbase at current sizes. Coinbase as a large listed player probably has the most ‘ammunition’ to engage in this activity, but there is still room for private mergers and then listing across a suite of other market participants.

The focus should be on the quality of the technology and the ability to scale up the client offerings and values, as these will be some of the main determining factors for market staying power and the ability to further monetize their market share.

In a note later this month, Mike will also touch on decentralised exchanges, yet another opportunity in the space with a deeper technical nuance.

As I said earlier this note, we are still on the frontier, looking for gold with everybody else – but it takes a keen eye and careful observation of the industry to be a successful “prospector”.

The views expressed in this article are the views of the stated author as at the date published and are subject to change based on markets and other conditions. Past performance is not a reliable indicator of future performance. Mason Stevens is only providing general advice in providing this information. You should consider this information, along with all your other investments and strategies when assessing the appropriateness of the information to your individual circumstances. Mason Stevens and its associates and their respective directors and other staff each declare that they may hold interests in securities and/or earn fees or other benefits from transactions arising as a result of information contained in this article.