Editor's Note: This article comes fromDeribit Deri's trading class (ID: deri_trader), published with permission.

Editor's Note: This article comes from

Deribit Deri's trading class (ID: deri_trader)

The biggest winners in the cryptocurrency space so far remain exchanges: exchanges like Coinbase, Binance, Liquid Global, BitMEX and Kraken have all been confirmed or rumored to be worth more than $1 billion. Among them, Binance is even the fastest company in history to reach the coveted "unicorn" status.

Crypto held on select exchanges as a proxy for exchange dominance. 

Source: CoinMetrics Network Data Pro

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Poloniex share of total trading volume (incl. altcoins). Source: The Block

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• The decline of Poloniex is a particularly illustrative example of the above point. In the absence of any major shocks (such as exchange hacks or strong regulation), the company's market share fell from nearly 60% in early 2017 to a paltry 1% in May 2018, and it was eventually acquired.

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Such a competitive dynamic can be explained by two factors:

Network Effects: Liquidity attracts liquidity. Marginal users are most likely to join the most liquid exchange, as it offers the best market depth and lowest spreads, while the successors cannot turn the tide.

Low switching costs: If users don't like the service provided by one exchange, they can withdraw assets and transfer them to other exchanges within minutes, without cumbersome application paperwork.

Since users are highly mobile, exchanges need to have a faster information feedback loop to make corresponding fast business decisions. If one exchange offers a new feature, other exchanges need to offer the same feature in a short period of time, or risk falling behind. Collectively, cryptocurrency companies may be among the fastest-growing companies in history, thanks to a unique combination of moment-to-moment market changes, regulatory arbitrage, and purely digital offerings.

Although competition is good for customers, it is undoubtedly a great pressure for exchanges, and it is not easy to stay ahead of their peers. In this analysis, we will examine features that are expected to become standard offerings on every spot exchange within the next two years.

(1) Interest Account

Since the crypto asset space consolidates fewer investable assets, it makes sense for exchanges to start optimizing for AUM and monetize other services rather than volume. The interest account (the exchange matches borrowers and lenders for a small commission) replicates the investment bank's original business model.

1.1 Mortgage Services

Source: The Rise of Staking by Binance Research

Most of the recently launched networks (such as Cosmos, Tezos, and Algorand) and upcoming networks (such as DFinity, Polkadot, NEAR, and Ethereum 2.0) have chosen Proof of Stake (PoS) as the Sybil resistance mechanism (Translator's Note: Sybil attack and It is called Sybil attack, which means that hackers use to establish multiple virtual identities, accounts or nodes to affect the reputation of the system). In PoS, cryptocurrency holders can reach a consensus by staking tokens.

If users already hold tokens on the exchange, it is a natural thing for them to mortgage them to earn extra returns, and the corresponding mortgage service is also a matter of course. As far as Tezos is concerned, Coinbase, Binance, and Kraken have all launched staking yield products within a month’s time.

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There is the most natural lending market between users of the exchange, and the funds never leave the cold wallet. The need to borrow comes from two main sources: margin traders and market makers.

A margin-trader on Binance automatically taps into the BNB lending pool, paying interest to BNB savers. Source: Binance Margin Trading Guide

The greatest demand for borrowing comes from margin traders. On Bitfinex, Huobi, OKEx, and Binance, traders need to borrow funds and deposit them into a margin account. They can then use these borrowed funds to trade with spot traders. This is in contrast to derivatives exchanges such as BitMEX or Deribit, where users only trade financial contracts.

Thus, borrowers of cryptocurrencies are short sellers, while borrowers of dollars and stablecoins are people looking to go long with leverage.

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A smaller source of demand comes from market makers looking to increase capital utilization and thus borrow USD or USDT to buy cryptocurrencies.

• 1.3. Exchange external market

• In addition to the internal lending market of the exchange, users can also withdraw funds to try to use external products or even users of DeFi protocols to obtain other investment opportunities.

• Exchanges certainly didn't want their customers to just withdraw their funds and walk away, so they also started brokerage businesses. The benefits of doing this are manifold:

Large exchanges have economies of scale. For example, Binance can decide to send users to some low-echelon exchanges that cooperate better;

The exchange has relatively complete risk preference information of users, which can reduce capital requirements;

Cold wallets that allow user funds to leave the exchange

Another great benefit is that the big brokers can offer some "alternative" sources of interest that were previously only available on external exchanges.

A typical example is synthetic dollar accounts earning interest. On BitMEX and Deribit, users can deposit BTC and short the same amount of financial contracts. This operation is equivalent to holding the equivalent dollar.

Investors can thus get paid to deposit BTC or ETH as collateral and go short, creating a high-yielding synthetic USD account. Arthur Hayes explained this trading opportunity in one of his blog posts.

Recent return history of various ETH pairs on Uniswap. Source: https://pools.fyi

Exchanges can also use DeFi protocols like Maker, Compound, Kyber, DYDX or Uniswap on behalf of their users. The first such example is OKEx, which has just introduced support for Dai savings.

There is no reason for exchanges not to provide such convenient services to their users.

An exchange with a brokerage presence allows its clients to offer all the earning opportunities in the cryptocurrency space within a familiar user interface, without any complicated on-chain transactions or self-custody.

Average USD transaction fees in Bitcoin (red) and Ethereum (purple). Source: CoinMetrics.io

(2) pay

• As our understanding of blockchains continues to improve, it becomes increasingly clear that they require high transfer fees to be secure. Although transfer fees have been low since their peak in 2017/18, exchanges need to plan ahead to prevent Bitcoin and Ethereum public chain transfer fees from becoming expensive again.

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• The exchange will establish a payment network covering other exchanges and merchants for users to trade. Executing micropayments with a second-layer settlement network between relatively reliable partners makes sense for several reasons:

These small transactions are unwilling to pay high main chain fees;

Private ledgers can process transactions faster and more privately than public chains;

2.1 Exchange-to-exchange

Federated sidechains like Liquid could see an influx of new users if fees on the base layer become prohibitive. Source: Liquid

Several cryptocurrency companies dream of becoming the "Depository and Clearing Corporation" of the Bitcoin world. Companies providing clearing and settlement services to institutions include BitGo and Liquidity Offset Network, a joint venture between Circle, Coinbase, Galaxy Digital, Bakkt and others.

Financial systems reluctant to join rivals could benefit from more “neutral” solutions such as Blockstream’s Liquid, which is basically a multi-signature wallet between large exchanges. While Liquid hasn’t seen any real company adoption so far, that’s likely to change quickly once fees spike.

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Exchanges could allow users to transact quickly and privately, benefiting users who are annoyed by the slow transactions and high fees of the blockchain's base layer.

Merchants are natural sellers of cryptocurrency, so it makes sense for exchanges to process their payments directly. This is another example of how Coinbase has been leading the market in terms of vertical integration with its Commerce product.

Source: Crypto.com

Another example is Bitrefill (a crypto-only gift card store) integrating with Bitfinex.

In terms of users, the previous concepts of Visa and Mastercard supported by cryptocurrencies due to regulatory reasons lagged behind expectations in 2017-2018, and are expected to be vigorously developed this year. Cards from Coinbase and Crypto.com (US and Singapore only) are already on the market, and recently Binance launched a card specifically for travelers. These cards serve a dual purpose of allowing users to more easily spend their cryptocurrencies, as well as aggregating trading volume for crypto/fiat pairs for the exchanges themselves.

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• (3) Tax service

Taxation services have so far been a topic that has received little attention. We believe that exchanges should invest more in this area for two reasons:

Exchanges have the same interests as their users: they do this by preventing money from flowing from the crypto space to the taxman.

Uncertainty about taxes and how they are calculated adds to the psychological and financial costs of holding and spending cryptocurrencies.

3.1 The value of education

3.2 Ease of integration with tax services

A native Gain/Loss tracker for investors who use Coinbase exclusively, eliminating the need for any third-party tax programs. Source: Coinbase

Exchanges can do a better job of helping users pay their taxes at the end of the year. A prerequisite for any kind of tax advice is that exchanges need to have a comprehensive understanding of their clients’ crypto portfolios and trading records.

Each exchange has native access to users' assets and transaction data from its venue, but for users trading across multiple venues, there needs to be a way to obtain important external data (for example, through an information sharing Export the data to the exchange. Third-party tax programs are TurboTax, CoinTracker, ZenLedger or CoinTracking.

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3.3 Tracking Tax Events

The biggest obstacle to spending cryptocurrencies today is not necessarily the lack of high or low expectations of future returns, but the tax event that is triggered with every payment. While organizations like CoinCenter are working to ease the regulatory burden, crypto banks can do their part by recording all transactions.

3.4 Tax loss

When users suffer a tax-related loss on a crypto asset, they can realize that loss can offset gains elsewhere. If applied correctly, the resulting tax bill will be lower. Shortly before we published this article, Kraken actually sent their users a guide on how to reduce tax losses.

3.5 Liquidity management

An important part of investing is properly managing one's liquidity needs. Whenever users are forced to liquidate assets for liquidity or tax reasons, they tend to get a much worse price than they would otherwise.

In this case, exchanges can provide temporary liquidity in the form of crypto-collateralized loans. Similar to margin trading, users can borrow fiat currency on the exchange to cover fees without incurring additional tax incidents from selling their cryptocurrencies.

Source: It’s a Mad Mad Mad Mad World (1963).

(4) Where is the competition?

Exchanges aren’t the only ones in this space that are moving toward their goal of becoming full-stack financial service providers. In fact, custodians and wallets have also found their way into financial services, incl. B&L (borrowing).

For example, BitGo Prime offers lending, while OSL Custody (the leading Asian custodian) offers term deposits (meaning they lend money to clients for a fixed period of time). Blockchain.com offers its own B&L desk for institutional clients. It is only a matter of time before they promote these products to retail customers.

in conclusion

Meanwhile, Crypto.com entered the market from the opposite angle. Starting with the wallet, they added the B&L first and the exchange last. While competition from non-exchange players has been relatively mild, we expect it to intensify as new players such as Matrixport and Babel Finance, as well as BlockFi from the US, enter the market.

At the end of the day, BTC and ETH are just capital, and companies will scramble to integrate as much capital as possible. As capital comes in, this will lead to opportunities to generate more capital.