Cryptocurrency is a bit like my daughter spilling her water: it’s everywhere, and it has taken its own form. Retail crypto exchanges, notably the business model itself, are seen as something new, or even something different. But the nuances of self-custody and blockchain technology mask a rather obvious fact. Crypto exchanges are first and foremost retail brokers. This distinction matters.
Retail History Repeats Itself
In the last decade, crypto exchanges enjoyed a nearly unlimited capacity to acquire, onboard and sustain retail clients in a global, unregulated marketplace. Some exchanges boasted onboarding over a million clients per month! Ironically, this remarkable growth occurred during a period when global regulators firmly tightened their grasp on retail brokers. Brokers across all asset classes dealt with tedious updates to trade reporting, best execution practices and marketing disclosures. The FX and CFD industry in particular was forced to comply with materially increased capital adequacy programs, client classification adjustments relative to client money rules, and leverage constraints by instrument. Regulation at the local level effectively closed international borders, limiting the ability for global brokers to operate without a physical presence. To top it off, Brexit changed the European theatre in dramatic fashion, sparking an equally dramatic reaction from retail brokers.
Nearly overnight, compliance desks grew by an order of magnitude. Both internal and external costs of legal and accounting budgets spiked. Executive boards beefed up roles in governance. Dealmaking and innovation slowed at precisely the wrong time. The combined direct and indirect costs of new regulatory mandates caused the cost of acquiring a customer to skyrocket, from around $400 to roughly $2,000 per client. Nearly every retail broker was caught flat-footed. Now, crypto exchanges are on the verge of facing the same onerous pressure of regulation.
In June 2023, the Markets in Crypto Assets Regulation (MiCA) went into effect as a uniform set of regulations across Europe. The UK’s FCA also updated its view on the use of its crypto registration and framework to come. Elsewhere, Hong Kong and Dubai established crypto-friendly regimes. The Bahamas, Bermuda, British Virgin Islands and Cayman Islands all had virtual asset service provider (VASP) programs. Japan, Singapore, Turkey and others are expected to make material updates in 2024. The point is that we are nearing the end of one era in crypto regulation and entering a new one, notably for the protection of retail consumers.
The story is still being written, but we can probably make some accurate predictions for where all of this goes. Capital adequacy, marketing disclosures, significant updates to onboarding practices (particularly around KYC/AML controls), client money rules, trade reporting and on and on and on. The final details are uncertain, but we know the overarching conclusion: the cost to acquire a retail crypto client is about to skyrocket.
Why It Matters: A New Strategy Demands a New Model
With the rising costs to acquire a client, focusing on day traders – in other words, clients who actively trade – is an obvious pivot for crypto exchanges. Peruse almost any client survey in any asset class, and you’ll find the number one factor for a retail day trader choosing one broker over another is cost. That’s all-in cost: spreads + commissions combined. When examining the spread, the broker’s execution model and technology begin to matter.
Every crypto exchange in the world operates a central limit order book (CLOB) execution model. This model is the easiest type of matching engine to build and easily replicable, which very much explains why hundreds upon hundreds of crypto exchanges have chosen to deploy it. Furthermore, most crypto exchanges are built on rather simplistic technology stacks, including WebSocket and REST API gateways. The shortcomings of the CLOB execution model and simplistic technology are not as apparent in a mass-market environment. This fact underscores why the dominant selling points of crypto exchanges today are the safety of their funds, protections around self-custody, charting packages, online interfaces, automated support functions, onboarding timelines, staking and more. The execution technology and costs of trading are secondary to the offering. In fact, most crypto exchanges don’t even show clients the bid/ask spread!
Let’s repeat that. Most crypto exchanges do not reveal to their clients the spread involved when they buy and sell crypto. Commissions are rather transparent, so why aren’t spreads? If crypto exchanges are going to lean on day traders to make up for the rising costs of client acquisition, this must change. Spreads must be transparent and cheap. To accomplish this, execution models and technology need to be not only reexamined, but wholly changed. For example, the counter to a CLOB execution model is a quote-driven electronic communication network (ECN) model.
If you look at the largest equities brokers who attract day traders – or the entire FX and CFD industry, for that matter – you will be hard-pressed to find anyone operating a CLOB execution model. The FX and CFD industry is especially interesting to examine as these firms onboard almost exclusively day traders. Their spreads are ultra tight, and they aggressively advertise these spreads as their leading differentiator. Imagine these brokers in the US, Asia, Europe and beyond all fiercely competing in a war on spreads, with not a single CLOB execution model among them.
In a future article, I’ll compare and contrast these two models in greater depth. Spoiler alert: the ECN model wins every time for its transparency, superior economics for traders and unique ability to segregate market makers from retail flow, protecting the interests of all venue participants. To illustrate this last point, in a CLOB, retail traders might find themselves in competition with a sophisticated market maker or HFT, who is acting as a taker on a given price. This is just one of the factors that tighten spreads on an ECN.
The blockchain is new. Self-custody is new. Cryptocurrencies are our newest asset class. However, the business model of operating a retail broker is not new. The requirements to win day traders are not new. If crypto exchanges intend to compete for their business, they need to adapt. They could also use a reminder. The “exchange” part of the crypto exchange label is a major hindrance, as seen in every other asset class, and that water always finds its level.
