The Digital Currency in the Eyes of Economists – The Exchange: The Glory of the King

Digital Currency in the Eyes of Economists: Series Preface

The digital currency in the eyes of economists – Classification: Bitcoin with no place for souls

The digital currency in the eyes of economists – market articles: will there be no leek in the currency circle?

[Editor's note] Faced with the new challenges of digital currency, economists are divided into two categories, one is scornful, and it is not worth mentioning that digital currency is a speculative bubble; the other is cautiously accepted and begins cutting-edge exploration. As the digital currency grows, more and more economists join the second camp. For this reason, Kay unveiled a series of articles on “Digital Currency in the Eyes of Economists”, which is the most comprehensive review of digital currency literature. In the six aspects of classification, market, exchange, price, risk, and supervision , the global economists' research on the frontier theory of digital currency is summarized, which provides a useful reference for interested researchers. This article is the third exchange in the series, the next one is the price article, so stay tuned.

Perhaps we have a lot of controversy about the classification of digital currencies, but one thing is beyond doubt: in the digital currency industry ecology, the core non-digital currency exchanges are the only ones.

Regardless of whether the digital currency is a currency, an asset, or a commodity, its price can only be realized in the market. The most effective way to buy and sell in the market is to openly trade on the exchange. Like the role of exchanges in traditional financial systems, digital currency exchanges play three central roles: facilitating transactions, price discovery, and providing liquidity. However, there are many obvious differences between digital currency exchanges and traditional transactions: natural borderless, all-weather non-stop trading, low barriers to entry, and so on. In-depth research will find that digital currency exchanges present many interesting and sometimes contradictory features due to the particularity of the transaction objects, such as: centralization, unregulated, opaque, etc.

The digital currency exchange is the earliest developed service in the digital currency industry. According to statistics, after the explosive growth of digital currency in 2017-2018, there were 244 exchanges with real trading volume in the entire market, trading 2112 digital currency trading pairs every day, with a total market value of 139 billion US dollars (as of March 20, 2019). day).

Development of digital currency exchanges

Between 2010 and 2016, the digital currency exchange was born and developed into a bridge connecting the two worlds: a traditional financial world with tight connections and a wild world of digital currency. Most users buy digital currency on digital exchanges and in currency. With digital currency, it is possible for users to use digital currency, or to buy goods and services, or to invest in a company (usually a blockchain project company), or do nothing, holding digital currencies looking to add value. If the user wants to exit the digital currency market, he also needs to sell the digital currency on the exchange to obtain the legal currency. The digital currency exchange has become an entry and exit point for the digital currency industry and is the intersection of the traditional financial system and the digital currency industry.

Digital currency itself is easy to use, anonymous, and decentralized. It is popular among criminals and is often used for cybercrime, money laundering and other illegal activities. Therefore, digital currency trading has always become a place to promote crime. The regulators are highly vigilant against digital currency exchanges. Only a few countries (such as Japan and South Korea) formally issue digital currency trading licenses. Most countries are still studying how to supervise. A few countries (such as China) even prohibit exchanges. All countries have strict anti-money laundering and customer awareness of banks and payment companies that are in contact with digital currency transactions. This has led most financial institutions to shun the digital currency exchanges for fear of getting into trouble and risk. Only a handful of banks and payment companies are willing to provide financial services to digital currency exchanges.

Beginning in 2017, a large number of alternative coins (Altcoin) emerged as bitcoin prices began to skyrocket and with ICO (new currency issuance, a way of rapidly financing in the digital currency market). The focus of the digital currency exchange has also shifted from the transaction of the original French currency and digital currency to the currency trading of digital currency and digital currency. The currency transaction was originally a negligible business, and according to diar's report, by 2018, the currency trading business has grown to 66% of all exchange business volume. The reason why currency transactions can grow so fast, and become the absolute dominant volume of transactions, is related to the characteristics of currency transactions. Currency transactions do not involve legal currency and do not require docking of traditional financial institutions. There is no difference between the digital currency and the exchange of one currency to another, so the regulator will not regulate such transactions. For this reason, the major digital currency trading platforms, namely, Coin, Fire, OKex and Bifinex, have risen to become the top exchanges in global trading volume due to the growth of currency transactions.

Digital currency exchange and regulation

A notable feature of digital currency exchanges is unregulated and opaque . There is no unified regulatory policy in the world, and most countries are still exploring and observing, waiting for the US regulatory to follow suit. The US regulation is mainly divided into four parts according to the four characteristics of the digital currency:

First, the currency attribute of the digital currency is controlled by FinCEN. If the digital currency is a currency, the exchange is the institution that operates the currency transaction. Therefore, the exchange needs to apply for registration of Money Service Business (MSB), which is under the jurisdiction of FinCEN.

Second, for the asset properties of the digital currency, the IRS of the US Taxation Office determines that the digital currency is a personal asset and is subject to property tax. Therefore, all transactions are obligated to provide the tax bureau with the user's transaction information. On November 29, 2017, Coinbase, the largest digital currency exchange in the United States, lost the case with the IRS and was sentenced to provide the tax bureau with 14355 user transaction information for IRS taxation.

Third, for the commodity attributes of the digital currency, the CFTC US Commodity Futures Trading Commission determined that Bitcoin is a commodity, so Bitcoin futures are under the jurisdiction of the CFTC. In 2017, CFCT approved the Chicago Mercantile Exchange CME and the Chicago Commodity Exchange COBE to start bitcoin futures trading.

Fourth, for the securities properties of digital currencies, the SEC believes that except for Bitcoin and Ethereum, most of the digital currencies are securities and need to be regulated by federal securities laws. For digital currency exchanges, the SEC believes: “If a platform provides trading services that are considered to be digital currencies for securities, then this platform is an exchange defined by the federal securities laws. Such exchanges need to be registered with the SEC to become national. Securities trading platform, or apply for an exemption."

From the point of view of the exchange, the attitude towards regulation is contradictory: on the one hand, they want to be regulated as a compliant exchange, so that they can connect with traditional financial institutions to accept financial services, and at the same time, create more Digital currency products, to meet the needs of more people, to open up a larger market; on the other hand, most of the current exchanges are operated by non-financial teams, and their practices are very irregular, such as false reporting of exaggerated transaction data, manipulation of the market The use of internal information to trade in advance and profit, etc., violates existing financial regulations, so if it is compliant, the exchange will lose a large amount of existing sources of income.

So we see interesting phenomena about the exchange: some exchanges turn to unregulated currency transactions, only a few adhere to the compliance route, and most others are evading supervision.

In fact, the top-ranking big exchanges, the main income comes from unregulated currency transactions. There are some exchanges, and the company's place of registration is in a place without supervision or supervision. For example, one of the top three exchanges is forced to move from China to Japan, Hong Kong, China, and finally registered in Malta. The registration of the fire currency was forced to move from China to Singapore, and OKEX was forced to move from mainland China to Hong Kong. They do this to circumvent regulation and possible prosecution.

Some transactions have always adhered to legal and legal operations, so the types of transactions offered are very limited, and they undertake huge compliance tasks, such as the well-known American coin exchange coinbase, registered in California, and the licenses applied to most states in the United States are subject to According to the supervision of the corresponding state, the transaction volume is only ranked in the world around 20, and the transaction types provided are only 7 digital currency and US dollar trading pairs. Until recently (April 2019), the currency transaction was opened, which is ahead of other rankings. The exchanges are not in a position to compare about 300 kinds of transactions, which is obviously at a disadvantage, but its advantages are compliance, investors and institutions are more assured. This also allowed coinbase to win the entry ticket for Facebook's launch of the Libra Alliance and become the only digital currency exchange among the members of the Creation Alliance.

There are also some exchanges that only do OTC business, transferring the tasks of KYC and AML to the trader, not the exchange itself, such as the more famous OTC service provider localbitcoin.

In most countries, the digital exchange business is not regulated and does not require a license. Therefore, the entry barrier is very low. As long as a trading website is equipped with a trading system, the basic functions of the exchange can be run. On the coinmarketcap website, 220 exchanges providing transaction statistics are listed. However, the digital currency exchange is a market for winners . Although there are so many exchanges, there are only a few dozen leaders who can stand out from the competition and have relatively real stable transactions because they operate a successful transaction. It is not easy. According to statistics, in the 220 exchanges, the top 20 exchanges accounted for 45% of the trading volume. Moreover, the transaction volume data of the disclosed exchanges is not reliable. For example, some exchanges use robots to trade each other to create a false transaction volume. It has been estimated that two-thirds of the transactions reported by coinmarketcap are false. The more the lower ranked exchanges, the more inclined the trading volume is fraudulent. If the real trading volume is used, the ratio of the trading volume of the top 20 exchanges can reach 75% of the total trading volume.

Digital currency exchange security

Security is the core and key to the exchange . Digital currency is a string of 01 numbers, most people put it in the wallet of the exchange, and a small part of it is transferred to their private digital wallet. Therefore, the exchange's wallet is a treasure house, which naturally becomes the hacker's preferred target.

The return and risk ratio of stealing the exchange's digital currency is too tempting: the value of digital currency is high, anonymous, difficult to track, transactions are irreversible, and generally not protected by national laws. Now hackers have stolen the exchange's digital currency, which has changed from a lone man behavior to a group operation mode. It has changed from an incident to a normalized hacker trying to attack.

There were a total of 30 public hacking exchange events in history, most notably in February 2014, when Mt.Gox, the world's largest exchange, was invaded, losing $350 million in equivalent digital currency, causing Mt.Gox to go bankrupt. collapse. But this is not the highest loss. In January 2018, the Coincheck exchange was hacked and lost $496 million in equivalent digital currency. Coincidentally, both exchanges are located in Japan.

But in fact, hackers invaded the exchange more often than the public knows, because there are many hacking incidents, the exchanges are strongly concealed and not disclosed. Security is so important that any taint in this area can cause user concern and affect the business. This is also a drawback of unregulated exchanges – users and the public can only know what the exchange wants to let everyone know.

In order to lose assets without being invaded, large exchanges spend huge amounts of money each year to compete with hackers. But there is a simple way to prevent intrusion, called a cold wallet. A cold wallet is a physical wallet that stores digital currency, and a hot wallet is a virtual wallet that is connected to the network. The cold wallet is physically and completely isolated from the network, thus ensuring that hackers cannot invade through the network. The price is that when the exchange frequently needs to adjust the amount of digital money stored in the cold wallet according to the customer's transaction, the period required for the cold wallet is significantly longer than that of the hot wallet, and the efficiency is greatly reduced. This requires a balance between safety and efficiency. Most exchanges have 60% to 90% of the digital currency in the cold wallet, and the rest are placed in the hot wallet. Of course, the proportion of the volume of transactions stored in the hot and cold wallet has been constantly changing with the market's trading conditions.

Even if the digital currency is stored in a cold wallet with the network completely disconnected, it is not necessarily foolproof. At the end of 2017, the CEO of an exchange registered in the UK was kidnapped in Ukraine and released after paying $10,000 worth of bitcoin. Digital currency has been used by criminals as money laundering and criminal tools, and even people engaged in digital currency have become targets of kidnapping, making this profession a high-risk option. This partly explains a strange phenomenon. In addition to the volume and price, the exchange rarely reveals too much about the organization's management address and team information. There are quite a few exchanges, even top-ranking exchanges, where users cannot know their real office address and management team. This peculiar phenomenon can only be seen in the digital currency world.

Liquidity, monopoly and decentralization

Like exchanges in traditional financial systems, good digital currency exchanges need to provide sufficient liquidity and products that meet customer needs. Compared with traditional financial market exchanges, the digital currency market is small and the number of participants is small. Therefore, transactional liquidity is another key to attracting users.

The biggest problem facing new or small exchanges is the lack of liquidity, the inability of users to trade, or the need for users to lose a large portion of their profits. The diversity of products is that users want to trade to the desired currency on an exchange. Therefore, in addition to mainstream currencies such as Bitcoin and Ethereum, exchanges need to constantly provide new potential new currencies on the market.

The old digital currency exchanges, with their accumulated brand benefits, clearly have advantages over small exchanges in terms of security, liquidity and products, and are more likely to attract new users, which in turn allows the big exchanges to consolidate their lead. Status. In addition to the average transaction fee of 0.1%, the income of the big exchange also includes the listing fee of the exchange on the SGD and the investment income. The listing fee on the SGD exchange is the fee required for the new digital currency to enter the exchange listing. Beginning in 2019, a new digital currency issuance model under the auspices of the exchange was called the Initial Exchange Offer. The exchange passed a rigorous review, selected good projects, and used the advantages of the exchange platform to help issue new digital currencies. The advantage of all the traffic portals in the big deal, so the new digital currency will find ways to be listed on well-known exchanges, so the listing fee has also risen. The listing fee on the well-known exchanges once exceeded $1 million. The investment income is the return that the exchange has gained by investing in the upstream of the digital currency industry, such as the mining industry, or downstream, such as digital currency applications.

The high transaction volume, high listing fees and high returns from investment made the exchange a very profitable company . For example, in the case of currency security, which ranks first in transaction volume, there are only 200 employees in the short period of establishment. In the second quarter after the establishment, that is, October-December 2017, the profit is as high as 200 million US dollars. In contrast, Deutsche Bank, the world's leading investment bank, is also Germany's largest bank and Europe's leading financial institution, with a profit of only $140 million in the first quarter of 2018.

The head of the exchange, in the unregulated digital world, expands freely. It not only provides the business of the exchange, but also deals with trading rules and rating services for digital currencies, and provides a series of financial derivative services such as digital wallet deposit, digital currency investment, digital currency investment banking and brokerage, which become the core and absolute of the digital world. Overlord. The digital exchange itself is already a huge monster, but it is not enough. It builds its own set of ecosystems on the basis of exchanges based on its own advantages, becoming the top of the food chain in the digital currency field and becoming the most valuable in the digital currency industry. The role of influence.

It is ironic that digital currencies have always advertised themselves as decentralized representatives, but exchanges that provide transactions for digital currencies are highly centralized and form a monopoly. The drawback is that the exchange is in an absolute position relative to the project side and the investor. In the absence of supervision, it is easy to generate monopoly and unfair market operations. At the same time, centralized exchanges have the potential to be hacked. In view of this, many entrepreneurs and technicians have been trying to provide decentralized digital currency exchanges (such as Paradex, which was acquired by Coinbase in 2018), but under the current state of the art, decentralized exchanges have not been successful. They are far from meeting the needs of trading clients in terms of speed of execution and liquidation, as well as liquidity and products, and they will take a long time to develop.

Because of the high return of centralized trading, the status is so special, so many traditional exchanges are also eager to enter the digital currency exchange industry. Of course, compliance and regulation are the biggest obstacles for traditional institutions to enter the industry. In 2017, one of the most eye-catching events in the digital currency field was that the US CFTC approved CME and COBE to introduce bitcoin futures trading (COBE did not launch the current bitcoin futures contract in March 2019 due to insufficient liquidity). This is a huge recognition of Bitcoin and a powerful investment tool for traditional institutional clients to invest in managing Bitcoin investments. NASDQ is also in the midst of preparing for the launch of Bitcoin derivatives.

Exchange academic research

Due to its core position in the digital currency field, the exchange has become an important target for digital currency research. Unfortunately, the current academic research on exchanges is very limited, mainly because the information on the digital currency exchange is opaque, many data are not disclosed, or the data disclosed (such as transaction volume) is not reliable enough. At present, the research on digital exchanges in academia is mainly limited to legal compliance, security technology and operation, and organizational structure. These are obviously topics of great concern to the exchange, but they are not the scope of our series. We mainly from economics and finance. Aspects to study exchanges.

At present, the research on the financial aspects of the exchange belongs to the field of Market Micro Structure. The main achievements in this field are concentrated in exchanges such as stock futures and foreign exchange, and there is still a gap in the digital currency exchange. The only valuable academic study is Brandvold's (2015) study of the price discovery of the Bitcoin exchange, which builds a mechanism to study how digital currency exchanges affect digital currency prices and prices when external fluctuations occur. Find.

As the industry matures, more and more exchanges will be regulated, so the transparency and quality of the data will be greatly improved. Academic research on digital currency exchanges in the field of economics is most likely to focus on the following areas:

First, the price arbitrage across digital currency exchanges. In theory, the exchange is globally borderless and can trade anywhere in the world in an instant, so in theory the same currency price for each exchange should be equivalent. However, in reality, the same currency will have a small price difference between each exchange, which creates a new profitable business model, and some professional traders specialize in earning cross-platform spreads. The development of these differentials and the impact on pricing are well worth studying.

Second, the impact of digital currency derivatives trading on the industry. Bitcoin futures for CME and COBE have had a profound impact on the digital currency industry. But this is only the beginning. Many traditional exchanges such as NASDAQ and digital currency exchanges such as OKEX, HUOBI and BIXMEX have started to launch derivatives transactions. NYSE's parent company, ICE, plans to launch Bitcoin Swap. Can these derivatives exchanges, like the derivatives trades of other assets, help price discovery, reduce price volatility, provide good hedging, or fuel market speculation?

Finally, the impact of the exchange's stable currency on the industry. Stabilizing a currency is a special kind of digital currency. Its price is anchored in legal tender, and the price of digital currency is kept stable through certain mechanisms. Stabilizing the currency in the world of digital currency, just like the dollar in the financial system, has become the most basic means of pricing. The digital currency industry has a huge demand for stable currencies because the digital currency itself is so volatile that it cannot be used as a measure of value. At the same time, because of the connection between the digital currency and the traditional financial system, there is a lot of supervision, so there is a lot of resistance. The stable currency can solve the value scale and exchange function. The most famous and widely used stable currency is the Tether (USDT) launched by the Bitfinex exchange, which is 1:1 anchored to the US dollar. Bitfinex claims how many stable coins are issued in the bank for how many dollars to endorse, but its authenticity has never been Verified. Another stable currency, called USDC, is also anchored by the US dollar, which was launched by the famous exchange Circle. Circle's shareholders include Goldman Sachs, Baidu, China Financial Investment Corporation and Bitman (the world's largest manufacturer of mining equipment). There are dozens of stable coins in the market, and the competition between stable currencies is fierce. Due to the dominant position of the exchange, the success rate of its launched stable currency is highly accepted by the market. What is worth studying in the future is the factors that determine the success of the exchange's stable currency, and how do these successful exchange-stabilized currencies affect the industry and ecology? The news that Facebook plans to launch Libra Stabilization Coin is undoubtedly a shocking bomb for the digital currency world and the global financial community. What kind of competition and cooperation will the stable currency of the exchange and the stable currency launched by the Internet giant? Is it possible for Libra to stabilize the currency market?

In short, the digital currency exchange is a veritable king in this industry, and it is the brightest pearl in the laurels. However, it is hung on the head of the king and has two swords of Damocles.

After the exchange is finished, the next price article – ups and downs in the bubble, so stay tuned.

=== References: ====

· Brandvold, Morten and Molnár, Peter and Vagstad, Kristian and Valstad, Christian, Price Discovery on Bitcoin Exchanges (November 16, 2015). Journal of International Financial Markets, Institutions and Money, Forthcoming. Available at SSRN: https://ssrn .com/abstract=2691456