Digital assets are categorised into digital, cryptocurrencies, and crypto or digital tokens. Digital asset innovation is often linked to the creation of bitcoin by the individual or group who published its blueprint in a whitepaper in October 2008 under the pseudonym of Satoshi Nakamoto. But it wasn’t until 22 May 2010 that the first payment was made when a block of 10,000 bitcoins was used to purchase two pizzas at the value of $41. Later that year bitcoin was listed on exchanges and priced against the US dollar. In February 2011 the price of bitcoin surpassed $1 and it traded between $36,000 and 37,000 on 25 January 2022.

As of 25 January 2022, Coinmarketcap.com lists more than 17,100 cryptocurrencies. The asset class has evidently grown from that first traded bitcoin in 2009 to about 5,200 different cryptocurrencies on 22 January 2020, to 7,800 on 20 January 2021

The growth in digital asset trading has since attracted a range of investors from retail traders to traditional financial institutions, to institutional investors.

New cryptocurrencies have expanded on the original idea set by bitcoin and a big push came with the introduction of Ethereum in 2015 that supports many new digital assets like DeFi and NFT. Decentralised Finance (DeFi) refers to both applications and businesses that intend to offer a decentralised financial system with improved transparency in comparison with the traditional financial systems. DeFi is based on smart contract platforms typically offered by Ethereum and allow users to engage in financial transactions such as sending and borrowing money without the need for intermediaries such as banks.

Non-fungible tokens (NFTs) are designed to store data on blockchains such as Ethereum and Solana that can be attached with a media containing file. NFTs should not be classified as cryptocurrency as NFT units are not interchangeable. Instead, NFTs are designed to allow artists and content creators to transfer ownership of the data and file, i.e., a token. Through this design NFTs can be sold and bought on exchanges and marketplaces such as Opensea that displays more than 3,000 NFTs. According to Chainalysis, more than $27 billion worth of cryptocurrency were sent by users to Ethereum based smart contracts e.g., ERC-721 and ERC-1155. These transfers were associated with NFT exchanges. In October 2012, Coinbase launched a service to buy and sell bitcoins through bank transfers.

The emergence and growth of digital assets exchanges have been both fast and exponential, in comparison with traditional stock exchanges.

Neil Sheppard, chief product officer of Singapore-based EQONEX Group, said, “Cryptocurrencies are just the tip of the iceberg. This year, we saw the proliferation of (NFTs.”

The global adoption of cryptocurrencies is driving its growth in spite of differences in the type of assets in different countries, and regions. In its global adoption ranking report, Chainalysis placed Vietnam, India, Pakistan, Ukraine, and Kenya at the top five countries for the adoption of cryptocurrency while the United States (US), Vietnam, Thailand, China, and the United Kingdom (UK) are the top five countries for DeFi.

Asia Pacific (APAC), is the fourth largest cryptocurrency market, and represents 14% of the total transactions worldwide. APAC recorded $572 billion in transaction value between July 2020 and July 2021, aa 70% jump.

“In comparison with the US, investors in APAC could appreciate the opportunities with digital assets trading much more,” said Arthur Cheong, CEO of DeFiance Capital, as he explained the reason for the level of interest in APAC.

The Singapore-based venture capital firm, DeFiance Capital, is currently curating some 50+ DeFi projects. Cheong stated, “We mostly invest in the early stages from C to series A and hold a portfolio of some fifty-plus DeFi protocols.”

According to DeFi Pulse, a total of $92 billion is locked in DeFi protocols as of January 20, 2022 across several financial services. Cheong also noted that DeFi has found numerous applications in financial services, such as asset management, decentralised exchanges, derivates, lending, and payments.

A decentralised exchange offers crypto traders peer-to-peer transactions through self-executing smart contracts and is an emerging type of digital asset exchange.

Major opportunities for digital assets exchanges

Around the mid-2010s, Binance emerged and is the current market leader among digital asset exchanges.

The growing market of digital assets means more business opportunities for both traditional stock exchanges and new exchanges. There are 672 digital assets exchanges registred as of July 2021, based on statistics from Chainalysis. While the number of digital assets exchanges tend to vary over time, a look at the competitive landscape suggests the market is quite fragmented; yet the core business idea of these exchanges is to act as the venue for the listing, distribution, and trading of digital assets.

Digital asset exchanges have ambitions to widen and deepen the digital asset market. The private market exchange ADDX has developed a multi-asset trading platform that offers investors access to private equity funds, pre-IPO equity, hedge funds, and wholesale bonds.

Darius Liu, chief operating officer of ADDX, said, “We fractionalise investments, and with this, we lower the minimum ticket sizes from $1 million to $20,000. By doing so, we can open the market to more investors. It means lower costs and a faster speed to issuance.” In this endeavour, ADDX launched a cryptocurrency product in December with the listing of a digital asset fund and in January it announced that one of its logistics real estate funds had achieved more than double its target returns of 12% per annum.

In an attempt to find appropriate business models, exchanges such as ADDX can act as the point of primary and secondary sales of digital assets. Digital asset exchanges can also engage in programmes called “air drops” or “earn drops” where the exchange, through various schemes, allocates assets to users with or without expectations on performance, in exchange for data such as know-your-customer (KYC) information and to provide design interface inputs. Such programmes are effective marketing tools for start-ups as they can outsource low-skills activities to users and end-users and increase their level of engagements.

The Singapore Stock Exchange (SGX) set up Marketnode, a blockchain based trade processing platform, n February 2021. Marketnode bears several characteristics that differentiate it from other digital asset exchanges. Rehan Ahmed, chief product officer of Marketnode, stated, “As an infrastructure provider we support marketed securities. At this point, we don’t deal with cryptocurrency firms and we don’t do tokenisation. Instead, we try to use digitisation to improve efficiencies in the processing of traditional financial services products, fixed income as an example.”

Digital asset exchanges can also provide services to support transactions. The Singapore-based EQUNEX Group has developed and branded its crypto custody services, Digivault, that is also marketed to offer “service levels distinguished in hot wallet and cold storage”. Typically, cryptocurrency traders use wallets to store ownerships of the asset, access the currency, and facilitate transactions e.g., send and receive tokens. Hot wallets enjoy the benefits of being connected to the internet and cold wallets/storage are not connected, that determines their level of vulnerability to hacks and theft.

Sheppard shared the rationale for the custodial business, “While the profit and loss of the trade may be the main objective for retail (individual) investors, institutional investors’ main objective is to safeguard their assets and avoid putting their reputation at risk in case of lack of security that comes with digital assets.”

Digivault, along with other companies such as Bakkt, Copper, and Paxo, are not disclosing their assets under custody, which is a central metric in the industry. Yet some of the largest players in the space keep digital assets worth tens of billions of US dollars in their custody services.

Custody is one important service for exchanges as facilities that can hold, move, and protect digital assets are critical for investors. The digital asset exchanges and other service providers can offer a range of services pre and post transactions.

Given the diversity of digital asset exchanges, there are several assessment frameworks to distinguish them. Crypto Compare Research for example considers the following criteria: KYC/transaction risk; quality/diversity of assets; legal/regulation; data provision; security; team/exchange; negative reports; and market quality. In its 2021 evaluation of 150 active spot exchanges released in August 2021, it ranked Coinbase, Gemini, Kraken, CrossTower, and Bitstamp at the highest possible level.

In terms of legal/regulation, one consideration is that exchanges need to choose the location of their headquarters. Coinbase and Kraken operate out of the US, Binance is headquartered in the Cayman Islands, FTX in the Bahamas, and KucCoin in the Seychelles. Hagen Rooke, a counsel at Reed Smith, said, “The offshore markets such as Seychelles offers access to fewer regulatory obstacle as can be found in other markets such as the US.” The regulatory obstacle can range from licensing requirements, to access to public-private partnerships venues, and to various sanction instruments at the disposal of the regulators.

Digital Asset Research is yet another research company that specialises in benchmarking exchanges and in its quarterly announcement presented in January 2022 it evaluated some 450 exchanges and placed exchanges on either vetted list or watchlist. The 21 vetted exchanges were Binance.US, bitbank, Bitfinex, bitFlyer, BITFRONT, Bitso, Bitstamp, Bittrex, CEX.IO, Coinbase Pro, Coincheck, CoinField, Gemini, GMO Coin Co., itBit, Kraken, Liquid, LMAX Digital, Luno, Okcoin, and Zaif.

Coinmarketcap ranks some 300 plus exchanges according to a set of quantitative factors including traffic, liquidity, trading volumes, and confidence in the legitimacy of trading volumes reported. In mid-November, it ranked Binance, Coinbase, FTX, Kraken, and KuCoin at the highest level among the listed exchanges.

Beyond these performance related ratings, funding of digital assets exchanges is a key concern. Several of select exchanges have been around for several years, yet they need continuous funding, as records of funding rounds show, e.g., Binance ($25 million), Coinbase ($547 million) FTX ($1,4 billion), Kraken ($133 million), and KuCoin ($20 million). Coinbase was listed in April 2021 and its market capitalisation was $46 billion on 25 January 2022.

According to CB Insights, investments in digital assets exchanges increased by 2,240% in the third quarter (Q3) of 2021 year-to-date compared with Q3 2020. EQUNEX Group operates one of a growing number of such exchanges. Its Group CEO Richard Byworth, remarked before the launch of the exchange business, “Institutional participation in crypto is at an inflection point.”

Yet the market capitalisation of digital asset exchanges is not comparable to the traditional stock exchanges. According to the World Federation of Exchanges, 2075 stock exchanges operate across the globe. Some of the world´s important stock exchanges facilitate transactions within other markets including the money, bond and currency markets. 

Although digital asset exchanges are not competing with traditional asset exchanges the choice of market remains an important one for both. Traditionally stock exchanges cater to both global and local securities trades. Meanwhile, their activities tend to be concentrated in some geographies more than others e.g., financial hubs and centres. Euronext Stock Exchange operates exchanges in Amsterdam, London, Paris, Lisbon, Brussels, Dublin, Milan, Oslo, and more. The Mumbai-based Bombay Stock Exchange trades securities in Brazil, China, Russia, and South Africa.

In comparison, digital asset exchanges are not bound to specific geographic locations. There are, however, regional patterns in digital asset trading which tie exchanges to specific geographies. Yet, the largest deals happen in the US, and the majority of investors reside in the US.

Moreover, some regions and countries have provded to be more welcoming than others. Several incumbent financial institutions in Singapore have ventured into digital assets in 2021. DBS Bank launched its digital exchange business in December 2020 and ramped up the business in 2021.

The revenues and costs uncertainties

The digital asset exchange business may have significant prospects; however, its valuation is a difficult task for both investors and the exchanges themselves. Uncertainties about potential revenues from digital asset trading and other related services such as custody remain a major obstacle.

To understand how investors estimate revenue potentials of digital assets, Cheong stated, “Most of the assets and most notably DeFi protocols generate revenues to the protocol.” Investors can project the future revenue streams based on the revenue numbers. This valuation can be used by investor for trading purposes and valuation of the token.

For exchanges offering trading venues the calculation of revenues requires consideration about volume. Liu added, “For exchanges, revenue is a function of the number of transactions that flow through the exchange.” Records show that transaction volumes can differ depending on the type of exchange.

The exchange business can operate through different business models such as centralised, decentralised, high-risk, over-the-counter brokers, and derivatives exchanges. Centrally-operated digital asset exchanges operate more like traditional stock exchanges and are regulated via KYC and anti-money laundering (AML) regulations. These exchanges offer a variety of transactions e.g., fiat/cryptocurrency, cryptocurrency/fiat, and cryptocurrency/cryptocurrency.

Don Guo, CEO of Broctagon, stated, “Most of the volume takes place with centralised exchanges and the institutional requirements for trading such as instantaneous trade and price sensitivity is high.”

The major portion of the volumes on centralised exchanges are generated through cryptocurrency/cryptocurrency trades e.g., bitcoin to ether and a minor portion of the volumes can be pointed to fiat/cryptocurrency and vice versa.

Digital exchanges given their trust-less design and peer-to-peer transaction model attract fewer transactions and therefore operate through lower transaction volumes than centralised exchanges.

A derivative exchange facilitates trades in derivatives with underlying assets that comprise one or more digital assets and the transacting parties have entered into agreement to conduct a transaction in the future according to conditions and price today. Over-the-counter exchanges offer trading with digital assets directly between two transacting parties.

To maximise volume potential exchanges can set up different businesses to offer different types of trades. The EQONEX Group consists of an institutional-grade cryptocurrency exchange, over-the-counter crypto trading desk, and a multivenue trading platform.

Typically, exchanges operate on the spread per transaction that such volumes generate. In its latest report, the US-based digital asset exchange, Coinbase, estimated its quarterly traded volume to be $327 billion, which is comparable with monthly volumes of the London Stock Exchange.

With the continual introduction of new digital asset types and tokens, it is a difficult task to size the digital asset market entirely. As Liu confirmed, “The private market is untapped, and we don’t know the size of the market yet.” Meanwhile, digital assets exchanges continue to increase the issuance and tokenisation of new assets.

While the revenue side of the exchange business requires particular attention to both known and unknown factors such as the transactions volumes and the spread, there is a need to also consider several cost elements.  Technology, liquidity, governance model, and organisation of resource for production and distribution of trading and post trade services are important cost drivers for digital assets exchanges

To ensure production of related services such as custody and other post-trade services the exchange business can rely on several features of distributed ledger technology (DLT). Sheppard explained, “DLT is designed so scaling doesn’t correlate with additional costs.” The promise of scalability is important as exchanges need to plan production of services and consider potential capacity building needs.

While technology can be controlled to a large extent for the production of services, the costs related to the distribution of services can be rather unpredictable. One aspect is the human involvement in distribution channels. For any exchange, one main objective is to attract investors and members to its trading platform and deepen the relationship over time.

Sheppard noted, “Customer acquisition in different channels, such as business-to-consumer and business-to-business, have become very difficult to predict and control.” This issue is caused by several underlying sources such as access to talents, market fragmentation, and competition.

For digital asset exchanges, the challenge of customer acquisition is followed by the challenge of offering a smoothly run exchange service. One element of this is liquidity that is a concern both in bearish and bullish markets. Guo stated, “Operationally, liquidity is one of the main mechanisms that determines client uptake and retention. It facilitates the trading experience fundamentally. Exchanges with poor liquidity risk losing clients and eventually trading volumes and finally seizure of operations.”

Both the issues of customer acquisition and liquidity should be less of a concern for established exchanges like the SGX that has ventured into the digital asset business. In September 2021, Marketnode announced it had partnered with ten internationally active and, more importantly, renowned banks.

On a question about the relevance of partners, Ahmed made the following distinction, “We need partners at two levels. We partner with law firms to get help with creating and structuring products. We also partner with various kinds of banks that are key in capital markets and important for distribution purposes.”

As Ahmed noted, Marketnode can secure access to geography and reach customers globally through the partners, which is important when operating out of Singapore. The partners also offer services such as post-trade clearing and custody that have become a necessity in the distribution of digital assets.

Both incumbents and new exchanges rely on third parties to secure minor and major processes around the production and distribution of exchange services. Standardised services can be a game changer for newly-established exchanges wishing to avoid costs. ADDX engages KPMG to audit its funds. Liu added, “For cloud computing, we source services from Amazon Web Services, and for eKYC and customer onboarding, we get from other third parties.”

Meanwhile, for exchanges, it can be critical to retain the more value-adding services in-house. Sheppard stated, “At the EQONEX Group, we enjoy many advantages when we control our custodial service, Digivault, then we use a service that we understand.”

According to Sheppard, the lack of such understanding needs to be dealt with that requires resources. He specified, “The current market trend requires that one invest time and resource to get the external services evaluated by third parties including regulators and standards setters.” However, the time allocations for such evaluations can be rather unpredictable and therefore the search can turn out to be costly.

Digital asset exchanges must comply with various regulation e.g., KYC that necessitates the implementation of various administration and related control processes. For incumbent exchanges that are involved in several different business areas, the related costs for administration are a function of the complexity of the organisation and the need to avoid potential conflicts of interest between various entities.

From the Marketnode example, such costs however, can be managed by choosing the appropriate governance model. SGX has set up a dedicated business entity for Marketnode. Ahmed said, “Marketnode has a separate board of directors than that of SGX. Among our shareholders, there is an understanding this ensures creativity and speed.”

In a similar fashion, DBS that is also seeking rent from its digital asset venture via DBS Digital Exchange has separated the new business from the parent.  Likewise, Deutsche Börse acquired the majority stake in Crypto Finance in mid-December, 2021. Jan Brzezek, CEO and co-founder of Crypto Finance, gave his rationale for the deal, “Established financial institutions increasingly want to start investing in digital assets and are looking for a trustworthy partner.”

The organised development phase involves distinct uncertainties including market, technology, management, regulation, and organisation.

Exchanges are an important vehicle in financial markets and an important channel for distribution of and investments in digital assets. The crypto innovation is set to to grow in importance not only with investors but also within the ever-expanding ecosystem. Sheppard envisaged the trend, “We should expect that with the introduction of other digital assets such as central bank digital currencies that companies are expected to have systems that can integrate with the digital ecosystem.”

Currently, regional differences condition the business opportunities for digital asset exchanges. Markets such as Singapore are catching up with development by offering exchanges fewer obstacles such as access to an ecosystem.

The establishment of a digital asset exchange business demands consideration of a plethora of decisions, such as external funding of the business, transaction flows and concentrations, product and services ranges, liquidity, and regulations.

The control of the costs of the digital asset exchange business comes with consideration of several other decisions regarding the appropriate governance model and the effective organisation of standard and critical processes.