This series seeks to answer: Why should exchanges be decentralized? In our last article, we laid out a call to arms for Crypto users everywhere.

In this article, we ask: What is an exchange? (and what does it do?)

TLDR — Exchanges are:

1. A public good designed to help users trade with the lowest friction possible.
2. They are also, due to intrinsic economies of scale, natural monopolies (or oligopolies).

Today, a few exchanges dominate volumes. Controlled by private interests, they reduce market efficiency and extract value from users. Decentralizing mechanisms pioneered by blockchain are ideal for solving these issues. Doing so will create more value for all participants and improve efficiency, bringing both assets and users into the space.

Part 1: What is an Exchange?

In the past exchanges were physical locations where people gathered to trade. Starting with early agricultural commodity exchanges, they now exist electronically. Crypto exchanges process huge volumes and respond at ever higher frequencies to real-time data. Enabling trade activity 24/7 and are accessible anywhere with an Internet connection they are essential financial infrastructure.

At their heart, however, exchanges are simple businesses designed for facilitating trade by matching buyers and sellers:

1. Economies of Scale — fixed costs are high (servers, software etc) and marginal costs are low (more trades doesn’t mean more costs).
2. More trading means average cost per trade diminishes
3. The most profitable exchange can then lower fees to capture more market share
4. Eventually, all liquidity concentrates on one or a few exchanges, eradicating competition.

In Econ 101 this combination of high fixed costs with low marginal costs and network effect is referred to as a ‘natural monopoly.’ When these monopolies are unregulated and privately owned, they are well-placed to create barriers which impede new entrants. In crypto these barriers include:

• Stickiness: users struggle to move between exchanges once they are familiarized with one. This creates dependence.
• Tiered trading fees: Fee structures are tiered in a way which extracts maximum value from smaller players and concentrates market-making power in a few well-endowed hands
• Specialized conditions which favor one set of users over others (ie. MEV in blockchains, dedicated servers for HFT etc.)

The table above clearly shows a number of these anti-competitive effects:

1. Large players get 50–100% discount on fees, when compared to small players (ie retail)
2. New market makers suffer from barrier-to-entry challenges, making tighter spreads more unlikely.
3. Exchanges benefit disproportionately at the expense of both sophisticated and retail users. Market makers take risk for providing liquidity, yet the bulk of value transfers to the exchange. This worsens pricing from makers and punishes less sophisticated users. A lose-lose for traders everywhere.

These are instances of market failure. Decentralization via blockchain can align these interests and fix these issues. To see how, we must understand the parties involved on the exchange and their roles in price discovery.

Exchange Participants

Exchange participants can broadly be grouped into one or more of three categories:

1. Makers
2. Takers
3. Arbitrageurs

Makers

can be any market participant who puts passive liquidity onto an orderbook. They help “set” market prices by continuously quoting prices they are willing to buy (called the “bid”) and/or sell (called the “ask” or “offer”) an asset. Professional market makers profit from the difference between these two prices– the bid-ask spread. They will quote a wide range of products and help create the liquidity other participants use to fill their trades. As such the bid-ask can be thought of as a profit margin for makers.

Takers

are market participants who want to take (or close) a position in an asset and execute a transaction on a maker’s quoted price, effectively taking passive liquidity from the orderbook. The bid-ask spread is the cost of accessing this liquidity.

Arbitrageurs

are a special class of traders who seek to make risk-free profits (arbitrage) by simultaneously trading the same asset in different exchanges at different prices. Typically they also make and take prices on the orderbook. Arbitrage brings more volume to markets and helps align prices across different exchanges. Opportunities for arbitrage are typically limited by transaction fees and market liquidity.

Price Discovery

Perhaps the most important function of exchanges is allowing markets to assign prices to assets, a process called price discovery. Asset prices communicate the aggregate information known to market participants and are a major component of decision-making in economic investment. Therefore, the quality of price discovery directly influences much of the goods and services produced by an economy.

Exchanges must be efficient and convenient for all participants to ensure optimal price discovery. Through our diagram above, we can see that there are a few key considerations we must solve for:

1. Tight spreads — tighter bid/offers will encourage more price takers to transact at lower costs, begetting more liquidity and volumes.
2. Ease of arbitrage — well-arbitraged markets will ensure better pricing, which encourages more volumes and helps diminish risk for market makers, whilst creating value for price takers.
3. Optimized fees — Fees must be designed to minimize costs to users whilst capturing value for all stakeholders to protect the system from bankruptcy and sustain infrastructure. With excessive fees, volumes will diminish and, in the absence of restrictive trade practices, traders will move to other venues. (CEXs have other barriers they use to keep users)
4. Low barriers to entry — Lowering barriers to entry allows more participants to compete on prices. This optimizes spreads, deepens liquidity for trading and leads to gains for all users.

Fixing Public Good Market Failure

Today’s exchanges fail to fulfill users’ needs because they are operated in the interests of the few.

Users overpay for fees, and competition is strangled as a handful of exchanges generate supernormal profits. Yet, CEX volumes dominate DeFi because users relinquish control, community, and self-custody, in favor of convenience and functionality.

We believe in something better.

Vertex will solve these problems by matching the convenience of CEXs to the high-minded ideals of DeFi– integrating important features into one DEX designed to make decentralized trading easy, efficient, and useful for all users.

Check out Part 2 of the CEX vs. DEX series here.

AN EXCHANGE’S KEY FEATURES and why they are essential.

We hope you enjoyed Part 1 of our DEX vs. CEX mini-series. Stay tuned for next week’s blog.

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