This piece is part one of a four-part series looking at trading cryptocurrency.
While both traditional exchanges and cryptocurrency exchanges facilitate trade across thousands of accounts, their setups are vastly different. A traditional exchange only carries out swaps between securities; it stays out of the broker/dealer role and doesn’t touch custody. Transferring digital assets requires transacting on a blockchain and storing funds in a digital wallet. These unique factors, combined with largely undefined regulation, mean that crypto exchanges perform several services in one.
Would the tradeoffs over custody, counterparty risk and centralization be worth the effort to make cryptocurrency exchanges work like traditional ones? Will cryptocurrency exchanges be able to work like traditional stock exchages, and should they?
One Function Versus Many
Centralized crypto exchanges like Binance and OKEx employ several services needed to coordinate digital asset trading. Each crypto exchange uses an order-matching engine to match buyers and sellers, verify accounts and finally process transactions. In contrast, traditional exchanges basically perform one service, carrying out trades through an order-matching engine. They don’t hold funds or perform the role of a broker/dealer.
Shane Molidor, Global Head of Business Development at FBG ONE Trading, explains crypto exchanges’ role as “more analogous to all-in-one platforms that interact with a custodian, the exchange, and a clearing agency, rather than just one place to exchange funds.”
While each of these functions were built separately for financial trading, Molidor says, “crypto platforms consolidate all of this functionality. If you deposit bitcoin with Coinbase Pro, for example, you’re commingling your assets with all their other customers who’ve deposited bitcoin. When you place a buy or sell order, Coinbase is serving as the broker/dealer introducing that order to the order matching engine. When the maker and taker interact with one another, the trades are settled immediately but back into the commingled accounts.”
This difference from traditional exchanges is what makes much of Wall Street and traditional investors uncomfortable using cryptocurrency exchanges. Cross-functionality also creates counterparty risk (the risk that one party will default on the agreement). Another key difference involves how crypto exchanges and traditional exchanges interact with data.
Data Centers and Cloud Services
While traditional financial exchanges rely on massive data centers in physical locations, most crypto exchanges rely on cloud services—more specifically, Amazon Web Services. Using AWS (or any centralized data center) puts crypto exchanges at risk of service outages like the time a human error brought AWS down in an entire region for five hours. While such outages are infrequent, crypto exchanges face some risk that a government will order their services cut off.
Crypto introduces the complexity of transferring funds using various cryptocurrencies with multiple blockchains, gas fees and digital wallets, along with counterparty risk, custody issues and regulatory uncertainty. While exchanges, market makers and traders are profiting, the differences between crypto exchanges and their traditional counterparts are keeping many potential investors out for now.
As more regulatory scrutiny comes to crypto, it’s possible the collection of services offered on crypto exchanges will start to separate in order to provide better protection against counterparty threats and regulatory violations.