Cryptocurrency exchanges vs Traditional stock exchanges

Introduction. Below, I will explore differences and similarities between traditional stock exchanges and the relatively new cryptocurrency exchanges. I will analyze the workflow of a traditional exchange, discuss the value proposition, and list key industry leaders. Then, I will delve deeper into cryptocurrency exchanges, reviewing their workflow as it exists today, identifying revenue drivers, and listing the key players in the field by transaction volume. Then, I will focus on a few key differences and similarities before highlighting the opportunities that emerge from the introduction of decentralized exchanges and automated market making (AMM).

Trading ownership rights to an asset is an activity as old as time itself. Whether the exchange is done directly between individuals or with the involvement of a facilitator, trading claims of ownership or indenture has its roots deep in human history. Most asset trading today is facilitated through order books. A trader can place an order — specifying the trading pair, quantity, and price — which is matched with the other side of the order book. Exchanges take a service fee to facilitate this matching process.

The biggest securities exchange today is the New York Stock Exchange, which was established in 1792 following the approval of the Buttonwood Agreement. Since then, traders and investors have relied on the New York Stock Exchange, NASDAQ, and other exchanges worldwide to trade fiat money for securities, including ownership shares, debt of a publicly listed company, Exchange-Traded Funds (ETFs), and derivative contracts including futures, forwards, and options.

Following the Global Financial Crisis in 2008, a new computer protocol emerged that would eventually become its own asset class, though that is still up for discussion per Gary Gensler and friends. This new computer protocol, Bitcoin, allowed users to transfer value directly to one another (peer-to-peer) via the internet. The new era of decentralized finance emerged on the backdrop of U.S. Federal Reserve Bank monetary policy in 2008 where extensive quantitative easing devalued the U.S. Dollar in exchange of supporting a floor on asset prices. Many viewed the response of the U.S. Fed as necessary to avoid another Great Depression. Others, including Satoshi Nakamoto (pseudonym of Bitcoin creator), deemed it irresponsible, which then triggered the creation of a different method of storing value and making payments, independent of decisions from central banks around the world.

By 2012, there was enough demand to trade in and out of the asset. Enter Coinbase. Brian Armstrong, an Airbnb engineer at the time, decided that he would create a product that would make it easy for people to buy bitcoin as opposed to creating (aka mining) it themselves. Today, Brian remains the CEO of Coinbase, a publicly listed $44Bn company and the 2nd largest cryptocurrency exchange in the world.

In the next few pages, I’ll discuss the importance of each industry, its strengths, and highlight any areas of opportunities that could emerge. I’ll explore how these industries could change in the future on the back of regulatory pressure and persistent innovation. Finally, I’ll conclude with a thought that is certain amidst the uncertainty brought on from cryptoeconomy: Finance has entered a new era.

Traditional Exchanges. Stock exchanges are networks within the broader stock market where brokers exchange shares of a publicly traded company. While most trading on stock exchanges today happens electronically, there are still parts of the market where floor brokers will execute the trades on behalf of market participants. The New York Stock Exchange in downtown Manhattan (11 Wall Street) has a physical space where brokers buy and sell securities during market hours primarily. The exchange business model is simple: connect liquidity providers with liquidity seekers. For this service, exchanges collect transaction and clearing fees. See below for a simple diagram depicting the flow of capital from the investor (bottom right) who uses their broker to place an order to buy a share of a company. The broker then goes to the exchange to find the amount desired from the client. In this exchange, there will be sell orders available at various prices…these sell orders may be there from other investors/traders or the company itself through an IPO or a separate equity offering. Important to note that the diagram below is too simplistic and ignores the role of intermediaries (e.g. investment banks) during an IPO, market makers, custodians, clearinghouses. I left these components out for a couple of reasons: 1) I want to focus on the flow of capital at a high level to draw comparisons with crypto exchanges, and 2) I don’t understand it well enough.

How do traditional exchanges make money? Transaction fees. That would be the simple answer. However, exchanges have evolved considerably and, even though transaction fees constitute a good chunk of revenue sources, there are other increasingly prominent revenue sources like market services, investment intelligence analytics, and listing services. As an example, here’s a breakdown of revenues from NASDAQ’s supplement to financial statements released in early 2021.

Over the past decade, there have been increasing pricing pressures to reduce transaction fees. It started with brokers, such as Robinhood, introducing $0 transaction fees for investors. In turn, these economics have been passed on to exchanges as trading services become increasingly commoditized. Therefore, exchanges have tried to rely on other revenue services to achieve recurring revenue streams (e.g. subscription-based) and differentiate themselves from other stock exchanges. In the example above, the Investment Intelligence line item increased at a CAGR of 16% whereas the traditional Market Services had a growth rate of ~8%, indicating NASDAQ’s focus in attaining new growth engines within the exchange.

Which are the biggest stock exchanges in the world? Chart below reflects 2021 transaction volume at various exchanges (source: World Federation of Exchanges). NYSE, NASDAQ, and Shanghai Stock Exchange lead the way.

Cryptocurrency exchanges. These exchanges provide a gateway to the cryptoeconomy. If an individual or an institution wants to first enter the crypto world by owning cryptocurrency, they would most likely need to visit an exchange online, open an account, and exchange fiat currency (e.g. USD, EUR, JPY, GBP, LEK, etc.) for cryptocurrency (e.g. BTC, ETH, SOL, etc.). The process flow is simple and examples of market participants, including the World’s richest person and a third world country, are listed below:

In the process above, there’s a direct relationship between the investor/trader and the exchange. In other worlds, a retail trader or institutional investor open an account with Binance, for example, go through the Know-Your-Customer (KYC) process to mitigate risks of money laundering or tax evasion, and start to buy and sell coins/tokens directly on the exchange. An investor can add fiat currency or any cryptocurrencies they already hold directly on the exchange and trade those assets freely with other market participants.

But where do the initial cryptocurrencies come from to be added to the exchanges? Cryptocurrencies or crypto tokens (cryptocurrencies operate on their own native blockchain whereas crypto tokens operate on an existing blockchain) are created through a process called “mining”, where miners expend electrical energy to solve a puzzle (this process is known as Proof of Work). Once complete, miners are rewarded with a coin or a token, which they can bring to the exchange and convert it to for other coins or government-backed fiat currency.

How do cryptocurrency exchanges make money? Cryptocurrency exchanges generate revenues largely from transaction costs. Higher transaction volume leads to higher transaction revenue for cryptocurrency exchanges. For most exchanges, there are revenue sources other than transaction fees, but most of the revenue (+85%) is driven by transactions. See below for an excerpt from the Coinbase 10-Q filed in November 2021:

Cryptocurrency exchanges see an increase in revenues when transaction volumes are high. Furthermore, transaction volumes increase when underlying cryptocurrency prices increase, at least historically. Therefore, cryptocurrency exchange revenues are closely tied to the price of cryptocurrencies. Many investors dislike this relationship and cryptocurrency exchanges themselves have focused on diversifying their source of revenue by adding new business lines. For example, Coinbase has introduced Coinbase Lending, which can allow the company to generate interest income on loans that it extends; FTX has added derivative trading which generates higher fees due to higher notional traded, etc.

Who are the big players? Coinbase is one of the oldest cryptocurrency exchanges in the World started by an ex-Airbnb engineer named Brian Armstrong. Binance is the biggest cryptocurrency exchange in the World founded in 2017 by Changpeng Zhao, who had previous experience in high frequency trading. The Winklevoss twins, involved with Facebook early before exiting the company in non-amicable terms, took their own shot at starting an exchange (Gemini) in 2014. Additionally, Sam Bankman-Fried, the richest 29-year[1] old since Mark Zuckerberg, reached his status after starting the cryptocurrency exchange FTX with the slogan “built by traders for traders”. But it’s not all success stories in the cryptocurrency exchange industry: Mt. Gox was the biggest cryptocurrency exchange in the years after the Global Financial Crisis handling 70% of global bitcoin trading at its peak until it filed for bankruptcy in 2014 following its inability to handle liquidation events, margin management, and cybersecurity concerns. However, since the demise of Mt.Gox, new players have emerged and the industry as a whole has grown larger and attracted major investment interest. As variable costs are near ~$0, it is easy to convince investors of the business model.

Main similarities. 1) Transaction fees remain a prominent revenue source and 2) both models rely on a central authority

Main differences. 1) Retail investors interact directly with the crypto exchange but they have to go through a broker to interact with a traditional stock exchange, 2) Self-custody of assets is available in the crypto economy but not in traditional finance, 3) Cryptocurrency exchanges allow trading 24 hours a day, 7 days a week. Traditional exchanges allow trading 6.5 hours a day, 5 days a week (excluding national holidays). 4) Settlement period is instant in crypto exchanges but can take up to 2 days in traditional exchanges (e.g. Robinhood Game Stop fiasco). I want to spend some time below talking about self-custody and how its nascence poses a problem for regulators. There are two different routes that an investor can take upon buying a digital asset, like a cryptocurrency or a non-fungible token (NFT). One route is to buy the cryptocurrency on an exchange and leave it there. Alternatively, an investor can buy the cryptocurrency on an exchange and immediately transfer it to a self-custody wallet (i.e. a location outside of the purview of the exchange where the investor is the sole custodian of the asset). This distinction is important because it concerns the IRS. I’ve listed both scenarios in the table below:

Though this example may not be truly material, it brings to light that regulation can change the way that the process is set up today to increase transparency and generate revenue for governments. The jury is still out on whether we will classify cryptocurrencies as assets (where we calculate capital gains/losses) or currencies that we use as medium of exchange, at which point, as the currency appreciates, there wouldn’t be any taxes due (or if the currency depreciates, you can’t use the losses to offset any other capital gains).

Decentralized Exchanges. [Will write about how these fit in next time]

Conclusion. Traditional exchanges and cryptocurrency exchanges serve the same purpose, but the actors involved, the lifecycle of a trade, and the ethos of the cryptoeconomy lead to differences between these two business models. Centralized cryptocurrency exchanges and traditional stock exchanges both rely on one central actor to match buy and sell orders. This business model leads to a predictable main stream of revenue that is highly dependent on transaction volume. While cryptocurrency exchanges have more than 80% of revenue come from transaction volume and traditional exchanges have reduced that reliance to 50%, the big driver remains the fees that the exchanges collect on trades. On the other hand, differences are vast, but most prominently, differences can be summarized in the following categories: the trade lifecycle is much shorter in the cryptocurrency ecosystem than in the traditional finance ecosystem; investors and traders serve as custodians to their own capital whereas a broker or a third-party custodian is involved in traditional finance; investors can trade cryptocurrencies 24/7/365 whereas trading hours are limited in stock exchanges; and while there are few players that dominate trading in traditional finance, the market is vast and ever changing in the cryptocurrency exchange world that only recently is starting to see a convergence towards a few big exchanges. There is an argument to be made that traditional exchanges can facilitate a simpler trade lifecycle that does not involve brokers, custodians, market makers, etc. However, there is also an argument to be made that these players provide true value to institutional and retail investors. Furthermore, traditional stock exchanges may not be suited to take on responsibilities that currently sit with brokers, such as providing user interfaces for retail investors, preparing tax statements for its users, and setting up call centers to meet investor questions. Maybe in the future, the cryptocurrency exchange market will shift closer to the traditional market because exchanges may not be able to do this all-in-one model at scale that exists today.

Time will tell how both industries will evolve or whether we’ll see a consolidation between traditional stock exchanges and crypto exchanges, but one thing is for sure: we’ve entered a new era of finance and we must adapt accordingly.