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The world’s major stock exchanges have been at the forefront of technology for decades, largely because of the massive potential for technological leverage and the astronomical amounts of capital and money at play. Recently, global exchanges have undergone a period of consolidation. On the other hand, in the cryptocurrency world, new exchanges have flooded the landscape, with different exchanges regularly gracing the top of the 24-hour volume lists. Some even reach into the billions of US dollar-equivalent on volume daily, though that volume is only a fraction of the daily volume on the world’s stock exchanges. And the forex exchanges, another proxy for crypto exchanges, absolutely dwarf crypto-exchange volume.
Could the traditional stock exchanges (SEs) learn something from the upstart crypto exchanges (CEs)? What are the CEs doing well that SEs could benefit from? And what are some of the ways retail investors and companies benefit from CE practices that are not implemented at the SEs?
A Brief Comparison of Trading Anatomy
First let’s compare how SEs and CEs differ in how trades are completed and recorded. For SEs, the bottom level is the broker. Retail investors work with a broker, and the broker is either a member of the exchange or partners with a member. Stock exchange members must be approved by the exchange, and they pay a rather hefty fee. (Here is the process for the NYSE and here is the process for NASDAQ.)
The investor places the trade with the broker’s public-facing platform, and the broker relays that information to an order management system. The exchange members maintain private direct-line networks to the exchanges, so public internet congestion is not a problem. The management system at the exchange’s physical location can communicate quickly with the exchange due to colocation, and the exchange’s system matches buyers and sellers across the members.
After the trade is completed, the exchange relays the completion information back to the member’s management system, which rides its private network back to the broker’s public-facing servers and finally is displayed to the retail investor.
On the other side, CEs do not have this layering of brokers and management systems. The retail investor at a CE connects directly to the exchange via the public internet, and all matches are performed from the same platform. This is a flat scheme, as there is no need to have the broker middleman, and connections for every trader are dependent on the reliability and speed of the public internet, not private networks.
The main takeaway: SEs maintain a vast, tiered empire that requires a lot of money to join at the higher level as members, whereas CEs directly interface with the public internet and therefore directly with private investors, with the fee for entry usually being an email address to sign up. Anyone can become a CE “member”, but only a select few can become SE members.
How is everything recorded? There are some interesting similarities: for SEs, a national government entity usually records ownership by individual members and brokers, and the brokers maintain their own records of which client owns what amount of stock. In the United States and United Kingdom, there is even a two- or three-day settlement period during which everything is recorded, and this quirk requires capital to be locked up for days while trades “settle”. Most countries follow this settlement-period style.
For CEs, many investors believe the blockchain records ownership, but that is only partially true. When a crypto investor deposits assets into a CE, the blockchain records the transfer of the asset (say, Bitcoin) from the individual to the CE, which usually takes a few minutes, depending on blockchain network congestion. But then all transaction recording is maintained directly by the exchange. There is no national entity to record ownership (partially due to the borderless nature of blockchain), and investors must trust the CE to faithfully record transactions.
If all exchange transactions were recorded on the blockchain, transaction volume would rise exponentially and the blockchain would become unusable, so CEs use their own servers (somewhat like a bank) to record transfers. This has the effect of instantly settling every trade because the exchange does not have to trust external parties (brokers and clearinghouses) to deliver assets. Everything is internal, and transfers are guaranteed by the exchange itself.
The main takeaway on transaction recording? The SEs and national entities record transactions for brokers who in turn record transactions for clients. The process can take a couple days to fully complete. The blockchain records deposits and withdrawals, while the CEs themselves, rather like the brokers, record which clients own which assets, but without reliance on third-parties, resulting in instantaneous settlement.
Side note: this internal CE recording applies to centralized CEs. Decentralized CEs, like EtherDelta, actually do record transactions directly on the blockchain. Decentralized exchanges have no authority to trust (except the blockchain itself), but trading can be extremely slow and costly (centralized CEs can charge so little because they just change the owner records on their own servers, but decentralized CE traders must pay blockchain transaction costs for every trade).
How Retail Investors Benefit from CE-style Practices
The prohibitively high costs and requirements to become an SE exchange member mean some entities will have better trading opportunities than everyone else, especially in the context of high frequency trading. Becoming a member means the ability to co-locate your servers and maintain private-network communication. That means brokers, even public-serving ones, can trade for themselves more quickly than they can trade on behalf of customers (customer orders must come through the public internet and the broker’s public-facing IT platform).
Private-interest members like proprietary trading companies and hedge funds can also access information earlier than the public thanks to co-located servers and private networks. CEs, however, are all public-internet-based. That means no traders get an edge over retail traders simply by having the money to build private networks and maintain membership.
Another oft-discussed difference is the fee structure. There are low-cost brokers who have embraced technology and automation for cost cutting, but they still must maintain memberships and networks. Exchanges themselves must pay for regulatory recording and other law-mandated activities, but CEs are simply moving asset records around on their own servers, incurring the costs of running a website, not an exchange. This is a bit of regulatory exploitation, since SEs are bound by certain securities laws while CEs are not.
One interesting feature of exchanges is discounts for using the exchange’s own proprietary cryptocoins for trading. Binance has its own cryptocurrency, and the traders who use it receive a discount on the already dirt-cheap trading fee. If a stock exchange were to allow members of the public to join, they could offer this discount for money deposited long-term, somewhat akin to a time-deposit solely used for trading fees.
One not-so-oft-discussed advantage for CE investors is open APIs (Application Programming Interface). Most CEs have APIs available for free to members (again, anyone who signs up), and sometimes CEs even maintain public APIs that require no membership at all. Much data available to the exchange is also available to the average investor at transfer times equal for all involved.
Conversely, SEs usually charge for data. NASDAQ offers plenty of options, and some are cheap, but those who want significant amounts of information will pay significantly for it, even as non-professionals. And here is the 34-page price list for Deutsche Börse (private individual costs start on page 28). But note that one still does not become a member and must still trade through a member, so using this data for HFT is unfeasible.
How Companies Benefit
So far, we’ve discussed how retail investors and traders benefit at CEs over SEs. Companies also reap some benefits from CE-style markets. One of the biggest is the disjuncture of raising capital and listing.
For traditional SEs, the company must choose a particular exchange, pass listing requirements (NASDAQ, London SE, Tokyo SE as a couple examples), and then trade on that exchange. There is also an extensive ecosystem built around initial public offerings (IPOs), with consultants and underwriters taking their cut. For CEs, the company may hold an initial coin offering (ICO) either on or off an exchange platform, in which the company directly interacts with the public, who directly buys “shares” (coins/tokens). But the differences do not stop at who is involved in the initial funding process.
CEs also approve which companies and coins may register with them. However, their requirements are generally much lower than the SEs, and in fact, many companies listed on CEs would not qualify for traditional SE listing – the CEs fill a market gap between small, bank-loan or venture-capital-only firms and large, public-ready companies. Listing on a major exchange like Binance simply requires that you send your coin information to them, though their approval process is admittedly a bit opaque. The Binance CEO himself admits it’s vague for outsiders. Even some decentralized exchanges, like IDEX, have an approval process.
Some CEs, however, have no oversight whatsoever. EtherDelta is one such exchange (actually just a smart contract), as is Waves, which has a simple form to create tokens on its platform. This unrestricted ability to list means any basement project backed by a single developer can issue tokens and effectively raise money (through selling their own holdings). It is like a nano-IPO without any of the requirements of listing on a SE.
A side effect of this disjuncture in listing and capital-raising is that any particular company can list on any exchange, and indeed many list on multiple exchanges. There is no need for depository receipts to trade foreign-listed coins, because exchanges are generally open to the global public. And listing on multiple exchanges reaches more people, since members are not shared evenly among the exchanges.
What SEs do better
CEs are not a panacea to solve all the problems or perceived problems at SEs. Often CEs have no government-backed deposit or investment insurance, and hacking is a major issue at CEs. The lack of regulation and oversight means traders are particularly vulnerable to corrupt exchange owners, whereas the layering of trust at SEs implies greater adherence to the rules. Arbitrage across CEs is currently closed manually. And finally, the setup of SEs admits many sources of assets (the members) while CEs are the sole source for traders on the platform.
Some of this is changing: security is always improving, and some insurance companies are offering protection against loss. Moreover, this is still a nascent industry, so the next few years will likely see rapid development and frequent change.
All-in-all, the SEs have to deal with regulatory and bureaucratic redtape that is currently circumvented by CEs, and the associated costs manifest in trading fees, slower trades, and much more interlocking complexity. But perhaps more importantly, companies and individuals are beholden to wealthy and powerful entities like brokers for access to traditional markets, while CEs and blockchain tech provide open access to data, market information, and a fair, level playing field. This global, open platform is a potential opportunity for fintech to challenge one of the most steadfast pillars of finance, the exchange.
My next article will explore this challenge in more detail.
Ruzbeh Bacha is the founder and CEO of CityFALCON.com. CityFALCON is creating a level playing field for investors and traders by democratising access to financial news and tweets. CityFALCON sources and collate financial big data, and then using the power of social media and crowd curation, creates a comprehensive and timely resource for investors and traders.
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