Exchanges Could Be Under Pressure

There has been an endless cycle of bad news in the past couple weeks as the bear market takes hold. As covered in last week’s Deep Dive, Celsius appears to be on the brink of insolvency because of reckless risk management and illiquidity. Most recently, Voyager, a crypto broker which offers (or offered) 9% yield on USDC, revealed that it has $660 million of exposure to Three Arrows Capital, and a request for repayment has not been fulfilled. Thus, Voyager will be taking a $500 million loan from Alameda Ventures, the VC arm of Alameda Research, which was formerly run by FTX CEO Sam Bankman-Fried.

Lower liquidity is one symptom of a bear market; reduced volumes is another. Low volumes and an expectation of low volumes in the future have already had an effect on crypto exchanges, which make most of their money from trading fees. As pictured below, BTC volume across three of the world’s largest exchanges has decreased significantly from its bull market peak, with the exception of the May 2022 collapse of Luna and UST.

Coinbase is laying off 18% of its workforce, Bybit 30%, and Gemini 10%. On the other hand, Binance CEO CZ announced that the exchange is hiring for 2,000 open positions, citing the exchange’s lack of Super Bowl ads and high-profile sponsorships. FTX, an exchange that certainly has spent a lot of money on marketing, will not be laying off employees or instituting a hiring freeze; Kraken also announced that it will be hiring for 500 open positions.

Exchanges face the following risks as we dive deeper into the bear market:

• Reduced volumes
• Fee compression
• New business verticals: staking/earn and venture

Fees

Crypto exchanges generate the vast majority of their revenue from transaction fees. Coinbase, one of the few exchanges for which we have this data available, generates nearly 90% of its revenue from fees. However, as competition has increased there has been significant fee compression. FTX, which has a relatively low taker fee of 0.07%, has reaped the benefits, while Coinbase’s (not Coinbase Pro) fluctuating fee, which includes spread, was nearly 4% at the time of this writing.

Just yesterday, Binance.US announced that it was eliminating fees for BTC trading while Coinbase announced that it would be phasing out Coinbase Pro (which offers lower fees than Coinbase) to create a unified account with Pro’s fee structure. Binance.US’s decision will put increasing pressure on U.S. exchanges, as new market entrants have been fighting for market share, which thus far has come at the expense of Gemini (1.49% fees).

Taking a global look, the below chart shows how FTX has grown its market share relative to Coinbase. As was the case with Robinhood, FTX set a new standard for lower fees and has created competition to offer the lowest fees.

Staking

In recent years, the business models of exchanges have grown more complex. Most significantly and concerningly, there has been a sharp increase in the number of exchanges offering staking rewards (often called “earn”). Generally this involves a user holding a proof-of-stake token (for example Solana or Polkadot) on an exchange to receive the associated yield. This can generally be considered low risk, as the exchanges are staking yield-generating tokens for users rather than generating yield through DeFi protocols or some other lending/borrowing mechanism.

However, some exchanges have adopted a riskier approach to their Earn programs. For example, Binance offers over 8% APY on BTC locked for 60 days using Venus Protocol.

Looking at Venus Protocol, it’s unclear where this yield is coming from, as the supply APY for BTC is just above 1%.

This is not to suggest that Binance will fail if there is a rush to redeem from their BTC staking option. As seen below, Binance is a juggernaut that has seized market share from formerly huge exchanges like OKX. Binance has 0.1% fees and does over $10 billion in volume most days; using back-of-the-napkin math that’s about $10 million in revenue each day.

The real danger comes in with smaller exchanges that have had their volume market share decrease offering these risky products. For example, a small Japanese exchange offers up to 5% APY on BTC, ETH, and XRP and explicitly notes that “lent cryptocurrencies are not managed as segregated funds” and goes on to say there is no guarantee that users will be repaid if it goes bankrupt. Another larger exchange offers a wide variety of Earn products, including a no-lock USDT deposit that earns 3.5% APR. These are far from the only exchanges to offer these types of products.

Venture

Another concerning trend involves exchanges increasingly delving into the venture capital space. Not only does this increase conflicts of interest, as exchanges are more willing to list and promote tokens that their venture arm has invested in, it also creates a more tangled web that can be stressed in a bear market. As detailed above, Three Arrows Capital’s trouble spelled trouble for Voyager, which then needed a bailout from Alameda (Alameda had invested $75 million in Voyager in 2021). Looking at another example, Tether (which has a relationship with Bitfinex) was an early investor in Celsius and reportedly loaned $1 billion to the platform in 2021. Tether then released a blog post stating that it had no losses related to Celsius and Three Arrows Capital. Given that Tether got a $41 million slap on the wrist for lying about its backing last year, one could be forgiven for not taking their statement at face value.

Conclusion

These staking products and webs of relationships are confusing, and that’s the point. A couple of days ago, Voyager’s exposure to Three Arrows Capital wasn’t well known. A lack of consistent regulations has allowed exchanges to branch out into a variety of businesses that all seemed successful when prices were going up. As prices remain low, volumes decrease, hedge funds unwind, and fees compress, exchanges will be put to the test. Those that have enough volume and spent responsibly through the bull market will likely be able to weather the storm, while those that played fast and loose with risky staking products and investments may go under if they aren’t acquired or bailed out by FTX or Alameda (what is the relationship between FTX and Alameda, anyway?). “Not your keys, not your coins” is more relevant than ever, and users should understand that they are taking a risk any time they hold crypto on an exchange, as well as extra risk if they use staking products.