Research on Cryptocurrency Exchanges and the Future Pattern in Regulatory Game
Cryptocurrency Exchange Research and Future Regulatory Patterns
Authors: Jam, CloudY
Editors: Vincero, YL
Regulation has two sides. CEX+CeFi=Traditional Commercial Bank. CEX is moving towards DEX.
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The impact of regulation on the development of CEX
Regulation will increase the implicit cost of trading
Implicit cost Explicit cost
Compliance may promote the inflow of incremental funds
Macro level Micro level
(Source: BTC volatility over the past 9 months)
A weak regulatory environment will enable the Crypto Market to develop more freely
In our observation, a strong regulatory environment has the following characteristics: a license or permit to operate, securities definition, and asset classification.
Regulatory agencies can require CEX to obtain specific licenses or permits to operate. These licenses and permits must comply with local regulations and compliance requirements, including but not limited to KYC and AML regulations. By issuing licenses and permits, regulatory agencies can impose stricter regulation on CEX. Secondly, some cryptocurrencies may be considered securities. If a cryptocurrency meets the definition of a security, it must comply with securities regulations and be subject to securities regulatory agencies (according to CoinMarketCap data, up to 67 cryptocurrencies are currently recognized by the SEC as securities.) In addition, in a strong regulatory environment, cryptocurrencies may be defined as a specific asset type. For example, different countries may consider cryptocurrencies to be financial assets, virtual assets, or digital assets. This classification may result in specific regulatory requirements and tax obligations.
In the early stages of the cryptocurrency industry, especially after the emergence of Bitcoin, regulatory agencies had not yet established clear rules and regulatory standards for the cryptocurrency industry, especially for important institutions such as CEX, because this field is a new Internet innovation. However, with the popularity of cryptocurrencies and the expansion of the market size, “regulatory evasion” has gradually become the focus, leading to a series of regulatory measures and rulemaking.
Initially, regulatory agencies only monitored and warned about the cryptocurrency market, alerting participants to the risks and challenges they might face, but did not implement specific regulatory measures. Later, regulatory agencies began to pay attention to illegal activities related to cryptocurrencies, including money laundering (but according to CZ in an interview, a report forwarded to CZ by an ambassador from a certain place mentioned that only 3% of Bitcoin transactions are related to illegal activities or problematic activities. This proportion is very small, actually lower than that of fiat currencies.) and illegal financing. Now, regulatory agencies are developing more comprehensive regulatory frameworks and more transparent regulatory standards, including but not limited to: information disclosure requirements, KYC and AML, licensing and registration requirements, framework and rule establishment, and regulatory cooperation.
According to the laws of economic development and historical cases, industries that lead the way in regulation may indeed gain better arbitrage opportunities or development prospects.
Early participants in the industry are often able to establish a strong brand influence and user base. As regulations gradually strengthen, these companies may have established good compliance frameworks and reputation, making them more likely to obtain recognition and support from regulatory agencies. Such first-mover advantages can bring these companies better market positions and competitive advantages, and use external regulation to establish deeper moats.
However, stricter regulatory requirements may cause some competitors to fail to meet compliance standards or bear the costs of regulation. As regulations become more stringent, investor confidence in compliant industry participants and projects may increase. They are more willing to invest funds in companies and projects that comply with regulatory requirements, reducing investment risks.
Overall, a weak regulatory environment may bring greater freedom and flexibility to the Crypto Market.
(Dogecoin "To The Moon" Slogan)
Regulation is an important trigger for changes in CEX competition.
In the early stages of the development of the cryptocurrency market, especially in the early days of BTC, the number of CEXs was limited, and the main focus of competition was to provide secure, highly liquid, and rich trading pairs. Early competitors include MT.GOX, BTC China (founded in June 2011), Kraken (founded in July 2011), Bitstamp (founded in August 2011), Coinbase (but early Coinbase was a payment processor), etc. With the growth of the market and changes in user demand, CEXs began to expand their platform functions and services, including adding derivatives trading, OTC trading, fiat trading pairs, lending, and insurance functions. The milestone event is the perpetual contract launched by Bitmex in 2016, with the maximum contract leverage increased to 100 times.
With the development of the global cryptocurrency market, CEXs have begun competing in different segments. Some CEXs focus on local markets, providing local fiat trading pairs and language support to meet the needs of local users. This has led to the emergence of some regional exchanges, such as Huobi (formerly known as Huobi.com) and OKEx (formerly known as OKCoin), which focus on the Greater China market, as well as Upbit and Bithumb, which focus on the South Korean market. In addition, CEXs that focus on derivatives trading have also emerged during this period, such as early players FTX and Bybit.
FTX and Binance are a later story. Early FTX focused on the derivatives track and occupied a leading position in the track in a relatively short period of time. Binance, as an early investor in FTX, also seemed to be indirectly involved in the derivatives track competition. Until November 2022, FTX’s scandal was exposed. The latest story is well-known, and we will not dwell on it. (Source: YM Crypto)
If the target of regulation is the object of its barrel, then FTX pulled the trigger to kill itself. The FTX scandal undoubtedly accelerated regulatory action against Binance, the world’s largest CEX, and Coinbase, a CEX known for its high compliance.
(Source: The Block)
Looking at specific events, every change in regulatory policy has a huge impact on the overall CEX industry:
On September 4, 2017, the Chinese government expressed a strong regulatory attitude and issued the “Announcement on Preventing the Risk of Token Issuance and Financing” jointly with seven ministries and commissions, announcing that “ICO is an illegal public financing activity and should be stopped immediately.” The announcement caused a dramatic change in the market structure: ICO was identified as illegal fund-raising, projects were cleared, and exchanges were forced to withdraw or go offshore. Bitcoin China and Yunbi stopped virtual currency trading, while OKCoin and Huobi closed their RMB business and transferred it overseas.
On November 9, 2022, FTX’s bankruptcy led to increased SEC regulation: “Within six months after FTX’s bankruptcy on November 11, 2022, SEC’s cryptocurrency-related law enforcement actions increased by at least 17 times, a 183% increase from the previous period.” After FTX’s compliance-friendly image collapsed, Kraken was the first to be subject to SEC’s stricter regulatory impact, as its pledge business was not registered with securities and was sued by SEC. Kraken ultimately reached a settlement with SEC by immediately ceasing to provide on-chain pledge services to U.S. customers and paying a $30 million fine. Coinbase naturally took over Kraken’s market share in this part of the pledge business.
Subsequently, on June 5th and 6th, 2023, the SEC filed lawsuits against Binance US and Coinbase. The SEC claimed that both provided unregistered securities trading and also alleged that the profit and pledging services provided by these two exchanges also violated securities laws. The charges against Binance were more serious, claiming that Binance engaged in clearing transactions and mixed customer funds between its domestic and overseas entities. These two lawsuits resulted in large amounts of funds being withdrawn from the two exchanges and flowing into the chain and other exchanges.
The Financial Services and Treasury Bureau of the Hong Kong Special Administrative Region Government released a “Policy Statement on the Development of Virtual Assets in Hong Kong” on October 31, 2022, indicating that Hong Kong is committed to promoting the development of the NFT, Web3.0, and Metaverse markets. The “Guidelines for Virtual Asset Trading Platform Operators” came into effect on June 1, and virtual asset trading platform operators will be able to apply for licenses and allow retail investors to use licensed virtual asset trading platforms. This has led to a series of new and old exchanges announcing their entry into Hong Kong, including New Fire Technology, Tiger Securities, DBS Bank, OKX, Bitget, and others.
It can be seen that the release of a policy can lead to the decline and rise of CEXs, and every major policy change is a reshuffle of the CEX industry pattern.
(Source: The Block)
Hedging Strategies for CEX Business Risks
CEX+Cefi=Traditional Commercial Bank
Abstract understanding: Although CEX is doing the work of an exchange, its essential model is still the traditional commercial bank model.
The essence of a commercial bank (hereinafter referred to as a bank) is to create credit currency, and its operation mode is to absorb deposits and issue loans. By absorbing deposits, the bank can obtain funds to support its subsequent business activities. Then, based on the deposits absorbed, the bank creates profits by providing loans to individuals, households, and businesses. When the bank provides a loan to a borrower, the borrower deposits the loan into their bank account. In this way, new deposits are created, giving the bank more available funds for loans and investments.
CEX initially only provided the most basic spot trading (such as the earliest spot trading platform established for BTC), and later developed derivative trading-perpetual contracts. However, the current CEX is still in the “black box operation” stage, and the exchange has not clearly stated its funding operation method for providing contract leverage. The leverage funds for perpetual contract usually come from two parts: own funds and user funds and deposits.
It can be reasonably inferred that:
• 1) Spot has become the entry point for absorbing funds for CEX, and the contract has developed into a direct application scenario for issuing loans, which ultimately creates credit currency. However, this form of credit currency can only be used within the CEX where it was created.
• 2) The use of user funds takes priority over proprietary funds. After all, the ultimate goal of CEX is to maximize the revenue from transaction fees while ensuring the safety of proprietary funds.
However, traditional commercial banks are generally required to operate separately, i.e., to separate securities investment businesses. CEX “part-time” as an investment bank, nominally, CEXs only issue platform coins; in fact, some projects do rely on CEX’s blood transfusion. By issuing platform coins, exchanges can increase their control over the ecosystem. Users who hold platform coins may benefit from different discounts, rebates, or rewards. In addition, platform coins can bring additional revenue and profit opportunities to the exchange. Platform coins are usually designed to be somewhat scarce, and their supply may be fixed or have a destruction mechanism, resulting in long-term deflation. As the platform grows and the number of holders increases, platform coins may rise, thereby giving CEX more benefits.
However, traditional commercial banks have open and transparent risk exposure due to the reserve system and capital requirements. Even if a single bank experiences a liquidity crisis or encounters a financial crisis, the central bank can act as the last buyer of commercial banks under certain conditions. Therefore, in the paradigm of traditional finance, commercial banks are often “too big to fail.”
Unfortunately, the massive CEX in the world of encryption currently lacks a transparent financial system and “the last buyer.” This may also be a significant reason why CEX is heavily regulated at present.
Clue: Mainstream CEXs are laying out in advance to meet the strict regulatory environment.
Large exchanges must move towards compliance and cooperate with legal deposits.
Smart CEXs are moving towards more decentralization to adapt to future strong regulatory environments. Coinbase not only provides custodial wallet services, but also plans to launch a Layer 2 solution based on OP Stack. Binance has successfully launched the OP BNB testnet, and Bybit has also announced the launch of its Layer 2 solution. In addition, Bitget has launched MegaSwap, a convenient token aggregation swap service for users that leans towards DEX. OKX is relatively aggressive and directly integrates its Web3 wallet with its CEX app to achieve the conversion of on-chain and off-chain assets.
Despite frequent regulatory lawsuits in the US, Binance is still recognized as the largest CEX in the market, with significant influence and wealth effects in its Listing, IEO, and LaunchBlockingd. As regulations gradually strengthen, Binance’s CEX business is somewhat trapped. In order to comply, Binance has made a lot of efforts, but the effect is not obvious. This will inevitably push Binance to further promote the development of on-chain businesses. BAS application chains and BNB Greenfield storage chains are the embodiment of BNB empowerment, building the BNB on-chain ecology.
Unlike Binance, OKX chooses to hedge regulatory risks using Web3 Wallet and OKBChain. The user experience of Web3 Wallet itself is among the best in similar wallets, and most importantly, OKX’s Web3 Wallet is embedded in the OKX App, which can achieve seamless conversion between on-chain and off-chain. This will help OKX avoid regulation while converting CEX users into OKB Chain to empower OKB. OKB Chain, accompanied by the Hong Kong policy launch, and backed by users from the OKX Web Wallet, occupies the right time and place. It can be said that OKX has achieved phased success in responding to strong regulation strategies.
As a second-tier CEX, Bitget still focuses on using hotspots and IEO to build its brand and empower its platform currency BGB, in order to attract more users. Therefore, its product and marketing capabilities still have some gap compared to larger CEXs. However, outside of CEX, it continuously absorbs other second-tier CEX users and potential incremental users through the matrix established by Foresight News and Ventures, which is somewhat effective. And it also announced that it will settle in Hong Kong and establish a licensed compliant exchange. It can be seen that second-tier CEXs are still struggling with user volume and brand, and are far from considering strong regulation. They can only embrace regulation-friendly areas.
• Open Exchange OPNX
Different from other CEXs, OPNX chooses to hedge regulatory risks on-chain. Its plan is to separate trading collateral from the matching engine: 1. User collateral, whether native assets or RWAs, is transparent on-chain; 2. Customer positions require a credit limit for the collateral related parameters of the on-chain assets owned by DAOs, and funds and clearing are mutually isolated. OPNX focuses on RWA and debt trading, which can largely avoid the impact of securitization, and debt trading, similar to Celsius and FTX, can also open up a large incremental market for it. For regulation, OPNX chooses to establish itself in Hong Kong, which is embracing a crypto-friendly environment in Hong Kong.
Insider: Perpetual contract business will not be easily abandoned
For CEXs, perpetual contracts are currently the largest source of revenue.
For users, what really makes them addicted is not just the novelty of being able to obtain leverage of hundreds of times, but also the dizzying feeling of easily obtaining a hundred times net assets. High leverage can make users feel the potential huge profits, stimulate their greed, and fast profits can bring excitement and satisfaction, and increase users’ speculative desires. The uncertainty of asset price changes also brings users stimulation and excitement, further encouraging them to try high-leverage trading.
Therefore, there is a kind of business tacit understanding between the supply and demand sides of perpetual contracts. “CEXs have patted the shoulder of perpetual contracts: if the market likes them, we will provide them.”
As we mentioned in the previous section, “regulation will increase the hidden costs of trading”, and the trading fee is unlikely to be significantly increased because the current total trading fees (Maker fee + Taker fee) are mostly between 0.01% and 0.1%. (Trading fee data Source: CoinmarketCap.com) If the marginal trading fee is increased, a considerable part of investors will be lost. Therefore, the perpetual contract, as the most profitable business of the CEX, may become a marginal substitute. In other words, the perpetual contract business segment may have more innovation to make up for the income loss caused by the increase in hidden costs.
(Source: Nansen, OP Research)
Overall, CEX, as a derivative model of the traditional commercial bank model, will consider both compliance and decentralized development strategies in its risk hedging strategy, as well as the dark strategies of continuously developing perpetual contract business innovations to ensure revenue stability and adapt to the challenges of the future heavily regulated environment.
Can DEX replace CEX?
CEX is in a difficult position, and DEX may have an opportunity for development.
In addition, the “listing effect” has overdrafted the future growth space of some tokens. The poor performance of the newly listed tokens, such as Binance, is the main reason. According to @Loki’s research, based on the Binance Listing announcement information, during the 13-month period from April 29, 2022 to June 4, 2023, Binance listed 20 new spot trading tokens and 14 old tokens. Among them, the average holding return of the 20 new tokens to the statistical time 20230604 was -22.3%, while the average return of BTC during the same period was 7.9%, and the price performance was significantly inferior to BTC.
We believe that the reasons for the poor performance of newly listed tokens are: Insufficient market incremental funds, new listed tokens will cause the diversion of existing funds. In the case of a poor market environment, the probability of new tokens breaking will increase.
• 1) Insufficient incremental funds: When the overall market liquidity is insufficient, newly listed tokens may not be able to attract enough incremental funds to support their price increases. In this case, investors may be more inclined to invest limited funds in mainstream tokens or assets with more stable returns, and adopt a wait-and-see attitude towards newly listed tokens.
• 2) Diversion of existing funds: The introduction of newly listed tokens may cause investors to transfer some of their funds from other tokens or assets to participate in the trading of new tokens. This may affect the liquidity and price of some existing tokens, especially in the case of a weak overall market, this impact may be more significant.
Therefore, in an unstable market environment or when investor confidence is low, the probability of new tokens breaking may increase.
Currently, CEX is facing challenges, while DEX may be entering a golden age of development?
The AMM mechanism created by Uniswap removes market makers and allows for on-chain spot trading that conforms to on-chain logic. However, the problems with AMM are also apparent. When there is not enough LP depth, the transaction slippage is huge. Even with moderate LP depth, the transaction slippage is still significant compared to trading on CEX, especially for assets with high trading volumes and good liquidity. Therefore, many large traders transfer their funds to CEX, conduct transactions, and then transfer the funds back to the on-chain platform.
For a long time after DeFi Summer, DEX did not achieve a breakthrough.
Recently, there have been some signs of a renewed DeFi boom. On the occasion of the expiration of the Uniswap v3 patent, a joint order book AMM mechanism led by Trader Joe appeared. Trader Joe calls it the Liquidity Book. The Liquidity Book draws on the ticks of Uniswap v3 and establishes small price ranges called bins, where transactions within each bin can be executed without slippage, and different strategies can be established based on changes in the number of bins and the distribution of funds, optimizing the experience for both traders and liquidity providers. Centralized liquidity solutions have also appeared in projects such as ve(3,3) to promote price depth and increase LP income. In addition, the custom LP incentive led by Camelot has also been favored by the market, and similar solutions have been launched by Maverick and Uniswap v4, allowing pool creators to freely add LP mining incentives to promote LP depth. These innovations have allowed Trader Joe to win the $ARB Liquidity War, quietly bringing Maverick’s trading volume to the fifth place on the ETH chain’s DEX, and making Camelot the largest native DEX on Arbitrum. Therefore, the Liquidity Book mechanism has allowed DEXs to make progress in spot trading. However, in terms of overall trading volume, the trading volume of DEXs is far from enough to compete with CEX. However, their market share is growing year by year, so DEXs are steadily developing relative to CEX, which is also related to the relatively stable trading volume of DEXs and the decreasing trading volume of CEXs.
(Source: The Block) (Source: The Block)
Aside from spot trading, perpetual contracts are worth mentioning. A good perpetual contract trading experience is a major reason why CEXs are difficult to replace. However, it is also the biggest source of income for exchanges, and a cake that on-chain protocols have long been eyeing. The characteristics of on-chain protocols are asset non-custody and a clear path for margin and liquidation, which is something that most CEXs currently lack and cannot achieve.
Using DYDX, the most CEX-like perpetual contract DEX, as an example, DYDX uses an order book model, where user assets are used in a non-custodial manner to settle trades and liquidations in a trustless manner. A chainlink oracle is used to obtain prices for positions and liquidations. A off-chain engine matches orders and a liquidation engine automatically closes positions. The oracle price equals the median price reported by 15 independent Chainlink nodes. During liquidation, positions are closed at the closing price and any profits or losses resulting from liquidation are borne by the insurance fund. DYDX v4 will be integrated into the Cosmos ecosystem to achieve lower latency and less wear and tear. However, one problem with DYDX replacing CEXs is that the index prices for fee and limit orders come from CEXs. As of June 21, DYDX’s 24-hour trading volume was $2.08 billion, still far behind the leading CEXs.
Unlike DYDX’s order book model, GMX uses an LP model, where traders become counterparties to LPs to achieve zero slippage and get rid of market makers to provide liquidity, similar to the advantages of spot AMM models. In addition, its fee is 0.1%, with a maximum leverage of 50x, no KYC, and no geographic restrictions, making it more attractive than DYDX (which has a maximum leverage of 20x and cannot be traded on DYDX with a US IP address). However, its disadvantages are similar to those of AMMs, with a limited amount of funds and a theoretical maximum order limit that depends on the TVL of GLP, making it less friendly to large funds. GMX v2 introduces customized Chainlink price feed services to achieve lower latency prices, but the final price is the average of the oracle price and the mainstream CEX price. Therefore, GMX is more dependent on CEX prices and it is more difficult for it to operate independently in the short term. As of June 21, the recent high, GMX’s 24-hour trading volume on Arbitrum for Swap, Mint GLP, Burn GLP, Liquidation, and Margin Trading was only about $426.8 million, about 20% of DYDX’s total trading volume.
Long-termism: DEX is more in line with crypto fundamentalism and blockchain justice principles
From the above DEX mechanism and data, we can see that the current share of DEX in the entire exchange market is still relatively low compared to CEX. At the same time, perpetual contract DEX still relies heavily on CEX in terms of pricing. However, this is all due to the low threshold interaction of CEX, which means it has more users than DEX and has access to market makers. The non-custodial mode of DEX’s security, margin, and clearing mechanisms naturally conforms to crypto fundamentalism and blockchain justice principles. Therefore, with the development of technology, when on-chain interaction and Web3 wallets are no longer obstacles for users to enter DEX, what we may eventually see is an on-chain DEX based on off-chain technology, while CEX will only be a place like most brokers that completely comply with regulations for large institutions to conduct bulk transactions and for retail investors to enter and withdraw funds. The exchange that is most like the one we described is the Open Exchange we mentioned earlier, which approaches decentralization from a more CEX-oriented perspective. So, in the short term, what DEXs may need to do is to sacrifice decentralization to some extent in order to achieve a better user experience. To achieve widespread adoption of DEX, we also need to wait for the following key technologies to be implemented and popularized:
Conclusion: If CEX’s ultimate destination is decentralization, are DEX’s advantages still valid?
We are optimistic about the future of CEX and commend the industry positioning of DEX. But when CEX moves towards decentralization, the outcome of DEX is still uncertain.