The exchange space in Bitcoin has been interesting. I have been observing it with a keen interest. Exchanges have been interesting to me my entire life. I was on the board of the worlds largest exchange. Everyone thinks exchanges are an easy business to run. After all, it’s just like a casino. Seems so simple. 60% of every transaction falls to the bottom line because it’s a fixed cost business. All ya gotta do is pump up the volume.
The exchange business is extremely difficult to run. More importantly, it’s really hard to operate. There are a lot of small things that happen behind the scenes which most people don’t appreciate. However, they make a gigantic difference.
A few years ago, I was at a Bitcoin conference in Chicago. A Chinese based exchange presented to an assembly of Bitcoin advocates. The presenter talked about how they had liquidity-a very important piece of trading, and how people could trade on margin. She was especially proud of their margin system.
When I queried her about margin, she said, “It’s 20%.”. I asked, “20% of what?”. “It’s 20%.”, she said.
When I asked her about clearing, she was totally stumped. After a few more questions, I said, “It sounds like there is counter-party risk on your exchange.”
Most of the startup exchange pitches I have seen don’t really understand counter party risk. They also don’t really want to enforce statistical based margin that is derived from underlying volatility. Much easier to calculate an accounting margin and hope.
In the last few days, China has forced Bitcoin exchanges to apply some rules. Volume has dropped off a cliff. Liquidity is nowhere. That tells me that they really never developed a true market for trading. Like a lot of things, it was “fake it till you make it.”
Volume was based on special deals for certain participants, wash trades, fake trades, fake bid/ask spreads that weren’t really there. This quote is telling,
Xu Qing, a spokesperson for Huobi, noted how these developments are impacting his exchange, telling CoinDesk: “The trading volume started plunging since we started charging trading fees.”
Imagine that. If you charge, people don’t trade. Imagine what volume at US exchanges would be if the exchanges didn’t charge and didn’t have rules around trading! As it is, institutional market participants can trade for as low as pennies per trade depending on their volume. Those pennies add up to real costs for them, and real profits for exchanges. To be clear, I am not advocating for free trading since the people adding a lot of the volume are providing liquidity and taking risk in many cases. It just goes back to basic economics: if something is given to someone at zero cost, the value isn’t as high as if they pay for the same item. Another way to look at it is charging a fee is like a tax. Tax something and you get less of it. In the case of Chinese exchanges, the “tax” caused all of it to go away.
The official excuse is that there have been no events to drive volume. Or, it’s Chinese New Year. That’s utter bullshit. CME Group average daily volume since Jan 19 has hovered right around 15M contracts per day. If we look back to the first of the year, it’s higher. Traders in equity options markets have been buying volatility, not selling it. That generally leads to higher volume. No doubt, holidays can have an effect on volume, but the economics of trading have changed and everyone responded.
In this day and age, it is extremely simple to build an automated trading system that can match bids and offers. There are off the rack programs one can put together to do it. However, building a true exchange that has a responsibility for providing fair and liquid markets combined with the responsibility of margining, clearing, and making sure all the customers are paid/collected from is an arduous undertaking. Startup costs are extremely expensive-and regulatory costs are very high. Chinese exchanges tried to do it on the cheap and it shows.
Last year, there was a run up in Bitcoin prices. Suppose you were long a lot of Bitcoin and wanted to cover? Without liquidity, if the price of Bitcoin goes out of favor, the slide down might be very painful. The trade might look like a roach motel.