February 12, 2019
On 29 January 2019, at the World of ExChanges conference hosted at SIX Group premises, for the Zug Crypto Valley Association a Panel debated the benefits of traditional exchange models versus crypto exchange models. See more about this event.
The Panel was lucky enough to have the following specialists:
- Richard Olsen, Founder Lykke – My goal was to disrupt capital markets and create a kind of financial Google; I wanted to create a company that has the qualities of good art. Let’s literally convert the world into an electronic market society
- Ivo Sauter, (Member of the Management Team, SDX since July 2018. 20 years experience in financial markets with Falcon Private Bank, Bank Julius Baer, Citi and Credit Suisse. Ivo launched crypto asset trading at Falcon.
- Ross Middleton, Commercial Director at Ethfinex, Part of the Bitfinex group, Ethfinex is a top 20 cryptocurrency exchange by volume. Together with Bitfinex, Ethifinex are one of the largest global crypto exchanges. Previously, Ross worked in market analysis and trading at Gazrpom.
- James Farrugia, (Partner, GANADO Advocates – Malta) – heads up Ganado Advocates Investment Services and Funds Licensing regulatory consultancy activities, more recently working on a number of blockchain projects. Ganado one of the leading law firms in Malta and James previously worked for the MFSA.
- Tal Cohen (Senior Vice-President North American Equities, NASDAQ) Previously CEO of Chi-X Global Holdings and CEO of Chi-X Americas. Before that worked with Instinet in electronic trading. Started his career with Arthur Andersen.
- The panel was moderated by Brian Taylor, Managing Director of BTA Consulting, who have had over 100 clients in the exchange space since 1991.
The purpose of the panel was to discuss which is the winning formula for the next generation of markets and why – is it going to come from the traditional exchanges or the crypto exchanges or a blend. At the end we will each make a prediction of top 2 trends for this industry for 2019 – one for the crypto space (any topic, business, technology advancements, whether bitcoin is a buy or a sell) and one for the securities token space. The following topics were discussed, but a number of crucial issues were raised on the panel:
Brian Taylor introduced the topic as follows:
- Traditional Exchanges operate in a world where in “Theory”: Trust is Law but in “Practice” they work in an environment with massive volumes of legislation which at the extreme do not eliminate counterparty risk. History shows there are periodic financial crises create significant moral hazards for tax payers through bank bailouts.
- By contrast, Crypto Exchanges operate in a world where in “Theory”: Trust is code in the smart contract and relies on the consumer understanding the code. In “Practice” Smart contracts are rarely sufficiently smart and are rarely contracts. Crypto currencies and stable coins are not financial instruments and very few have guaranteed redeemability. A lot of the venues providing these products do not comply with KYC/AML standards.
The panel debated which is the right model to create trust. There was no consistent conclusion but the traditionalists believe that permissioned solutions will still be the way forward. James Farrugia suggested that the crypto markets are likely to become increasingly regulated to enhance trust and investor protection and will need to provide improved governance models. It was mentioned during the event that more than US$1.5 Bn has been hacked from crypto exchanges with no reliable legal framework for recourse. Ross Middleton believed that decentralized exchanges will grow as individuals who use these markets want to see these distributed models become more secure, efficient and trusted. Until the decentralised markets are ubiquitous they are unlikely to be fully accepted.
Centralisation v Decentralisation
The centralised model includes a neutral authority (the exchanges/CCPs/CSDs) for most of the value chain. These models are totally reliant on intermediation with significant intermediation costs. The market structure is B2B4C. Even if the current model can create securitised tokens they would have to be offered through a multi-intermediated structure. By contrast, in the fully decentralised model, the primary market switches to ICOs and the secondary market is a C2C model but still with some reliance on the “network” infrastructure. The drawbacks of the decentralised model appear to be complexity on how to rely on AML/KYC compliance, no way to revert a transaction, a full loss if positions are hacked, and at the extreme no market control function (the arbitrator and provider of fair and orderliness). The tra
ding model operates on caveat emptor – let the buyer beware, but, the operators of these early stage markets often operate a model whereby the market owner seeks to provide immediacy and liquidity by being the buyer to the seller and the seller to the buyer. So, while the theory is that a C2C market is less vulnerable to price manipulation and wash trades, in practice it would appear to be the opposite. Indeed, Tal Cohen believed that traditional markets see this as a conflict of interest. Both Lykke and Ethfinex on the panel provide liquidity between the C2C and did not believe that this would destroy neutrality on the marketplace.
Trying to compare fees (or more broadly implicit and explicit trading costs) between traditional markets and crypto exchanges is quite a challenge if not currently impossible. Tal Cohen stated that it is currently to use transaction cost analysis on modern crypto exchanges, making it very difficult to use these markets as a traditional asset class. Richard Olsen stated that Lykke offer trading for free and venues should offer interest on deposits by the minute. This is the explicit costs. However, any analysis that shows that crypto markets are cheaper than traditional markets is not reliable currently. The traditional markets can demonstrate end to end costs (i.e. including intermediation and implicit costs) in the most liquid securities at around 5 Bps. This has been achieved through massive economies of scale, competition and innovation.
Predictions at end of the event –
- Brian Taylor – the current shape of CCPs and CSDs will be remodelled completely for cash markets and certain aspects of intermediation will disappear in the next 5 years.