Regulation has two sides. Regulatory intervention can increase the hidden costs of trading, but it can also attract more funds into the market by enhancing compliance. In addition, the rigor of the regulatory environment will also affect the free development of the crypto market, with weaker regulatory environments being more conducive to the free development of the crypto market.
CEX+CeFi=Traditional Commercial Bank. The essential model of CEX is still the traditional commercial bank model, which earns interest by attracting deposits and making loans. However, CEX currently lacks “the last buyer,” which may be another important reason why CEX is currently subject to strong supervision. At the same time, some smart CEXs are trying to implement some advanced business hedging strategies to prepare for stronger regulation that may come in the future.
CEX is moving towards DEX. Although DEX is considered to be a possible replacement for CEX in the long run, there is still debate about whether it can ultimately replace CEX. We have observed that CEX continues to innovate to meet market demand and competitive pressure. At the same time, we cannot ignore that DEX is more in line with the long-term principles of Crypto orthodoxy.
The Impact of Regulation on CEX Development
Regulation will increase the hidden cost of trading
Hidden costs are a type of cost that economic organizations (enterprises are a form of economic organization) often face in their operations, as opposed to explicit costs. Hidden costs refer to future costs and transfer costs that are somewhat concealed and caused by corporate or employee behavior. They are a kind of cost that is hidden in the total cost of the enterprise, free from financial supervision and audit.
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Explicit costs can directly link transaction quantity and records, but hidden costs tend to be hidden in the total cost and are difficult to accurately measure and are often overlooked. The characteristic of hidden costs is that they are not subject to financial supervision. These costs may touch on aspects such as time costs, information asymmetry, errors, and incomplete compliance, thereby increasing the hidden costs hidden in the overall cost.
In the case of CEX regulation, the increase in the hidden cost of trading due to regulation is particularly significant. Regulatory agencies may require exchanges to adopt more stringent identity verification and anti-money laundering (KYC) measures, which not only increase the exchange’s additional human and technical resources to ensure the compliance of transactions, but may also affect the speed and convenience of transactions, bringing external time costs and uncertainty to traders. In addition, regulatory compliance disclosure requirements may also cause asymmetry problems, causing users to face more trading risks and operational restrictions, further increasing hidden costs. In the end, these hidden costs will be passed on to CEX users, which may be reflected in higher transaction fees, withdrawal fees, and lower wealth management yields.
Compliance May Drive Incremental Fund Flow
However, compliance may drive incremental fund flow into the crypto market. With the optimization of the regulatory environment and the increase in transparency, investors’ confidence in the security of funds in the crypto market and their investment expectations will increase, attracting more funds to enter the crypto arena. When a CEX meets regulatory requirements and adopts compliance measures, investors will be more confident in putting their funds into it, thus increasing their investment positions in crypto assets.
（Source: BTC's volatility over the past 9 months)
Weak Regulatory Environment Will Allow Crypto Market to Develop More Freely
In our observation, a strong regulatory environment has the following characteristics: a license or permit to operate, a definition of securities, and asset categories.
Regulators may require a CEX to obtain specific licenses or permits to operate. These licenses and permits must comply with local regulations and compliance requirements, including but not limited to KYC and AML regulations. By issuing licenses and permits, regulators can impose stricter supervision on CEX. Secondly, some cryptocurrencies may be classified as securities. If a cryptocurrency meets the definition of a security, it must comply with securities regulations and be subject to securities regulators’ supervision (according to CoinMarketCap data, currently, there are as many as 67 cryptocurrencies recognized by the SEC as securities). In addition, in a strong regulatory environment, cryptocurrencies may be classified as specific types of assets. For example, different countries may view cryptocurrencies as financial assets, virtual assets, or digital assets. This classification may result in specific regulatory rules and tax requirements.
In the early stages of the cryptocurrency emergence, especially after the appearance of Bitcoin, as the field was a new internet innovation, regulatory agencies had not yet formed clear rules and regulatory standards for the cryptocurrency industry, especially for important institutions like CEX. However, as cryptocurrencies become more popular and the market expands, “regulatory escape” has gradually become a focus, leading to a series of regulatory measures and rulemaking.
In the early days, regulatory agencies only monitored and warned about the risks and challenges that participants in the cryptocurrency market might face but did not formulate specific regulatory measures. Later, regulatory agencies began to pay attention to illegal activities related to cryptocurrencies, including money laundering (but according to CZ, in an interview, a report forwarded to CZ by an ambassador from a certain place mentioned that only 3% of Bitcoin transactions are related to illegal activities or problematic activities. This proportion is very small, and in fact, lower than that of fiat currencies.) and illegal fundraising. Now, regulatory agencies are formulating more complete regulatory frameworks and more transparent regulatory standards, including but not limited to disclosure requirements, KYC and AML, licensing and registration requirements, framework and rule establishment, and regulatory cooperation.
According to economic development laws and historical cases, industries that are at the forefront of regulation may indeed have better arbitrage space or development prospects.
Early participants in the industry often have a strong brand influence and user base. As regulations gradually strengthen, these companies may have established good compliance frameworks and reputations, making them more likely to be recognized and supported by regulatory agencies. Such a first-mover advantage can bring these companies better market positions and competitive advantages, using external regulation to build deeper moats.
However, stricter regulatory requirements may lead to some competitors being unable to meet compliance standards or unable to bear the costs of regulation. As regulation intensifies, investors’ confidence in compliant industry participants and projects may increase. They are more willing to invest funds in compliant enterprises and projects, reducing investment risks.
Overall, a weak regulatory environment may bring greater freedom and flexibility to the crypto market.
(Dogecoin "To The Moon" Slogan)
Regulation is an important trigger for changes in the competition pattern of CEX
In the early development of the cryptocurrency market, especially in the early days of BTC, the number of CEXs was limited, and the main focus of competition was to provide secure, highly liquid, and rich trading pairs. Early competitors included MT.GOX, BTC China (established in June 2011), Kraken (established in July 2011), Bitstamp (established in August 2011), Coinbase (but early Coinbase was a payment processor), etc. With the growth of the market and the changing needs of users, CEX began to expand its platform functions and services. Including adding derivative trading, OTC trading, fiat currency trading pairs, lending and insurance functions. The milestone event was the perpetual contract launched by Bitmex in 2016, with a leverage of up to 100 times.
With the development of the global cryptocurrency market, CEXs began to compete in different segments. Some CEXs focus on the local market, providing local fiat currency trading pairs and language support to meet the needs of local users. This has led to the rise of some regional exchanges, such as Huobi (formerly known as Huobi.com), OKEx (formerly known as OKCoin) focusing on the greater China market, and Upbit, Bithumb focusing on the Korean market. In addition, CEXs focusing on derivative trading have emerged during this stage, such as early FTX and Bybit.
FTX and Binance are stories that happened later. Early FTX focused on the derivatives track and occupied the top position in the track in a short period of time. Binance, as an early investor in FTX, seems to have indirectly participated in the competition in the derivatives track. Until November 2022, the FTX incident was exposed. The latest story is well known, and we will not go into too much detail. (Source: YM Crypto)
If the target of regulation is the object that its gun is aimed at, then FTX pulled the trigger to kill itself. The FTX storm undoubtedly accelerated the regulatory agencies’ actions against Binance, the world’s largest CEX, and Coinbase, which is known for its high compliance.
Looking at specific events, every change in regulatory policy has a huge impact on the entire CEX industry’s landscape:
On September 4, 2017, the domestic government expressed a strong regulatory attitude and jointly issued the “Announcement on Preventing Risks of Token Issuance and Financing” with seven departments, announcing: “ICO is an illegal public financing activity that should be stopped immediately.” The announcement caused a dramatic change in the market landscape: ICO was identified as illegal fund-raising, projects were cleared out, and exchanges were forced to withdraw or go offshore. Bitcoin China and Yunbi stopped virtual currency trading businesses, while OKCoin and Huobi closed their RMB businesses and transferred overseas.
On November 9, 2022, FTX’s explosion led to an increase in SEC’s supervision: “Within six months after FTX’s bankruptcy on November 11, 2022, SEC’s enforcement actions related to cryptocurrencies increased by at least 17 times, an increase of 183% compared to the previous period.” After FTX’s embrace of compliance collapsed, Kraken was the first to be affected by SEC’s stricter supervision. Its pledge business was not registered as a security and was sued by SEC. In the end, Kraken immediately stopped providing on-chain pledge services to US customers and paid a $30 million fine to reach a settlement with SEC. Coinbase naturally acquired Kraken’s market share of this pledge business.
On June 5th and 6th, 2023, SEC successively sued Binance US and Coinbase. SEC believes that both provide unregistered securities trading, and at the same time claim that the profit and pledge services provided by these two exchanges also violate securities laws. The accusation against Binance is even more serious, claiming that Binance engaged in settlement transactions and mixed customer funds between its local and overseas entities. These two lawsuits resulted in a large amount of funds being withdrawn from the two exchanges and flowing into the chain and other exchanges.
The Financial Services and Treasury Bureau of the Hong Kong SAR Government released a policy statement on the development of virtual assets in Hong Kong on October 31, 2022, indicating Hong Kong’s focus on the development of NFT, Web3.0, and metaverse markets. The “Guidelines for Virtual Asset Trading Platform Operators” came into effect on June 1, allowing virtual asset trading platform operators to apply for licenses and allowing retail investors to use licensed virtual asset trading platforms. This has led to a series of new and old exchanges announcing their entry into Hong Kong, including Xinhuo Technology, Tiger Securities, DBS Bank, OKX, Bitget, and others.
It can be seen that the release of a policy can lead to the rise and fall of CEXs, and every major policy change is a reshuffle of the CEX industry.
Hedging strategies for CEX operational risks
CEX+Cefi=Traditional Commercial Bank
Abstract understanding: Although CEX operates an exchange, its fundamental model is still that of a traditional commercial bank.
The essence of a commercial bank (hereinafter referred to as a bank) is to create credit currency, and its operation form is to absorb deposits and issue loans. By absorbing deposits, banks can obtain funds to support their subsequent business activities. Then, based on the deposits collected, banks create profits by providing loans to individuals, households, and businesses. When a bank provides a loan to a borrower, the borrower deposits the loan into their bank account. In this way, new deposits are created, allowing banks to have more available funds for loans and investments.
CEXs initially only provided the most basic Spot trading (such as Spot exchanges established specifically for BTC), and later developed into derivative trading – perpetual contracts. However, the current CEX is still in the “black box operation” stage, and the exchange has not clearly explained its funding operation for providing contract leverage. Perpetual contract leverage funds usually come from two sources: self-owned funds and user funds and deposits.
As a result, one can reasonably speculate:
• 1) Spot has become the entry point for CEX to absorb funds, and contracts have developed into direct application scenarios for lending, with the ultimate result being the creation of credit currency, but this form of credit currency can only be used in the CEX where it was created.
• 2) User funds have a higher priority than self-owned funds. After all, the ultimate goal of CEX is to maximize the revenue brought by transaction fees while ensuring the safety of self-owned funds.
However, traditional commercial banks are generally required to operate separately, that is, to separate securities investment and other businesses. CEX “part-time” the role of an investment bank. In name, CEXs only issue platform coins; in reality, some projects do rely on CEX’s blood transfusion. By issuing platform coins, exchanges can increase their control over the platform ecosystem. Users holding platform coins may benefit from different discounts, rebates, or rewards. In addition, platform coins can bring additional revenue and profit opportunities to the exchange. Platform coins are usually designed to have a certain degree of scarcity, and their supply may be fixed or have a destruction mechanism, so they may experience long-term deflation. With the development of the platform and the increase of holders, platform coins may rise, thus enabling CEX to gain more benefits.
However, traditional commercial banks have open and transparent risk exposures due to the reserve system and capital requirements. Even if a single bank encounters a liquidity crisis or a financial crisis, the central bank can act as the last buyer of the commercial bank under certain conditions. Therefore, in the paradigm of traditional finance, commercial banks are often “too big to fail.”
Unfortunately, the giant of CEX in the crypto world currently lacks a transparent funding system and lacks “the last buyer”. This may also be an important reason why CEX is currently heavily regulated.
Mainstream CEXs are laying out early to meet the strong regulatory environment
Large exchanges with large amounts of funds must move towards compliance and cooperate with legal inflows.
Smart CEXs are developing towards more decentralized roads to adapt to the future strong regulatory environment. Coinbase not only provides custody wallet services but also plans to launch a Layer 2 solution based on the OP Stack, and Binance has successfully launched the OP BNB test network, while Bybit has announced the launch of its Layer 2 solution. In addition, Bitget has launched MegaSwap to provide users with convenient token aggregation Swap services, which are more inclined to DEX. OKX is relatively radical, directly integrating its Web3 wallet with CEX App to achieve on-chain and off-chain asset conversion.
Although Binance is frequently sued by US regulators, it is still widely recognized as the largest CEX in the market. Its Listing, IEO, and LaunchBlockingd still have a huge influence and wealth effect. As regulations gradually strengthen, Binance’s CEX business is somewhat trapped. In order to comply, Binance has made a lot of efforts, but the effect is not obvious. This will inevitably push Binance to further promote the development of on-chain business. BAS application chain and BNB Greenfield storage chain are the manifestations of empowering BNB, building the BNB on-chain ecology.
Different from Binance, OKX chooses to hedge regulatory risks by using Web3 Wallet and OKBChain. The user experience of Web3 Wallet itself is among the best in the same type of wallet. The most important thing is that OKX’s Web3 Wallet is embedded in the OKX App, which can realize seamless conversion between on-chain and off-chain, which will help OKX avoid regulation and convert CEX users into OKB Chain to empower OKB. With the launch of the Hong Kong policy, OKB Chain, backed by users of the OKX Web Wallet, occupies a good position and can be said to have achieved phased success in responding to strong regulation strategies.
• Open Exchange OPNX
Different from other CEXs, OPNX chooses to hedge regulatory risks in an on-chain way. Its plan is to separate trading collateral from matching engines: 1. Regardless of whether the user’s collateral is native assets or RWA, it is transparent on the chain; 2. Customer positions need to be guaranteed by credit limits for the collateral, and collateral-related parameters must be determined by DAOs that own these on-chain assets, and funds and clearing are mutually isolated. OPNX focuses on RWA and debt trading, which can largely avoid the impact of securitization, and debt trading similar to Celsius and FTX can also open up a large incremental market for it. For regulation, OPNX chooses to establish itself in Hong Kong, which is also embracing a crypto-friendly environment in Hong Kong.
Dark horse: The business of perpetual contracts will not be easily abandoned
For users, what really makes them addicted is not just the novelty of being able to obtain 100 times leverage, but also the dizzying feeling of easily obtaining 100 times net assets. High leverage ratios can make users feel the potential for huge profits, stimulate their greed, and quick profits can bring excitement and satisfaction, as well as increase users’ speculative desires. The uncertainty of asset price changes also brings excitement and excitement to users, further encouraging them to try high-leverage trading.
Therefore, the supply and demand on both ends of perpetual contracts have formed a certain business tacit understanding. “CEXs have patted the shoulder of perpetual contracts: if the market likes it, we will provide it.”
In the previous section, we mentioned that “regulation will increase the implicit cost of trading”, and the transaction fee rate is unlikely to increase significantly because the current total transaction fee rate (Maker fee+Taker fee) is mostly between 0.01% and 0.1%. (Transaction fee rate data source: CoinmarketCap.com) If the marginal transaction fee rate is increased, a considerable part of investors will be lost. Therefore, perpetual contracts, as the most profitable business of CEX, may become the marginal substitute. In other words, the perpetual contract business sector may have more innovations to compensate for the loss of income caused by the increase in implicit costs.
To sum up, as a derivative model of the traditional commercial bank model, CEX will consider the regulatory compliance, decentralized development of the bright line strategy, and the dark line strategy of continuously developing innovative perpetual contract business to ensure revenue stability and adapt to the challenges of future strong regulatory environments.
Can DEX replace CEX?
CEX is under attack, and DEX may usher in a good development opportunity
In addition, the effect of listing has overdrafted the future growth space of some tokens, and the poor performance of the new tokens listed on Binance, for example, is the main reason. According to @Loki’s research, based on Binance Listing announcement information, during the 13-month period from April 29, 2022 to June 4, 2023, Binance newly listed a total of 20 spot trading tokens and 14 old tokens. Among them, the average holding return rate of the 20 new tokens to the statistical time of 20230604 was -22.3%, while the average return rate of BTC during the same period was 7.9%, and the price performance was significantly inferior to BTC.
Regarding the listing effect, we believe that the poor performance of newly listed tokens is due to the lack of incremental funds in the market. The introduction of new tokens may cause a diversion of existing funds. In a weak market environment, the probability of new tokens breaking is correspondingly increased.
• 1) Insufficient incremental funds: When the overall market liquidity is insufficient, newly listed tokens may not be able to attract enough incremental funds to support their price increases. In this case, investors may be more inclined to invest limited funds in existing mainstream tokens or assets that offer more stable returns, and take a wait-and-see attitude towards newly listed tokens.
• 2) Diversion of existing funds: The introduction of newly listed tokens may cause investors to transfer some of their funds from other tokens or assets to participate in trading of new tokens. This may affect the liquidity and price of some existing tokens, especially in a weak market overall, this impact may be more significant.
Therefore, in an unstable market environment or when investors lack confidence, the probability of new tokens breaking may increase.
Currently, while CEX is facing challenges, will DEX usher in a golden age of development?
The AMM mechanism created by Uniswap eliminates market makers and realizes spot transactions that conform to on-chain logic. However, the problems with AMM are also obvious. When there is not enough LP depth, the transaction slippage is huge. Even with moderate LP depth, compared with CEX trading, the slippage is still significant, especially for targets with large trading volume and good liquidity. Therefore, we can see that many large investors transfer funds to CEX, conduct transactions, and then transfer back to the chain.
For a long time after DeFi Summer, DEX did not show a breakthrough progress.
Recently, there have been some frowns of DeFi’s resurgence. On the occasion of the expiration of the Uniswap v3 patent, an AMM mechanism led by Trader Joe appeared, called the Liquidity Book. The Liquidity Book draws on the tick of Uniswap v3 and establishes bins with small price ranges. Transactions within each bin can be realized without slippage. At the same time, different strategies can be established according to changes in the number of bins and the distribution of funds, optimizing the experience of both traders and liquidity providers. The plan of centralized liquidity has also appeared in the project ve(3,3) to promote price depth and increase LP income. In addition, the custom LP incentive led by Camelot has also been welcomed by the market. Maverick and Uniswap v4 have launched similar plans, allowing creators of pools to freely add LP mining incentives to promote the depth of LP. Such innovations have enabled Trader Joe to win the Liquidity War of $ARB, and Maverick’s trading volume has quietly reached the fifth place on the ETH chain DEX, while Camelot has become the largest native DEX on Arbitrum. It can be seen that the Liquidity Book mechanism has enabled DEX to make some progress in spot trading. However, in terms of overall trading volume, the trading volume of DEX is still far from enough to compete with CEX, but its market share is growing year by year, so DEX is steadily developing relative to CEX, which is also related to the relatively stable trading volume of DEX and the declining trading volume of CEX.
Besides spot trading, another notable feature is perpetual contract trading. A good perpetual contract trading experience is one of the main reasons why CEX is difficult to replace, but it is also the largest source of revenue for exchanges, and it is a cake that on-chain protocols have long coveted. The feature of on-chain protocols is the non-custodial nature of assets and the clear path of margin and liquidation, which most CEXs currently do not have and cannot achieve.
Taking the perpetual contract DEX-DYDX, which is most like a CEX, as an example, DYDX uses an order book model, and user assets are used in a non-custodial manner to settle trades and liquidate them in a trustless manner. The off-chain engine matches orders using price feeds for positions and liquidations, and the oracle reports the median price from 15 independent Chainlink nodes. At the time of liquidation, the position is closed at the closing price, and the profit or loss from the liquidation is borne by the insurance fund. DYDX v4 will be integrated into the Cosmos ecosystem to achieve lower latency and less wear and tear. However, one problem with DYDX replacing CEX is that the index prices for fee and limit orders are sourced from CEXs. As of June 21st, DYDX’s 24-hour trading volume is $2.08 billion, still far behind the top CEXs.
Unlike DYDX’s order book model, GMX uses an LP model, which allows traders to become counterparties with LPs, achieving 0 slippage and getting rid of market makers to provide liquidity. This is similar to the advantages of the spot AMM model. In addition, its fee is 0.1%, the maximum leverage is 50 times, there is no KYC or geographic restrictions, which is more attractive than DYDX (maximum leverage is 20 times, and US IPs cannot trade on DYDX). However, its disadvantage is also similar to that of AMM, which is that its funding capacity is limited, and the theoretical upper limit of orders is related to the TVL of GLP, making it not very friendly to super large funds. GMX v2 introduces customized Chainlink price feed services to achieve lower latency prices, but the final price is the average of the oracle price and the mainstream CEX price. Therefore, GMX is more dependent on CEX prices and is more difficult to operate independently in the short term. Recently, on June 21st, GMX’s 24-hour trading volume on Arbitrum was only $426.8 million, which is only about 20% of DYDX’s total trading volume (including Swap, Mint GLP, Burn GLP, Liquidation, and Margin Trading).
Long-termism: DEX is More in Line with Crypto Orthodoxy and Blockchain Justice Principles
From the above DEX mechanism and data, we can see that the current market share of DEX in the entire exchange market is still relatively low compared to CEX, and perpetual contract DEX even relies heavily on CEX in pricing. However, this is all due to the low threshold interaction of CEX, which results in more users than DEX, as well as the introduction of market makers. The security of the non-custodial mode of DEX and the transparency of the margin and clearing mechanism naturally conform to Crypto orthodoxy and blockchain justice. Therefore, with the development of technology, when on-chain interaction and Web3 wallets are no longer obstacles for users to enter DEX, what we may eventually see is an on-chain DEX based on off-chain technology, and CEX will only be like most securities firms, completely in compliance with regulations for large institutions to conduct bulk transactions and for retail investors to deposit and withdraw. The exchange that most resembles what we described is the previously mentioned Open Exchange, which starts from a more CEX-oriented perspective to decentralize CEX. So, in the short term, what DEXs may need to do is to sacrifice decentralization to some extent in order to achieve a better user experience. To achieve the widespread use of DEX, we still need to wait for the landing and popularization of the following key technologies: