As digital assets continue to evolve from their original objective – being an efficient form of payment – they are increasingly being seen as investment assets (or securities) rather than payment methods. Some of the reasons behind this lies in their inherent risks, such as price volatility, fraud, and market manipulation. These are also in traditional capital markets. In order to deal with said risks and eventually limit shortfall and exposure to unknowledgeable retail investors, regulations must be drafted and digital asset activity over-sighted. We will further explore regulation considerations for digital asset exchanges. 

Therefore, the two main paths that can be taken by regulators regarding cryptocurrencies are:

1. Add digital assets service providers (i.e exchanges) within the scope of the existing financial services regime. Therefore, the list of financial instruments includes cryptocurrencies, or
2. Create an appropriate and proportionate regime that draws on the existing one [1].  Naturally, the decision would ideally be carried out at an international and cooperative level, but is generally done at a country level, directly impacting digital asset service providers that operate in multiple jurisdictions [2].

Digital asset exchanges will have a number of regulatory and fiduciary responsibilities. These include the trading process and the actors involved in it. Furthermore, the extent to which the regulatory institutions (depending on their geography) cover these actors is among them. For example, investors trading through a centralized exchange based in New York are subject to both state and country-level regulations.

Risks and responsibilities of digital asset exchanges

Many of the issues and risks associated with trading on Crypto-Asset Trading Platforms (CTPs) [3] are similar to those associated with trading on traditional trading venues. However, due to the operational models of some CTPs, unique issues and risks arise. This may prompt regulatory authorities to consider new, alternative or tailored regulations for digital asset exchanges, to the extent permissible by law.

The Board of the International Organization of Securities Commissions (IOSCO) – the international body that brings together the world’s securities regulators and develops, implements and promotes adherence to internationally recognized standards for securities regulation – issued a comprehensive document in 2020 encompassing risks and regulatory considerations of digital asset exchanges, tackling the main areas that may have an impact on their objectives, which include protecting investors and ensuring that markets are fair, efficient and transparent [4]. 

Six key considerations for regulators

Some of the key considerations that regulators must take into account when overseeing exchanges include: 

1. Access to CTPs and onboarding. Regulatory authorities should analyze how access is provided to CTPs. In this case, determining the extent to which CTPs provide non-intermediated access to investors must be paired with who is responsible for the on-boarding process. Moreover, this includes the execution of the on-boarding process.
2. Safeguarding participant assets. Where a CTP holds participant assets, a key consideration for regulatory authorities is how such assets are held and safeguarded. This includes considering what arrangements are in place in the event of a loss, including a loss due to theft from, or the bankruptcy of, the CTP.
3. Conflicts of interest. A key consideration for regulatory authorities is the extent to which conflicts of interest exist due to the internal structure and organization of a CTP and, if so, how they are managed. A common conflict of interest includes the funding of order-book depth by the exchange. This creates friction between users and the exchanges’ success.
4. Market integrity. Regulatory authorities should consider existing rules relating to market abuse and the capacity of CTPs to prevent and/or detect market abuse.
5. Price discovery. Promoting and incentivizing efficient price discovery should be a key characteristic that CTPs should support.
6. Technology. Though mostly related to asset security, technology describes the mechanisms used by CTPs to facilitate resiliency, integrity and reliability of critical systems.

Scalable digital asset exchanges

Scalable Solutions swiftly adapts to new circumstances, both technological and regulatory. We have a variety of partners to help our clients navigate the regulatory requirements needed to run an exchange. This presents our clients with a comprehensive strategy to rapidly build digital asset exchanges.  

Schedule a demo with our team to find out more about our exchange software and how we can help you. 

 

 

 

References

[1] Sotiropoulou, Anastasia, and Stéphanie Ligot. “Legal Challenges of Cryptocurrencies: Isn’t It Time to Regulate the Intermediaries?.” European Company and Financial Law Review 16.5 (2019): 652-676.

[2] In the USA, several federal and state administrative and regulatory agencies keep a close eye on digital assets; including the SEC, CFTC, FTC, IRS, OCC, FinCEN, and more.

[3] The specific denomination of digital asset trading venues can vary depending on a few factors. This can be the jurisdiction, regulatory authorities and determination of specific processes that can be carried out within the exchange. These include trading and/or custody of digital assets. The Financial Action Task Force defines them as Virtual Asset Service Providers (VASPs), while ECB’s AMLD 5 defines them as Virtual Currency Exchange Platforms (VCEPs). 

[4] FR02/2020 Issues, Risks and Regulatory Considerations Relating to Crypto-Asset Trading Platforms, Report of the Board of IOSCO. https://www.iosco.org/library/pubdocs/pdf/IOSCOPD649.pdf

New participants in the digital asset space need to familiarize themselves with the basic actors, actions, risks and potential opportunities that the industry offers. Learning about liquidity in centralized and decentralized exchanges is just as important as learning how to secure your funds – either via a trusted exchange or private keys.

After incorporating this basic knowledge, the next step involves gaining a deeper understanding of how the rest of the elements in the ecosystem work. Let’s take some time to dive into one of these parts – OTC trading.

What is OTC trading

Over-The-Counter (OTC) trading operations are those that are not registered or carried out in any formal exchange. 

We previously introduced the concept of order-books for centralized exchanges – where the orders of every user are bundled together into a massive ledger, which connects identical transactions from different sides of a trade (buying and selling). Liquidity provided through market making along with retail orders can be found in this ledger. There are, however, some types of orders that due to their nature cannot be executed normally through these – relatively shallow – order books without significantly altering price and liquidity. Enter OTC desks.

OTC transactions are those carried out between two parties without the intervention of an exchange. Because both parties don’t have to abide by exchange rules (such as rice settlement), the terms for the transaction can be different from that of an exchange, with different settlement volumes and prices, resulting in a bilateral contract.

On traditional financial markets, OTC transactions mainly refer to those involving public though unlisted stocks, penny stocks, and many other asset types – including derivatives  such as options, forwards, and futures. In the digital asset industry, the menu is smaller. 

There are many estimates comparing the OTC market to its spot counterpart – the typical exchange trading venue. In 2018, the TABB group estimated that the OTC market amounted to 2-3 times that of the spot market [1]. More recent studies propose OTC activity ranging from U$S 50-70 bn/month to $US 20bn+ per day. 

Digital assets OTC trading

As introduced above, digital asset OTC trading is limited to fewer markets; spot, futures and options take the largest portion of it. Nonetheless, they present both advantages similar to its traditional finance counterpart, as well as some new benefits.

Advantages of OTC trading

Advantages of digital asset OTC trading include:

• Minimal price slippage. Because the predetermined price is unique and does not depend on both sides of the exchange order book, the price slippage – the difference between expected and actual price – is minimal. Additionally, OTC trades enjoy a limited lock-in price period. 
• Anonymity & confidentiality. OTC desks enable some anonymity and confidentiality features, thereby helping large traders maintain their intentions hidden from the public.
• Higher pair availability. For some lesser-known cryptocurrencies, OTC allows for higher volume transactions than they would find on a public exchange.
• No trading limits. While typical digital asset exchanges limit the amount of daily volume traded -in USD terms-, OTC desks don’t set these limits, and enable big transactions.
• Trader verifiability. Through platform KYC, fraud is virtually eliminated. Traders post their wallets to showcase they are in possession of the necessary funds to take on the transaction. One can also count on live information of recent deals, in order to minimize variability. Finally, there is insurance available.

SCALABLE Exchanges

SCALABLE offers interactions with a number of participants within our liquidity solution, as well as the possibility for clients to integrate them. Besides the typical brokers, instant exchanges, traders, order routers, ML specialists, and market makers, participants include OTC desks. Given this diverse mix of participants, high-quality market microstructure can be set up in the digital asset space, thus ensuring a strong and effective order flow.

Sources

“How Does OTC Crypto Trading Actually Work?” Nasdaq, www.nasdaq.com/articles/how-does-otc-crypto-trading-actually-work-2021-05-17.

References

[1] “Crypto Trading: Platforms Target Institutional Market.” TABB Group, 5 Apr. 2018, research.tabbgroup.com/report/v16-013-crypto-trading-platforms-target-institutional-market/. 

[2] “How Crypto OTC Trading Works: Insights From Top Liquidity Providers.” OKEx, 25 June 2020, www.okex.com/academy/en/how-crypto-otc-trading-works-insights-from-top-liquidity-providers.

While the topic of forks in blockchain experienced its peak of attention in 2017, it is worth reviewing concepts that are likely to resurface once again. As we introduced in our previous blog article, What is Blockchain Forking – An Introduction [1], forks are mechanisms in which an underlying blockchain protocol changes such that it may split the blockchain, which may or may not happen depending on the level of consensus reached among miners.

We covered the main types of forks, as well as what planned and controversial forks are. Here we will tackle the following questions: Why is fork handling important and how do exchanges handle forks?

Economically, it’s important to understand that a fork technically replicates the legacy of its original chain, but it cannot replicate the Network Effect [2][3]. Because the number of users in a forked chain rarely surpasses that of the original chain, the network is smaller, and therefore, less valuable. This is why Bitcoin forks do not match the value of Bitcoin in terms of transactions, market capitalization, etc. 

For this reason, many exchanges and wallets don’t support every forked token. If the fork is supported by a wallet or exchange, one can transfer funds to one of these service providers by handing over the private keys before the “snapshot” is being taken [4]. The “snapshot” is the copy of the exact ledger containing all existing coin transactions and accounts recorded. Its use is to designate new forked coins to those who originally held that specific cryptocurrency. Basically, it serves as an end point for those who had coins up to that moment and are entitled to the same amount from the new forked token. 

Digital asset exchanges and forked tokens

As stated, exchanges are reluctant to add every forked token. This stems from the fact that new coins can have less-secure networks, smaller communities, or can be wiped by original chains. Some of the conditions from top exchanges that need to be met in order to introduce forked coins include [4]:

• Forked blockchains must be usable, stable and secure.
• Strong two-way replay protection must be in place [5].
• The underlying technology behind the forked coin must contribute value.
• There must be a testnet available before launch.
• The size of the forked coin network must reach critical mass.
• Before the hard fork is activated, official client software must be launched and pass open beta test testing and assessment.

The Scalable Solution

Having time to react to forks is essential to mitigate the risks associated with “bad” forked coins. Verifying tokens on testnets to eventually switch the mainnet on is an absolute requirement. Informing users which coins the exchange supports and the information behind each one shows a transparent nature, allowing for a trusting partnership between the exchange provider and user. Unfortunately, nowadays it is not clear which exchange supports which forks, and some exchanges may need up to 5 months to carry out due diligence and list newly forked coins [6]. 

From a technical perspective, it’s important to know that our team can handle any fork swiftly and safely. Even when there is no replay protection, we have a series of processes in place to provide a secure solution. Our white label software can provide an exchange with the resources to make it successful from the get-go. Hence, a big coin menu and choice of forked tokens provides our exchange clients with unparalleled benefits and service options for their users. 

 

 

References

[1] “What is Blockchain Forking – An Introduction.” scalablesolutions.io, Scalable Solutions, 26 July 2021, 

http://scalablesolutions.io/news/what-is-blockchain-forking-an-introduction/ 

[2] “Metcalfe’s Law.” Wikipedia, Wikimedia Foundation, 15 Jan. 2021, en.wikipedia.org/wiki/Metcalfe%27s_law.

[3] Roussou, I., Dritsaki, C., & Stiakakis, E. (2019). The Bitcoin’s Network Effects Paradox—A Time Series Analysis. Theoretical Economics Letters, 9(6), 1981-2001. 

[4] “How Do Exchanges Handle Forked Coins?” CryptoCompare, 1 Mar. 2018, www.cryptocompare.com/coins/guides/how-do-exchanges-handle-forked-coins/ 

[5] Replay protection eliminates the possibility of any duplicate transactions arising on both blockchains. After the fork occurs, the new altered chain no longer accepts transactions from the original chain, and vice-versa.

[6] “Hard Fork Policy 2019.” Data.cryptocompare.com, CryptoCompare, 31 July 2019, data.cryptocompare.com/reports/hard-fork-policy-2019. 

Far from being definitive and achieving universal acceptance, blockchain networks have certain aspects that warrant improvement. For example, blockchain protocol governance (block size, miners’ rewards, etc.) need constant improvement that can help evolve alongside users’ needs. A regular response to these problems entails creating new tokens while keeping the basic protocol, or making entirely new ones. However, occasionally the choice includes updating the current software version.

Developers usually design these improvements and implement them via updates to each blockchain’s network. Blockchain code is open source, which acts as a leverage. The main reason behind these improvements is to add new functionalities and fix security issues. In the eventuality of fraudulent and malicious actors, it can also void and reverse transactions.

However, and as with most things in life, they come at a ‘cost’. Sometimes,  not all actors in the network accept the new updates. Since decentralization characterizes blockchain networks (an attribute gained by the consensus generated by the parts involved), this results in blockchain ‘forks.’ 

Soft, hard, and temporary forks 

Blockchain forks are similar to tree branches or bifurcations. Once an original chain requires amendments and/or improvements, the newly accepted update must branch out to create a new fork, stemming from a common body.

The classification of forks mainly falls within two categories, depending on the effect the update has over the previous blockchain and the consensus mechanisms that govern it.

• Soft forks are what are known as ‘backward-compatible.’ Basically, they work with older versions. Bitcoin’s SegWit is the classic go-to example to demonstrate how a new class (Bech32) node could still receive and verify non-SegWit transactions.
• Hard forks, on the other hand, require all nodes in the network to upgrade to the new version, or stop being accepted as valid in the new network. Hard forks are a permanent divergence from the previous version. In the case of partial adoption of the new version, they can derive in multiple versions running on the same software.

Planned vs controversial forks in blockchain

In planned bifurcation, participants voluntarily update the new rules, and those who don’t, stay in the old chain with fewer participants. Conversely, controversial bifurcation implies a disagreement within the community regarding the update, so the protocol divides itself into two distinct chains and cryptocurrencies. Both chains will have their own community and will evolve separately. 

The bifurcation is based on an original protocol, so corresponding transactions are stored in each chain, and newly created cryptocurrencies are equally assigned to the original protocol. 

A list of cryptocurrency forks on Bitcoin, Ethereum and LiteCoin can be found at ‘Forks’ [1], specifying name, symbol, original blockchain, fork date and block, coin distribution and status (currently forked, unforked or cancelled).

Some of the most notable examples include the first Bitcoin [2] fork that created Litecoin in October 2011, and the August 2017 fork to form Bitcoin Cash. Shortly after, the SegWit (soft fork) functionality became active. Within the Ethereum realm, a 2016 hack almost compromised the entire network and forced a subsequent hard fork [3][4].

 

Forking blockchains

It seems forks will continue to exist for the foreseeable future, given the constant need for updating blockchains and their functionalities. If you’re looking to start new coins or tokens, especially by forking already existing ones, Scalable Labs can help. Scalable Labs is a development engineering house that is blockchain agnostic and has dealt with over 70+ different blockchains. We specialize in custom blockchain projects – get in touch with us here to bring your project to life. 

 

 

 

References:

[1] Forks.net. “Cryptocurrency Forks.” Cryptocurrency News, forks.net/list/

[2] “The Ultimate List of Bitcoin and Alt-Cryptocurrency Forks.” UNHASHED, unhashed.com/bitcoin-cryptocurrency-forks-list/. 

[3] “How a $64M Hack Changed the Fate of Ethereum, Bitcoin’s Closest Competitor | CBC News.” CBCnews, CBC/Radio Canada, 28 Aug. 2016, www.cbc.ca/news/technology/ethereum-hack-blockchain-fork-bitcoin-1.3719009;

[4] Kuhn, Daniel. “Did Ethereum Learn Anything From the $55M DAO Attack?” CoinDesk, CoinDesk, 30 Sept. 2020, www.coindesk.com/ethereum-learn-dao-attack. 

Sources:

Maddrey, Nate. “Blockchain Forks Explained.” Medium, DigitalAssetResearch, 18 Sept. 2018, medium.com/digitalassetresearch/blockchain-forks-explained-8ccf304b97c8. 

As a professional white-label exchange provider, we aim to expand upon every characteristic of cryptocurrency exchanges; main types of exchanges, their strengths and weaknesses. We initially embarked on a more technical approach on exchanges, diving into specific attributes such as custody, security, latency and fees [1]. We also looked into their functionalities – lending/borrowing, liquidity providing, derivatives offerings, and more [2]. 

After reviewing some feedback and carefully analyzing the available knowledge on digital asset exchanges, we feel it is time to re-discover exchanges with a more holistic mindset. We want to display a solid overview both for those just entering the digital asset space, as well as for those that want to enhance their understanding of cryptocurrency exchanges. It is therefore imperative to first introduce what exchanges are. 

Defining exchanges

At its core, an exchange  (noun) is the act of giving one thing and receiving another in return. In today’s evolved world we can think of a classic and daily example for this: buying a good (thing one) with money (thing two). Historically, and before the existence of money, those cases involved barter transactions [3], where two goods were transacted with no -cash- intermediary. Nowadays, exchanges are the digital or physical places where things are traded. Simplistically, they are marketplaces that enable the transfer of goods.

We interact with a number of exchanges throughout our daily lives. From Amazon and eBay to the London Stock Exchange, to buying electronic goods and selling stocks. 

What do exchanges look like in the blockchain space? 

Cryptocurrencies were born from an ethos of decentralization, and as such, weren’t initially accepted by institutions that live within the traditional financial centralized ecosystem. If a user that holds a checking account researches the financial product available by the bank, they will not see cryptocurrencies as possible offerings. Therefore, new venues such as cryptocurrency exchanges were created to access this new digital asset class. 

Overview of exchange types: CEXs and DEXs

Within the financial industry -more specifically the digital asset space-, exchanges can be categorized into centralized and decentralized exchanges. Brokers, cryptocurrency funds and traditional centralized cryptocurrency exchanges (CEXs) form part of the first category. Alternatively, decentralized exchanges (DEXs) form part of the second one. Both provide a trading venue that allows for buying and selling of digital assets, while taking commission from the service. However, the conceptual role that each represents could not be further apart from each other. 

Centralized exchanges are run by organizations that oversee their day-to-day operations such as (technical) maintenance, security, and growth. They provide the infrastructure and take full custody of users’ funds. Conversely, decentralized exchanges provide the infrastructure but allow for peer-to-peer transactions, which means that funds never touch the third-party (exchange) wallet.

How are tokens transacted within cryptocurrency exchanges?

The way transactions are carried out vary depending on the type of exchange used. 

CEXs take hold of users’ funds in a similar manner as banks. While the funds belong to a user, they don’t have possession, but access to them. Therefore, transactions in CEXs are settled internally through centralized order books, while balances are UI settled and displayed to users. It is only after a user withdraws the funds from the exchange that they regain possession of them.

Alternatively, DEXs are a series of linked smart contracts that enable users to trade digital assets without having to grant the custody and security of their funds to a third party. Smart contracts act as the ungoverned intermediaries that match orders to liquidity pools instead of trading against other people [4]. For a wider overview of the differences between CEX’s and DEX’s, you can read our article here. 

Scalable Digital Asset Exchanges

Scalable Solutions is a power-hub based in Switzerland that offers white-label exchange technology solutions. Besides centralized exchange software, Scalable is developing a decentralized exchange for the users that require these specific venues. As we continue to explore the main aspects of exchanges, it will become clear that we have an unmatched product equipped with the most sophisticated tools in the industry. 

We have a track record of proven excellence through SLAs and trillions of dollars processed through flagship split-of-a-second transactions. 

Schedule a demo with us to access leading digital asset exchange infrastructure.

 

 

 

 

References

[1] “Exchanges: Centralized v Decentralized .” Resources, Scalable Solutions, 26 Oct. 2020, http://scalablesolutions.io/news/centralized-vs-decentralized-exchanges/. 

[2] “Digital Asset Exchange: Main Functionalities .” Resources, Scalable Solutions, 7 Dec. 2020, scalablesolutions.io/news/digital-asset-exchange-main-functionalities/. 

[3] “A barter transaction involves two parties and is one where one basket of goods and services is exchanged for another basket of different goods and services without any accompanying monetary payment.” OECD. Glossary of statistical terms. https://stats.oecd.org/glossary/detail.asp?ID=181 

[4] “Smart Contracts and Their Characteristics.” Resources, Scalable Solutions, 7 Apr. 2021, scalablesolutions.io/news/smart-contracts-and-their-characteristics/.