At Draper Dragon Fund, we’ve been closing tracking and investing in the crypto startups since 2015, watching a diverse array of crypto startups emerge overthe last few years. Crypto exchanges were the first type of crypto business tofind product-market fit. Today, in many ways, they are the beating heart of the crypto industry; exchanges like Binance, Coinbase, and FTX are among the biggest and most profitable companies in the crypto sector today. Here, we will provide an overview of the industry’s developments and introduce some of our investments that we are especially excited about.
What is an exchange? Broadly speaking, an exchange is a physical or virtual placewhere buyers and sellers find each together to trade. The most basic function of an exchange is to facilitate trading activity and minimise the cost of searching for liquidity. In return for this service, exchanges charge traders' transaction fees. A natural byproduct of exchanges is price discovery: an exchange that attracts significant amounts of orders and trades from a largeand diverse body of market participants generates informative market prices. As exchanges scale up, the improved liquidity attracts more traders, forming avirtuous cycle (“liquidity begets liquidity”); this network effect is what makes exchanges a defensible and lucrative business.
Many types of assets trade on exchanges. In US equities, the majority of trading activity happens at exchanges like NYSE and NASDAQ. Futures contracts are exclusively traded on futures exchanges. However, exchanges don’t play anequally prominent role in every asset class. For trading fixed income and currencies, dealers play a dominant role in providing liquidity. In asset classes like residential real estate, trading activity relies heavily on brokers. What role do exchanges play in crypto? In the crypto market today, it is estimated that roughly ½ of all spot trades occur on exchanges, in terms of transactional volume. The other half of trading activity is “over-the-counter,” meaning that it takes place off-exchange (typically arranged between two counterparties, one of them being an OTC dealer). An interesting characteristic of crypto exchanges is that they service the entire lifecycle of a trade and arevertically-integrated. Not only are crypto exchanges responsible for matching orders, they also clear and settle the trades while taking custody of customers’ funds.
Crypto is a global market, and liquidity is fragmented across a large number of marke tvenues around the world. There are various regulatory regimes that governcrypto exchanges, depending on the jurisdiction. Generally speaking, regulation pertaining to crypto exchanges examine them from two aspects: as money service businesses and as markets. To comply with local regulations as money service businesses, crypto exchanges are required to take appropriate measures toidentify and avoid handling “dirty money.” Such measures include performing customer due diligence and filing suspicious activity reports. In some jurisdictions, regulatory agencies also hold crypto exchanges responsible forinvestor protection, by porting current rules and requirements that apply totraditional markets or setting forth new ones, on matters such as order handling, market surveillance, and risk management. The types of instruments (spot/derivatives, bitcoin/tokenised securities) serviced by the exchange also determine the rules that apply.
While most of crypto trading takes place on centralised exchanges, decentralised exchanges (DEX) are seeing an increase in traction since the summer of 2020.Today, decentralised exchanges comprise roughly 5% of total exchange-tradedvolumes. The main difference between centralised and decentralised exchanges is that the latter are non-custodial: until the trade reaches settlement, theuser’s cryptoassets do not leave his wallet. As for trade execution, some decentralised exchanges match customers’ orders using smart contracts on the blockchain, whereas others ("hybrid DEX") execute customer orders off-chain andspecify settlement on-chain.
Our team at Draper Dragon believes that there is still room for innovative new exchanges to introduce interesting new products or tap into underserved markets. By doing so, they have the chance to carve out a niche or evenchallenge the industry incumbents. We’d like to highlight two exchanges weinvested in that have a lot of potential.
GlobeDX is a cryptocurrency derivatives exchange. Globe aims to attract a largefollowing of professional traders to its platform, by utilising high performant technology, introducing a novel mix of index derivative instruments, and establishing a fair market structure for participants. It is expected to launchthis year, in the near future. We’re thrilled about the bitcoin VIX productthey will launch, modelled after CBOE’s famously popular S&P500 VIX.
HKbitEX is a leading digital asset exchange. Headquartered in Hong Kong, HKbitEX is committed to providing a compliant and regulated digital asset spot trading andover-the-counter (OTC) trading platform for global professional investors. HKbitEX was one of the first organizations in Asia-Pacific to apply for a virtual asset trading platform license’ from Hong Kong’s Securities andFutures Commission (SFC), which will further enable them to offer compliant, secure and reliable digital asset trading services.
(Source: Draper Dragon https://mp.weixin.qq.com/s/p5HIN41jU1ujVsIs0xyylQ )