The essence, risks and new opportunities of exchanges from the perspective of monetary finance

Why do you understand that the exchange must first understand the bank? Where are the new opportunities for the exchange? What are the systemic risks facing the exchange? …… Recently, the chain catcher invited independent monetary and financial researcher, Dr. Long Bailu, Ph.D., Ph.D., from Tsinghua University, to share the theme in the Catcher School on “The Essence, Risk and New Opportunities of Exchanges from the Perspective of Monetary and Financial Affairs”.

Dr. Long Baiqi graduated from Tsinghua University with a master's degree in computer science. He focuses on cryptocurrency technology and monetary and financial theory, and is one of the first Libra authors in China. As a continuous entrepreneur, Dr. Long founded Zhixiang Technology and received 27.5 million RMB investment, focusing on financial cloud computing, quantitative investment and machine learning. He was the chief technology officer of Zhongjin Jiazi Investment Fund and worked as a financial service in Accenture and IBM. Consulting executives, representing Accenture as the chief designer of the new generation trading system project of the Shanghai Stock Exchange.

Hello everyone, I am very happy to have this opportunity to discuss and discuss with you. The topic I shared today is "The Essence, Risk and New Opportunities of Cryptographic Exchanges from the Perspective of Monetary and Financial Affairs", which is divided into five parts:

The first part, first review the theoretical basis of monetary finance;

The second part is to look at the business model of the exchange from the perspective of monetary finance;

The third part analyzes the system risk of the exchange from a financial perspective;

The fourth part explores the future opportunities of the exchange;

The fifth part is about exchange customers, products, operations and technology.


Reviewing the theory of monetary finance

In the traditional financial system, the first role of banks is financial intermediation, mainly to absorb deposits and issue loans . The so-called "short-term long-term loan" means that most of the short-term demand deposits are absorbed. The loan period for borrowing is relatively long, so the bank will assume the function of term conversion and risk conversion.

From a legal perspective, after the depositors deposit funds into the bank, they no longer own the funds. The deposits are just a proof of the bank’s debtors (I owe you – IOU), and all the funds are pooled together to form a pool of funds. To further carry out business. Banks are the only institutions that are legally able to carry out the fund pool business.

The second role of the bank is to create money through loans . Generally, everyone will think that bank lending must first absorb deposits. In fact, banks do not need to have deposits before lending, and banks create money while lending. For example, if you go to the bank to borrow one million to buy a house, the bank creates a deposit account for you on the debt side of its balance sheet. You can spend one million directly by writing one million in this account.

In this process, the bank does not need to transfer money from anywhere else. It can be said that this million is created out of thin air. At the same time, the bank will create a loan of one million yuan on the asset side of its balance sheet. The lender will return the principal and pay interest in accordance with the agreed time limit and interest rate. The bank destroys the currency when the loan is returned. Banks also create/destroy currencies in the form of purchases/sales of assets.

Therefore, when banks make loans, they create one million assets and liabilities at the same time on both ends of their balance sheets, so the balance is balanced.

In China, the central bank mainly restricts the ability of commercial banks to create money through the deposit reserve system . Assuming a deposit reserve ratio of 10%, if the bank has a reserve of 10 million yuan in the central bank, the bank can create up to 100 million yuan in deposit currency, or a maximum of 100 million yuan in loans. The central bank also uses the bank's regulatory indicators set by Basel III, such as capital adequacy ratio, leverage ratio and liquidity ratio, to require banks to absorb losses and constrain their ability to create money or loans.


In fact, many countries in Europe and the United States no longer use the concept of deposit reserve, but follow the standards of Basel III, such as the Bank of England and the Swiss National Bank.

For commercial banks, the main risks at the business level are mainly divided into two types, one is liquidity risk, and the other is insolvency, which is the so-called liquidity risk . Liquidity risk, that is, liquid assets owned by banks are insufficient to meet the needs of depositors to withdraw cash. The main form of expression is bank runs. The banking system's approach to risk prevention is mainly supervision (macro-prudential and micro-prudential), deposit insurance plans, the central bank's final lender's obligations (providing emergency liquidity for banks), and the central bank's use of government funds to rescue banks.

Although banks can issue loans without depositing money in advance, banks still rely mainly on stocks to reduce compliance costs. Banks create money through loans and use the spread of deposits and loans as the main source of profits. The debt side of the bank is mainly deposits. The bank's asset side includes loans and proprietary trading. Banks prefer mortgage lending, especially lending with home and financial assets, because such mortgage risk assessment models are standardized.

Banks do not like commercial loans to new businesses because of the high risks, lack of collateral, and the lack of risk assessment capabilities of banks. Large banks are increasingly enjoying self-operated speculation, especially in big European and American banks, because banks can create and use money at very low cost.

Looking at the exchange's business model from a currency perspective, we must first understand that the essence of the exchange is the bank, or the exchange's most important ability to make money, from the power of creating money in a vacuum like a bank.


Exchange business model

One of the most important businesses of the exchange is to attract investors to trade. Investors' recharge or recharge is essentially the exchange's zero interest rate . Commercial banks also like to take care of the savings because of the lowest cost of obtaining funds, and there is still a cost to commercial banks, and there is no cost to the exchange.

Investors form the debt side by filling the currency and refilling the exchange, which is the basis of the exchange's asset pool . The exchange does not set up a separate escrow account for each user as in the traditional exchange, but instead creates a virtual account for them. The account number is just a number, which represents the debt owed by the exchange to investors.

Once the exchange has a liability side, it can develop asset-side business, such as providing financing (stable currency) and securities lending (other digital assets) services to investors, which corresponds to the financing and securities lending business of traditional brokers or exchanges. . The daily exchange rate of the mainstream exchange is about 1%, which cannot be described by usury, and the vast majority of exchanges can achieve up to five times leverage.

The fund-raising service provided by the traditional brokerage is a typical financing business. The funder borrows the funds that exist in the bank escrow account, but the currency exchange does not have the pre-existing stable currency and digital assets for the financing and securities lending business. The exchange is only created out of the box when it is needed, without any cost.

On the surface, this business is not risky to the exchange because the borrower has mortgaged its assets on the exchange for borrowing funds. But don't forget that the numbers in the exchange account do not represent the actual assets. They are just the borrowers of the investors owed to the exchange. So it seems that investors borrowed funds from the exchange with the assets in their own accounts. In fact, they mortgaged the debts owed by the exchange to the exchange and borrowed money from the exchange.

This road looks familiar, yes, the dollar is like this. For example, when the US economy needs more dollars but the Fed is inconvenient to directly issue additional currency, the US Treasury will issue $10 billion in government bonds, and global investors will exchange $10 billion in government bonds in the hands of $10 billion, and then the Fed The purchase of this $10 billion in national debt from the market has resulted in an additional $10 billion in currency.

In the process, the entire economy has increased its currency by $10 billion, but in fact the world has not changed anything, produced any actual products or services, and created no added value. The US dollar system can operate like this because the United States is endorsed as the sovereignty of the country as the world's first economy. When it is not good, it can use its most powerful military power to strengthen this guarantee. But what does the currency exchange do so?

The other asset-side businesses of the exchange also have self-operated businesses, such as market manipulation and speculation on other exchanges or in-house transactions after obtaining these coins from the pool of funds. Other asset-side businesses also include project investment by the currency exchange. In the past few years, almost all digital asset exchanges have established a huge investment ecology. There are many air projects, many of which are zero, so the investment in air projects Also lost a lot of money, who will bear these losses? The fund pool bears.

In fact, the traditional bank's asset-side business (mainly lending) will also encounter bad debts. Basel III has made very clear arrangements to require banks to meet the multi-level capital adequacy requirements to strengthen the bank's ability to absorb these losses. And self-rescue ability when encountering a liquidity risk. However, there is clearly no similar arrangement in the currency exchange industry.

The exaggeration of the currency exchange is to directly write the number of assets in your account to participate in the transaction, such as the so-called "forcible coin" on many exchanges. We do not evaluate the behavior of the exchange from a moral level. From the nature of the banking business, this is equivalent to the exchange (as a bank) lending itself.

I remember that as mentioned above, banks create money by making money out of nothing. So the exchange is understood as a bank, and the bank lends itself to the loan, and it has the magic to create money at will. Traditional banking supervision has long understood this risk, so global banking supervision strictly prohibits this kind of self-inflation.

But there are also fish that slip through the net. For example, in the global financial crisis of 2008, the British Barclays Bank and the Swiss bank UBS created billions of dollars to lend to their so-called investors through this self-inflicted behavior – the Middle East consortium from Qatar. The latter used borrowed funds as capital to inject Barclays and UBS, and took them out of the quagmire of the financial crisis. These two investments have not yet released details due to their non-compliance and black box operations.

Although the exchange's trading services and OTC services are still the main source of revenue for the exchange, they are essentially a package of the bank's core business model. If the exchange cannot create a large amount of assets out of thin air, the income of these two businesses cannot reach the current volume.

Although there is a lack of actual operating figures for the exchange, many channels have learned that the direct income of most of the exchange's fund pool business has exceeded half of its revenue. Considering that the exchange's generous transaction fees and OTC service fee income come from its magic of creating assets out of thin air, we consider the nature of the exchange to be reasonable.


Exchange system risk

Since the magic of creating money/assets out of thin air is so easy to use, where does the exchange risk come from? It is from the user to raise coins. If a large-scale user withdraws money, it is a kind of run for the exchange, because the exchange will leverage the digital assets of the pool to generate a large amount of assets, whether it is lending or self-operated speculation or investment. The exchange basically removes most of the currency in the asset pool, which creates a huge leverage . The platform currency is the same. Most of the platform currency or the stable currency issued by the exchange is also used to divert the fund pool, but in fact the asset end is still the original fund pool.

According to traditional bank data, the core capital ratio of the exchange is very low, but the leverage ratio is very high. Before the financial crisis, the traditional European and American banks generally had a leverage ratio of more than 50 times. This is still constrained. In the case of an exchange that is currently not constrained or transparent, who is going to constrain the exchange's leverage ratio and core capital ratio? This is the most important indicator for managing the risk of an exchange system. In the absence of regulation and industry self-discipline, it is only the fear of the founder of the exchange that can constrain the leverage of the exchange.

The above discussion assumes that the exchange does not cheat but conducts normal banking operations. If the transaction does something bad, the founder maliciously transfers or shorts the assets, etc., this is a pure scam. In the history of the traditional banking industry, this kind of thing happened in a large amount, and it absorbed a large amount of deposits and then ran away by means of high interest rates. This kind of thing has also occurred in a large number in the field of digital currency finance, and will continue to happen.

In the traditional banking industry, commercial banks actually have endorsements by central banks and deposit protection plans. The central bank as the lender of last resort can provide liquidity protection for commercial banks. When commercial banks are insolvent, the central bank can even use government funds for assistance. However, in the financial world of counting coins, when an exchange is run, only God can be prayed.

At this time, the exchange is running in addition to bankruptcy. This situation is more common in small exchanges, and the big exchanges have not happened.

Some time ago, Qian’an was hacked and stole 7,000 bitcoins. It’s not that the money is really stolen. It’s also possible that the market has turned around in the past, and the price of bitcoin has risen sharply. Many big households hope to put the currency. suggest. The exchange saw that the demand for the recent currency was great, but there were not so many coins in hand, and the best pretext was hacked. It is very funny that the number of currency exchanges is frequently and frequently caused by various security incidents every year, but everyone is safe and unwilling to declare that they are financial-grade exchanges.

The author used to be the chief designer of the trading system of the Shanghai Stock Exchange. The code written by hand ten years ago is still supporting more than one-half of the daily trading volume of securities in China. There have never been any accidents. It seems that the author and the financial newcomers of the number of coins have a higher understanding of the "financial level" than the difference between college students and primary school students.

Compared with traditional bank runs, there are many costs. After all, the cost of printing, distributing and keeping banknotes is relatively high, so the speed and scale of traditional bank runs are actually limited. But for encrypted digital assets, there is no friction cost for the coin, because it is digital, so its run should happen in real time, detonate instantly, and the scale will be very large. Any exchange is afraid of a run, and no one exchange can withstand a run.

At the same time, we also need to know that manufacturing a run does not require a lot of cost, because the run is more people's hearts. As long as the user is mentally aware that an exchange is at some risk, the run is formed. So you don't need a hacker to make a run, just hire a water army. The water army is still much cheaper than the black one, isn't it?

No one is currently going to run on the exchange because it is not good for themselves, because the exchanges are now in the same mode, with very low capital adequacy and extremely high leverage, and there is a very high systemic risk. Anyone who uses a run-through method to attack a competitor is not good for himself. It is equivalent to the US-Soviet hegemony with nuclear weapons.

But if there are exchange players in the future and their business model does not rely on leverage, what is the best competitive strategy for him? The answer is obvious – making runs.

If the result of manufacturing a full market run is that all exchanges are run without distinction, including themselves. For an un-alleyed exchange, the result is only a loss of customers and assets, the balance sheet shrinks, but the core capital is not lost, so it will not go bankrupt. For a leveraged exchange, the result is not only the loss of customers and assets, but the high probability of bankruptcy or running, so the final result of a full market run is that there are only a few exchanges that are not dependent on leverage or have very low leverage. Survive.


New opportunities for the exchange

The future opportunity of the exchange is definitely in the stable currency. Many exchanges want to develop stable currency, but the development of stable currency requires common infrastructure, such as asset management and clearing of the decentralized model, and the collateral management framework.

The collateral management framework includes a list of eligible collateral and collateral risk management. The former sets certain qualifications for the stocks or collateral required for currency issuance, such as the total market value of assets, concentration, risk measurement, etc. Specific assets calculate and manage their volatility risks (including market risk and liquidity risk, etc.) and calculate the mortgage discount rate. These business capabilities can be viewed as a common financial infrastructure for cryptocurrencies.

The trend of stable currency issuance in the future is to issue a full reserve , such as Libra, which is a stable bank for the full reserve bank and the currency, and its model is part of the reserve. In addition to supporting mainstream digital assets such as Bitcoin and Ethereum, the management of reserves can put typical French currency assets , such as sovereign government bonds denominated in RMB or USD, and the method of interest for each reserve may be different. These are all new topics.


In addition, stable currency supply and demand adjustments, such as additional issuance, recycling, currency monetary policy (quantity and price control), stable currency value stabilization mechanism, and the creation and distribution of coinage taxes, are all related to stable currency.

The above infrastructure and system related to the stable currency, the exchange can build part of it through its own capabilities.

We can understand the relationship between stable coins and exchanges from three levels.

First, the exchange is a huge asset entry, so it can be one of the most important coins in the future. However, when the reserve is provided as a coin, the exchange's competitors include wallets and asset management institutions, and the size of the assets they can influence is comparable to that of the exchange. The coinage of the coin is of course to share the coinage tax.

Second, the exchange is an important usage scenario for stable coins. The stable currency usage scenarios are primarily payment, exchange media and value storage. Of the three uses of the currency of the exchange, the latter two are mainly. The exchange can be seen as the largest channel for the stable currency. The distribution of the stable currency coinage tax will eventually have a channel allocation mechanism. Therefore, the exchange, as the largest channel for the stable currency, can participate in the distribution of the coinage tax.

Third, the exchange, as a coin, contributes to the stable currency generated by the reserve in the coinage. This stable currency use scenario is the global network of the stable currency. From this perspective, the entire stable currency network has become a tentacles of a single exchange, and the exchange and the stable currency system are actually mutual channels.

Exchanges want to make stable coins, but hundreds of stable coins may eventually survive one or two, because the stable currency system is very complicated. Many people don't really understand what a complete monetary and financial system has to do.

I expect that most exchanges in the future will not make stable coins themselves. Many people regard the simple mortgage of legal currency to the bank to issue stable currency as a complete monetary and financial system, which reflects the ignorance and arrogance of monetary and financial theory and practice. Therefore, it is necessary to improve the understanding of financial theory in the field of blockchain and cryptocurrency, respect the objective laws of finance, and promote the development of blockchain and digital currency business with a scientific attitude.


Exchange Frequently Asked Questions

Finally, I will briefly talk about the exchange's customers, products, operations and technology.

From a product perspective, I believe that future currency transactions will gradually disappear, because the currency transactions are generated for historical reasons. The biggest reason for the existence of currency transactions is to contribute excess fee income to the exchange. If the exchange raises its asset risk management level (market risk and liquidity risk – the main management objectives of the collateral management framework), then any digital asset can be converted into a legal currency asset in real time, and no currency transaction is required.

There is another reason for the prevalence of currency transactions, because everyone has some illusions about mainstream currency becoming a standard payment method. For example, it is expected that Bitcoin can become a universal payment tool, but attempts to become a universal payment instrument for Bitcoin have proved to be a failure. I still insist on this point of view. The universal payment instrument can only be a legal currency or a stable currency. All other cryptocurrencies will eventually appear as an asset.

In addition, to improve the professionalism of derivatives, the derivatives of mainstream exchanges are now very poor in terms of professionalism. There is also a need to reduce the handling fee, and the handling fee is still very high.

From an operational perspective, the exchange must change the mindset of traffic first. The ultimate goal of traffic thinking is to cut the leek, without exception. If you want to be a good exchange, you must change the mindset of traffic first. Now why are people still talking about traffic, because the institution or Old Money has not entered the market strictly, but the trend has become more and more obvious, so the exchange must be prepared.

Now many people who do exchanges have an illusion that the technology of trading is very simple, then I can directly say that the safety, stability, reliability, professionalism, etc. of all exchanges now reach the financial level exchanges. Requirements. Fortunately, the problem is not serious, because the user's needs are still at a relatively low level, but if we stand in the future, if you want to enhance your competitiveness, you must spend more energy on the technical level. Really able to achieve financial-grade exchanges.

There are two points in the business model of the exchange. First, reduce leverage, or simply no leverage. As mentioned above, the best competitive strategy for unleveraged exchange players is to let other exchanges be run. A huge market panic will kill them and you will survive.

Second, the exchange business model must be truly community-based, but the premise is that the exchange business model, governance structure, and operation methods should be completely transparent, and truly tell the users/investors that the money-making method is open and transparent.

If you don't even dare to make money, how can you achieve community-based business model? At present, all exchanges rely on direct creation of money, profit-making spreads and manipulation of the market to make big money. However, the outside world can only rely on fees and fees, but all these incomes now account for half of the exchange's income.

Many people regard the business of securities companies as the development trend of the exchange business. This is just a superficial effort. It only rotates around the exchange and does not change the nature of the exchange.

Finally, thank you for listening, my sharing ends here.

Author: Long Tao White

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