Are Cryptocurrency Exchanges The Next Iteration Of An Exchange?
Almost everyone is familiar with pictures or movie scenes from tradition stock exchanges that trade things like equities, commodities, options, etc. But the reality is that most of these scenes are anachronisms, the crowds are almost all gone, floor brokers standing for hours has been replaced by seats for almost everyone, and the noise is more of a low hum broken only by news reporters that use exchanges as sound stages. Even though the technology, and resulting behavior, have changed significantly, much of the structure and plumbing of exchanges remains a legacy of times past.
The original idea of the exchange was just that, a physical space in which an exchange of goods (in the case of stock exchanges equities) could be take place. “Floor Brokers” that represent the interest of their clients could meet there on the exchange floor and exchange one asset (e.g. dollars) for another good (e.g. stocks). To better facilitate this exchange clearinghouses were set up to take in and distribute the assets, facilitating settlement and delivery and reporting back to the brokers if there was a problem, or when a transaction was completed. On top of this there are custodians, usually brokerage firms or banks that held assets on behalf of the clients, once everything became electronic (i.e. no more stock certificates) this became a fixture. This system was started in centuries ago, in the US, with the Buttonwood Agreement in 1792. And this has been considered the model, that is until recently when cryptocurrency exchanges came onto the scene.
Cryptocurrency exchanges provide a central meeting place to transact buy and sell orders like other exchanges, but that is where the similarity ends. You see, cryptocurrency exchanges allow retail and institutional customers to transact directly with other market participants, i.e. no broker intermediaries. If you are a retail investor of equities in the US, the chances of your order ever going to an exchange to be executed is about nil, thus the payment for order flow I’ve talked about previously, much less interacting directly with other market participants. And even if your order did go to an exchange, it would have to be via a stockbroker, yes this adds superfluous steps, but they can collect fees for this. But, of course, the fees don’t stop there, remember that clearing house and custody service I mentioned previously, you don’t think those are free, do you? Besides cost they also require another, maybe the most, valuable commodity, time.
Cryptocurrency exchanges by comparison combine these various functions so that they essentially act as the broker, the exchange, the clearinghouse, and in many cases, the custodian. The result of this more modern innovation is that not only is it a much more streamlined process, its also almost instantaneous. If you want to know the cost of not being instantaneous take a look at this article on Robinhood’s latest challenges. So, you might ask, “why don’t other exchanges do this?” Well, in my experience there are several reasons, all of the players mentioned previously are suddenly disenfranchised from this legacy system. And when you’re no longer part of the transaction there is no ability to collect fees. This also adds a layer of transparency, since one entity is the broker and clearing house all transactions on a particular exchange can be aggregated. There is also the cost to the parties involved in the process, consider the legacy systems that would have to be modified and/or replaced to facilitate such a modernization, this is quite significant, and might be difficult to pass along to customers.
The current cryptocurrency exchanges are not a panacea, but the certainly provide a working example of how things could be done on other exchanges, addressing many of the recent (and legacy) concerns that have been raised by customers, market participants, and regulators. We live in a time defined by improvement of legacy institutions and processes. There is a significant opportunity here, if these same parties can be open to the considerations highlighted by the operating model of cryptocurrency exchange’s rethinking of the whole process of trading, clearance, settlement, and custody.