Exchanges
Let’s say you want to purchase and trade cryptocurrencies such as Bitcoin and Ethereum: you would not be able to do so with your local broker or on a regulated stock or commodities exchange. Instead, you would have to purchase your coins on a cryptocurrency exchange (there are many!), such as Coinbase, Binance, Bittrex, Bitfinex, and Gemini. Most of the world’s cryptocurrency trading is carried out on such exchanges.
Exchanges operate as either market makers or matching platforms. As matching platforms, exchanges match buyers and sellers, and take a portion of the trade value as a commission. Sellers specify the amount and the price they’d like to sell at, which are put on a common ledger called the order book. Buyers look for orders in the order book or create their own buy order if no one is selling at the price they are looking for. The exchange matches buy and sell orders by price and processes the trades.
Alternatively, though less commonly, exchanges might act as market makers, providing the liquidity to traders themselves. In such situations, traders would technically not be trading with other traders but with the exchange, which would in turn trade with another party. This allows for greater trading volume and eliminates fulfillment delays, while increasing the stability of the spread between buy offers and sell offers.
Centralized exchanges keep customers’ coins and tokens in hot wallets and private keys in off-chain databases until users withdraw their deposits. This allows users to easily trade between fiat or digital currencies. However, the centralized nature of this storage means that exchanges are responsible for all their users’ cryptocurrency accounts and the private keys that go with them.
Policies vary from exchange to exchange. Coinbase, for example, maintains 98% of customers’ digital currency offline and in cold storage, acting as an effective custodian (see below), with the 2% kept on online servers and insured. Cash balances are held in custodial accounts with U.S. banks or in liquid treasuries. Bitfinex, on the other hand, stores 0.5% of its cryptocurrencies in live hot wallets, with 99.5% in cold storage.
While most exchanges have dedicated security teams in order to protect their customer’s’ private keys from theft, the mere fact that they store millions of private keys make them prime targets. The history of exchanges is filled with high-profile blowups: more than 980,000BTC has been stolen from exchanges. These range from the famed hack of Mt. Gox - then the world’s biggest exchange - in 2014, where 850,000BTC (currently worth US$5.2bn) was stolen, to a hack of BitGrail in February this year, where US$195mn worth of new cryptocurrency NANO was withdrawn by criminals. And despite its security measures, including U2F, 2FA, account monitoring, withdrawals protection, multi-signature wallets and API key permissions, Bitfinex lost 120,000 BTC (currently worth US$744mn) to hackers as well.
Some exchanges also offer their own trading platforms to users. Coinbase, for example, offers Coinbase Prime, a powerful platform specifically targeted at experienced traders and crypto funds.
Regulated Exchanges
The problems facing exchanges have led the Intercontinental Exchange, which owns the New York Stock Exchange, to form a new company called Bakkt which aims to provide a federally regulated exchange for Bitcoin. ICE is partnering with Microsoft, BCG and Starbucks to launch Bakkt, with the ultimate goal of making Bitcoin sound and secure enough an offering to become a standard instrument for institutional and retail investors. According to Jeff Sprecher, the founder, chairman and CEO of ICE, two things have been preventing institutional investors from engaging with cryptocurrencies: “trading on an official exchange, and safe storage for digital currencies on an institutional scale.” Bakkt hopes to be able to provide the whole package: combining a major federally-regulated exchange with clearing and storage.
It will do so under the umbrella of ICE’s Commodity Futures Trading Commission (CFTC, the commodities equivalent of the SEC)-regulated exchange. This would be distinct from the current exchanges available, which while called ‘exchanges’, are regulated as money transmitters, trust companies, or swap execution facilities. Trading on Bakkt would operate via one-day futures, contracts that would settle trades in a single day. At the end of the day, ICE’s clearing house would ensure the appropriate movement of cash and Bitcoin tokens. Clients’ private keys (what allows them to sign the coins) would be stored offline in ICE’s heavily guarded digital warehouse and be released to clients on request. This would effectively provide the two layers of security money managers regard as essential that Sprecher mentioned above: purchasing a commodity (digital token) through a regulated broker-dealer that is a member of the ICE futures exchange.
Decentralised exchanges
Arising as a solution in the other direction, peer-to-peer (P2P) exchanges aim to provide decentralized exchanges maintained exclusively by software. These P2P exchanges allow users to trade directly with each other and without requiring trust in third parties to process their trades. Instead of matching orders in order books P2P exchanges match the people behind orders, allowing them to conduct the deal without intermediaries. This results in significantly lower exposure to governmental interference, greater privacy, lower costs, and greater security. However, they face issues with liquidity and tend to be unintuitive, as a result of catering to a smaller audience.
OTC Brokers and market makers
Exchanges, however, aren’t the only places that bitcoin is being exchanged. Bitcoin is also traded in ‘dark pools’, or through over-the-counter (OTC) brokers, also known as market makers. These brokers connect buyers and sellers of cryptocurrencies directly and outside of exchanges, and tend to serve high net worth individuals, family offices and hedge funds: clients who “put a lot of value in executing a full block of 1,000 or 5,000 coins at once”, according to Harry Yeh, managing partner at hedge fund and venture capital firm Binary Financial. Market makers tend to hold deep reserves of currencies to provide liquidity to their clients. These OTC trades reduce volatility in the market generated by big trades, as OTC brokers move coins between sellers and buyers outside of the major exchanges. One such OTC broker is Tilde, launched by Grasshopper, one of Singapore’s leading proprietary trading firms.
Custodians
Almost all bitcoins stolen to date have been stolen from ‘hot wallets’: customer accounts held by exchanges. The increase in the number of crypto funds and general volume have spurred the rise of firms aiming to provide custodianship services. “There are a lot of investors where custodianship was the final barrier [to entering the market],” says hedge fund manager Kyle Samani. Custodians are institutions which hold customers’ securities for safekeeping in order to minimize the risk of theft or loss. In the traditional hedge fund world, a fund’s custodian might be its prime broker, or another established custodian bank. In the world of cryptocurrencies, custodians would assist in storing coins in ‘cold storage’ – completely cut off from the internet and protected by randomly generating back-up keys or stored in bunkers in the Swiss Alps to protect them from electromagnetic pulse weapons.
In July 2018, Coinbase launched its custodianship service, Coinbase Custody. It offers features such as on-chain segregation of assets, split offline private keys that require a “quorum of geographically distributed agents to use cryptographic hardware to sign transactions” and robust cold storage auditing and reporting. Big financial institutions are also getting on board. In May, Nomura joined other firms to create a custody consortium called Komainu. Goldman Sachs is considering a custody offering for crypto funds, alongside J.P. Morgan, Bank of New York and Northern Trust group. Most investment advisors are required by the SEC to keep client funds with qualified custodians: the rise of institutional custodians might open the gates to large volumes of institutional and retail capital.
Sources and further reading:
https://en.bitcoin.it/wiki/Currency_exchange
https://www.coindesk.com/bitcoin-brokers-trade-millions-without-exchange/
https://rados.io/list-of-documented-exchange-hacks/
http://fortune.com/longform/nyse-owner-bitcoin-exchange-startup/
https://www.forbes.com/sites/norbertmichel/2018/08/13/new-bakkt-venture-could-make-bitcoin-as-mainstream-as-starbucks/#6d3c983836c8
https://medium.com/herdius/decentralized-vs-centralized-exchanges-bdcda191f767
https://medium.com/outlier-ventures-io/decentralised-exchanges-whats-the-point-6980c6b4b62f
https://cointelegraph.com/explained/p2p-cryptocurrency-exchanges-explained
https://en.wikipedia.org/wiki/Cryptocurrency_exchange
https://www.quantinsti.com/blog/top-9-cryptocurrency-trading-platforms/
https://www.bloomberg.com/news/articles/2018-06-18/regulated-crypto-custody-is-almost-here-it-s-a-game-changer
https://bravenewcoin.com/news/crypto-otc-brokers-guide-7-names-to-watch/
https://www.bloomberg.com/news/articles/2018-08-06/goldman-is-said-to-consider-custody-offering-for-crypto-funds
https://blog.coinbase.com/coinbase-custody-is-officially-open-for-business-182c297d65d9
https://www.ft.com/content/db5a20ea-9ca1-11e8-9702-5946bae86e6d
http://www.asiaone.com/business/singapore-proprietary-trading-firm-grasshopper-launches-tilde--an-overthecounter-trading
http://fortune.com/2018/05/02/goldman-sachs-cryptocurrency-trading-desk
https://hackernoon.com/understanding-decentralized-exchanges-51b70ed3fe67?gi=bedc4c99ea7b
https://www.investopedia.com/articles/investing/111914/look-most-popular-bitcoin-exchanges.asp