This article is part of the continuing series on Bitcoin and the Bitcoin Ecosystem.
Bitcoin exchanges provide platforms and services for the bitcoin marketplace enabling individuals and institutional investors to buy and sell bitcoins, trade in bitcoins as digital assets and exchange with fiat currencies (and other commodities such as gold and silver).
Bitcoin exchanges provide platforms and services for the bitcoin marketplace enabling individuals and institutional investors to buy and sell bitcoins, trade in bitcoins as digital assets and exchange with fiat currencies (and other commodities such as gold and silver).
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An overview of bitcoin exchanges and trading marketplace around the $6 billion capitalization of bitcoin. Bitcoin exchanges worldwide support the large community of retail and institutional investors and have evolved different operating models. Note: Firms included in the illustration are representative examples in each category and may support more than one operating model. |
Like the currency, bitcoin exchanges are de-centralized and many Bitcoin exchanges offer 24x7 trading. A majority of exchanges are start-ups run as online businesses and support a multi-national client base. The largest exchanges are based in Europe, US and China which account for 90% of trading volume.
Influence of Exchanges
Exchanges play a key role in driving bitcoin supply and demand. Exchanges enable investors to trade bitcoin in currency or commodity of their choice. Today bitcoin exchanges allow bitcoins to be traded in more than 30 different fiat currencies, most cryptocurrencies and assets such as gold and silver. Bitcoins can be used in forex trading, CFDs and also as exchange traded notes.
Because exchanges are decentralized and unregulated, many have been a source of risk for investors who have lost funds through online thefts, scams or poor mismanagement involving exchanges.
Bitcoin’s exchange rate was established in 2009 at 1309 BTC equivalent to 1 USD (about half a million at today’s rate) and surpassed 100 USD in 2013 by which time, 40 web based exchanges were operational. As many as 45% of shut down by April of that year, followed by the implosion of Mt Gox which had a virtual monopoly in bitcoin trading, in 2014 .While leading exchanges have since matured, exchanges failures still continue with around half of exchanges closed or inactive.
Exchange Service Offerings
Bitcoin exchanges compete on different fronts. Some offer full services around bitcoins from wallet hosting, trading and payments. Others offer trading and investment products structured around cryptocurrencies.
As a peer to peer decentralized network, bitcoin traders can transact directly. Some exchanges offer online marketplace services, where buyers and sellers can contact one another and transact directly either online through the platform or offline.
Other exchanges work as intermediaries with providing automated trading platforms and/or broker services. Clients have to comply to KYC and AML requirements and generally link a fiat (usually client’s local currency) bank account to buy BTC or receive fiat currency from sales. The exchange platform accepts and matches buy and sell orders based on limit or ask pricing or through auctions. Exchanges may also support conversions to a limited basket of currencies. Exchanges charge transaction fees although BTC/BTC trades are usually free.
Different exchanges offer different fee structures, spread and trading options to leverage and short. Exchanges have also offering margin swaps and futures contracts representing an evolution of the marketplace. Because exchanges manage fiat transfers and hold customer funds, they are treated as money services businesses that have to comply with AML and KYC regulations.
Over the Counter (OTC) trading marketplaces Bitcoin-OTC IRC channel are preferred for high value transactions, and major exchanges offer trading desks.
Evolution of the Bitcoin Trading Marketplace
Bitcoin exchanges have evolved in response to the growing adoption by mainstream users and institutional investors, as well as regulatory treatment and classification of bitcoins by different nations/jurisdictions. Again, some of these are arguably diametrically opposite to the peer to to peer version of the currency, but they underpin the growing maturity of bitcoin as an asset class.
These are some of the significant achievements in the short span of three years from 2013 to 2016.
Bitcoin Price Index
Bitcoin prices are generally indexed at BTC to USD, BTC to Euro and Yuan.
Bitcoin prices vary across exchanges across the world and arbitrage is possible. Services such as Bitcoin Average and CoinDesk introduced the concept of Bitcoin Price Index in 2013. Bitcoin Price Indexes are based on averages from trading data from multiple exchanges across the world.
Coindesk’s XBP (Dollar and Yuan) is based on a simple average of prices from exchanges which meet pre-defined criteria such as an international client base, minimum transaction value and settlement time. Exchanges are added or removed depending on whether they meet the criteria.
Coindesk’s XBP (Dollar and Yuan) is based on a simple average of prices from exchanges which meet pre-defined criteria such as an international client base, minimum transaction value and settlement time. Exchanges are added or removed depending on whether they meet the criteria.
In May 2015, NYSE introduced NYBXT its bitcoin pricing index using data from transactions on Coinbase, the leading US exchange.
Advanced Trading and Settlement Products
Exchanges and bitcoin broker dealers have offered financial products such as futures, short selling, margin trading, derivatives and other structured products. Derivative products and CFDs can bring in more liquidity and allow traders to speculate on bitcoin without holding the currency. Advanced products carry more than the usual risk as investors operate in a relatively limited market capitalization (of 6 billion USD).
Bitcoin Backed Securities
Bitcoin backed securities are now available through XBT a bitcoin based exchange traded note (ETN) that was listed on Nasdaq Stockholm. The ETNs are 100% backed by bitcoin and are tradeable in USD and Euro. Bitcoin backed securities are another option to trade in bitcoins without buying the currency.
Settlement Sidechain
Bitcoin node operator Blockstream announced their plan to launch an interoperable settlement sidechain (Liquid) which would allow consortium of participating exchanges and major institutional traders can make high volume trades and make instant settlements (a Ripple within bitcoin?). The stated goal of Liquid is to improve the liquidity and increase capital markets participation in bitcoin trading .
Regulation
Exchanges providing fiat conversions or accepting funds in fiat have to comply to KYC and AML regulation in the countries they operate. In USA, different states and compliance bodies such as FINCEN have required registration from exchanges as money transmitting businesses.
Leading exchanges have tried to remain compliant with the local laws and regulations, applying and publicising licensing and registration information. itBit has secured a banking license in New York while Genesis Trading became the first licensed broker dealer in digital currencies, operating as a division of SecondMarkets, an SEC licensed broker-dealer regulated by FINRA and the SEC. Firms have also voluntarily adopted best practices (usually mandated in the financial services industry) for managing customer funds. Brokers such as UK based Coinfloor publish their methodology for storing client funds and publish a Provable Solvency Report on client funds.
Risks and Challenges - An Uphill Battle for Bitcoin Markets
Bitcoin exchanges are diverging into blockchain and fintech, while others continue to support miners and daily conversions in bitcoins. Exchanges on the whole are still in start-up mode and the failure/burn rate still remains high.
Volatility
Bitcoin prices fluctuate dramatically and so do transaction volumes. Between 2012 and 2016, the price has moved from $1 to $1200 at its peak and a $300-$400 average in 2016. Price spikes are triggered by developer announcements, legal status and judgements, geo-political events and exchange losses,thefts and closures. A security event can cause major run of exiting investors. While exchanges should maintain 100% of client bitcoins, this has often not been the case. In some case, fiat or bitcoin reserves have woefully underfunded. Exchanges have their bank funds frozen for suspect transactions, going into a death spiral.
Regulation
Regulation around bitcoin is still evolving, especially at the intersection with fiat and other regulated financial products. Regulation is a double edged sword which can make or break exchange start-ups.
The costs of licensing and compliance can be a barrier to entry for smaller players. Further, the requirements for licensing, regulatory reporting and compliance are not clear as the treatment of bitcoin as a commodity or currency differs across countries. This has led to different countries or industries excluding or limiting bitcoin exchanges from access to existing banking system, as in the case of Australian banks freezing accounts of bitcoin companies.
The costs of licensing and compliance can be a barrier to entry for smaller players. Further, the requirements for licensing, regulatory reporting and compliance are not clear as the treatment of bitcoin as a commodity or currency differs across countries. This has led to different countries or industries excluding or limiting bitcoin exchanges from access to existing banking system, as in the case of Australian banks freezing accounts of bitcoin companies.
Security
Exchanges have themselves become a risk factor in bitcoin pricing with many events such as thefts and closure shaking investor confidence and triggering sudden (and steep) declines or volatility in pricing. Many exchanges that closed have ultimately lost client funds through a combination of online security hacks, fraud and lax practices.
Bigger exchanges have matured since, and have taken up security practices such as offline cold storage of coins, maintaining reserves and insuring customer funds and replacing lost bitcoins.
Complexity
Bitcoin is currently undergoing through a major evolution and transformation phase as debates on blocksize, competing cryptocurrency and regulatory pushbacks create stress on over the top solutions. It may be too early to bring in structured financial products and create a trading and lending ecosystem using bitcoins with investors still coming to terms with the unique features of bitcoins.
Bitcoin Exchange and Trading Trends
The evolution of Bitcoin exchanges and trading appears to be heading in different directions in different regions, and to an extent influenced by the state of financial markets there.
While transaction volumes are huge in China, where miner dominate, bitcoin exchanges in developed markets of US, Europe and Australia are headed towards inclusion of bitcoin in the existing capital and asset markets. Major exchanges are applying for regulatory permissions and licenses to operate as broker dealers or securities institutions to expand the reach and liquidity of bitcoins. Exchanges are also integrating other digital currencies and rebranding their offerings as block chain solutions than bitcoins.
In the next article, we cover a cross section of leading and innovative bitcoin exchanges.
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