The Structure of Competition between Cryptocurrency Exchanges

In the past few days, the SEC has sued Binance and Coinbase for operating as unregulated securities exchanges. What role do these super-large crypto exchanges play in the broader ecosystem of international crypto exchanges? My student Junyi Hu and I have a new paper on this, here’s a link.

While crypto super-exchanges like Binance and Coinbase exist, the crypto exchange ecosystem appears quite competitive. There are over 100 crypto exchanges active in the United States alone, and most of these exchanges trade the same few crypto-assets! Why are there so many exchanges? Why don't Binance/Coinbase, and other large exchanges just absorb all the others? Secondly, given that the market for crypto exchanges appears quite competitive, how much influence do Binance/Coinbase/etc really have on market outcomes?

In the paper we show a somewhat surprising fact. An intuitive model is that exchanges compete for an approximately fixed trade volume. If Binance/Coinbase lists a token, trade volume on smaller exchanges should decrease due to cannibalization. Exchanges which haven't listed will lean away from listing.

Surprisingly, we find that the opposite holds! When Binance/Coinbase lists a new token:

• Trade volumes on other exchanges increase!

• Other small exchanges become more likely to list the token!

In economics language, small and large exchanges seem to be complements, not substitutes!

What is going on here? We propose a simple theory where small exchanges, rather than competing with Binance/Coinbase for a fixed customer base, have captive customer bases, and rely on market maker arbitrage with Binance/Coinbase to provide liquidity for their customers.

Essentially, our story is that small exchanges are "costly windows" into Binance liquidity for their customers. A small exchange, perhaps, figures out how to navigate the banking and regulation system in a small country, say for example, the Philippines. But the Philippines crypto market is too small for deep liquidity, so the small exchange invites market makers to arb it against Binance/Coinbase. When customers sell to a market maker on the Philippines exchange, the market maker then sells into the deep liquidity on Binance.

Our results imply that large exchanges play a "leader" role in crypto markets, which is understated by their modest share of trade volume. Due to the complementarity we show, large exchanges' listing decisions cause large indirect volume increases on other exchanges.

In traditional finance, regulators decide what can be publicly traded, imposing disclosure and governance requirements in the process. In today's crypto markets, large exchanges like Binance/Coinbase decide what is listed, causing much of the rest of the market to follow.

It's not inconceivable that large exchanges have incentives to avoid listing very low-quality tokens, and lean towards listing high-quality tokens. But do we like the status quo where a few profit-motivated private entities have such large power to determine market outcomes?

Again, here’s the paper. Let me know if you have any questions or comments!