December 21, 2022|Commentary

Year in Review: The Exchange as a Marketplace (And Nothing More)


Written by: Paul Kremsky, Global Head of Business Development at Cumberland

In Traditional Finance, exchanges are refreshingly boring businesses. There are most likely very few people reading this who can name the CEOs of NASDAQ or CME. This is a good thing; when a TradFi exchange makes headlines, it's usually for the wrong reasons. Exchanges done right are marketplaces; they set the rules, design derivative products, provide a venue, and take a small fee for the trouble. For months at a time, they are businesses that would be considered by most to be boring: steady, dependable place on which to transact.

This is not the case in crypto. Nearly since the industry's inception, the centralized crypto exchange has been at the center of the conversation. Decisions made by exchanges have enormous impact on the market on a regular basis. The founders are household names known by their initials, with millions of followers on Twitter. A significant percentage of the entire industry is employed by exchanges.

There's a reason that the industry places so much emphasis on crypto exchanges. Crypto exchanges are not just exchanges.

As opposed to TradFi, where an exchange is a fairly simple marketplace, crypto exchanges have grown to be full-stack, one-stop shops. Exchanges regularly play the role of custodian, clearinghouse, lender, even trader. They are able to offer this full-stack coverage because the infrastructure in this space is still in its adolescence and the exchanges have the one asset that any business depends on: a customer base.

The outcomes from this type of vertical integration range from slightly positive to catastrophic. In the best-case scenario, it simply results in a one-stop-shop user experience. but it's unlikely that a single entity is top-of-class in each of the many silos they're participating. So, when a customer uses an exchange for every service they require, there are probably pieces of the offering that aren’t best-in-class.

A worse scenario is one where the exchange operates its own trading desk, which gets access to customer information: positions, stop levels, balances. Even if a Chinese Wall is placed around an exchange's trading desk, the question still remains on why the desk exists.

The absolute worst-case scenario doesn't even need to be named. It just happened. More than a million FTX creditors, with professional investors among them, just found out the hard way the danger of using an exchange wallet as a proxy custodian.

Crypto exchanges offering the full stack have been the norm since day one, and as an industry we've come to accept it. But with the catastrophic collapse of FTX, expectations are changing quickly. Our OTC desk always sees the most volume when there are issues with exchanges, and the 30 days following the FTX collapse saw more onboarding submissions than in any other month year-to-date. The possibility of bad actors at the exchange level became very real, very quickly, and it now seems extremely likely that the market will move away from exchange vertical integration and towards a model resembling TradFi FX markets.

In this model, the majority of assets and capital won't be parked on centralized exchanges. Instead, digital assets will reside in countless silos around the world and the functions of custody, lending, settlement, clearing and (most importantly) liquidity will be offered by an array of intermediary nodes and providers in an interconnected but non-interdependent web. OTC trading is the lifeblood of spot FX liquidity and will only become more important for crypto going forward; after all, currencies are bearer assets and so is crypto. Liquidity will aggregate at OTC nodes, with exchanges rounding out liquidity and largely serving retail clientele.

In 2023, we expect to see the emergence of a variety of regulated entities that will become trust-worthy providers for various market services. Each will carve out a niche and partner with a network of other providers to offer a consolidated full-service stack to end users, much like how the thousands of banks around the world currently aggregate OTC FX liquidity into their settlement mechanisms and offer it to clients, along with various options for leverage, custody, etc. Many of these niches, in fact, will likely be filled by TradFi service providers making their way into the space.

On our OTC desk, we often speak to institutions that are coming into digital assets for the first time. A common set of questions includes: Do you lend? Do you have a custody offering? Do you offer direct-market access?

We do not. We are an OTC desk, and we offer really, really good liquidity across a variety of assets. The reason we're able to offer best-in-class liquidity is because that's where we’ve chosen to focus. When institutions ask us where they can find custody or which OMS to use, we're happy to introduce them to partners who we've worked with, who we know to be best-in-class in their own niches.

Even if customers aren’t ready to demand this type of specialization in the way we predict here, we expect (and hope) that regulators will. Trading institutions will want regulated exchanges, and regulators have a pretty good model for what exchanges should look like, if customers are to be protected. Those examples are the boring businesses, the CME and the NASDAQs of the world: the exchange as a marketplace, and nothing more.

Read Part 6 of our Year in Review series, “Shaping the Next Wave of DeFi Innovation with Cumberland Labs.”

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