- A competitive analysis of blockchain cryptocurrency exchanges: Part 1.
It’s no secret that this past year has seen an explosion of cryptocurrency activity as blockchain technology has been hailed as the way of the future. Most of the conversation around blockchain is related to more technical topics such as latency issues, security, and scalability. Given blockchain’s wide application across industries, I see a real value in starting conversations about the ways in which blockchain will impact fundamental business models. I do my best to take a technical topic and adapt it to the average business reader. As with any rapidly evolving space, these conversations will constantly update and adapt to the current market and I welcome additional thoughts on these topics.
As a business school student, I would be remiss if any conversation did not begin with a good ol’ industry analysis. Blockchain is a tool, not an industry in and of itself. As such, I will focus on one application of this technology — cryptocurrency exchanges. I chose this application because cryptocurrency exchanges offer a robust set of companies to analyze, as well as a clear and obvious market solution. Additionally, I believe some of the fundamental market forces that will impact this industry are applicable widely to companies built using blockchain technology. I will first discuss what a cryptocurrency exchange is and then look at the industry concentration. In future posts, I will examine barriers to entry, substitutes, and buyer/supplier power. Using this analysis as a foundation, I will also discuss competitive decisions firms must make and ways in which firms can position themselves to prosper.
Please note: This post is written assuming some understanding of blockchain technology. If you’re new to the space, check out this out this deck a classmate and I made that gives a comprehensive overview of blockchain technology and if you already know about blockchain, but want to learn about cryptoassets, Linda Xie, has great “beginner’s guides” on Medium.
The market for cryptocurrency exchanges is highly concentrated with a strong first mover advantage. High consumer preference for security and reputation has sustained the outsized power and market position for first movers but this differentiation may not be defensible for the sustainable future as new technology is developed that provides heightened security measures. Additionally, new companies may enter the market and steal niche customer segments whose differentiated needs can be more directly addressed. Given this, we would expect the large, powerful players to heavily invest in way to sustain their learning curve advantage and capitalize on the network effects that produce a liquid market.
What are exchanges, and do we need then?
Blockchains are decentralized ledgers that rely on separate “nodes” or computers to maintain a copy of the ledger and validate new entries on the ledger. The “reward” or “payment” for supplying this computational resource is called a “cryptocurrency”. In the case of Bitcoin, it’s called Bitcoin (clever, I know) and in the case of Ethereum, it is called Ether. Owners of these cryptocurrencies or digital assets can transfer the ownership to any other person or entity (technically to their public key, but I’ll spare you the technical details). To do this, you’d have to write computer code in the underlying blockchain’s coding language that tells the blockchain to execute a given transaction. This of course requires some sophistication and computer programming knowledge. Additionally, this assumes you know who you actually want to transact with. In the case of wanting to buy/sell a cryptocurrency but not knowing a willing buyer/selling, exchanges can act as a market maker — pairing buyers and sellers and taking a fee in exchange for this service. Lastly, cryptocurrency exchanges provide efficient dissemination of price information. In an efficient market, you would expect to see the same price posted in all exchanges or else there would be opportunity for arbitrage. (However, it should be noted that we have seen deviations in price between exchanges. This is discussed more below).
In summary, exchanges offer 2 products:
1) They credit liquidity by creating a marketplace for buyers and sellers to find each other
2) They allow users to easily record their transactions on the blockchain ledger
Exchanges themselves can be set up in several ways, but the three most common types of exchanges are outlined below.  It is important to note that every exchange has their own specific way to calculate price, connect buyers and sellers and collect a fee.
Exchanges make money by charging fees to transact in the case of trading platforms and direct trading or a spread in the case of brokers. For example, Coinbase, perhaps the best-known brokerage exchange, charges a “spread of between 25 to 100 basis points determined by the size of your transaction, market volatility and length of time using Coinbase” on top of the market exchange rate. Additionally, Coinbase charges users to convert their cryptocurrency to fiat currency. Conversion fees, which vary based on your location, payment method, and other circumstances, can range from 1.49% to 3.99% in the U.S. Additionally, Bitcoin and Ethereum transactions require a fee to incentivize miners to verify your transaction (this fee is in addition to the Bitcoin/Ether reward the winning miner receives). There are numerous transactions that need to be verified and a “miner fee” provides financial incentive for your transaction to be included in the next block (i.e. added to the ledger).
Competition, substitutes and compliments:
There are hundreds of cryptocurrency exchanges; however, they do not all exchange the same currencies, both crypto and fiat.  Trading Bitcoin (BTC)/USD is not the same as a trading Ethereum (ETH)/EUR. While is it possible to switch between exchange pairs to end up at BTC/USD, transaction costs and other frictions such as trade execution delays make this difficult and unlikely. For simplicity, I will look at BTC/USD as the conclusions can be extended to any other exchange pair. In this market, the degree of concentration is high as there are over 40+ exchanges, however, the top 3 firms account for over half of the trading volume. 
In a concentrated market, horizontal differentiation can stop a product from becoming a commodity. Firms differentiate based on idiosyncratic preferences, in order words tastes that differ from one person to the next. Exchanges have differentiated themselves based on:
- Level of security
- Currencies traded
- Financial products
- Method of market making (i.e. matching buyers/sellers, order book, auction, etc.)
- Speed of execution
- Level of regulatory compliance
- User experience
- Centralized vs. decentralized Exchanges
The degree of horizontal differentiation in a concentrated market depends on the magnitude of consumer search costs or how easy or hard it is for consumers to learn about alternatives.  Given the digital nature of this industry, search costs can be categorized as low, thus implying firms will need to have high degrees of differentiation to capture market share.
Even though companies currently have some differentiation, what matters most in sustaining a competitive advantage is how defensible these differentiators are. Mt.Gox had an early mover advantage, and monopolistic position as the only exchange until a security breach led to its demise. Learning from this, Bitfinex in dealing with its own hack in 2016, worked to compensate customers through a BTX token exchange in in which investors were given a 36% haircut to compensate for a hack that drained 120,000 BTC from the exchange’s reserves. Conversely, exchanges like Coinbase, have excelled due to their commitment to security and adherence to regulations. Security breaches have also created pressure for the creation of decentralized exchanges which offer heightened security because there isn’t a single point of failure. 0x is perhaps the best-known company developing this solution.
Given recent high-profile hacks like the $533 million hack of Coincheck or the $30 hack of Tether, we would expect a convergence in increased security measures by exchanges and more value flowing to companies with reputations for being secure. The increased value placed on security has strengthen the importance of reputation and strengthen the position of incumbent firms. This early-mover advantage has created several isolating mechanisms or economic forces that limit the extent to which a competitive advantage can be duplicated or neutralized through the resource-creation activities of other firm for the largest exchanges. In addition to these exchanges benefiting from reputation and being further along on the learning curve, they also benefit from network effects that lead to increased liquidity.
The extent that these attributes can be copied will determine if the marketplace is driven towards perfect competition where firms become price takers and market concentration increases until economic profits are zero (i.e. price will equal marginal cost). With time, these advantages are susceptible to deterioration as other exchanges persist and new technology (such as technology that allows traders to trader across exchanges) is developed. Perfect competition is unlikely as liquidity is defensible and replicating superior technology is difficult. Additionally, can create artificial differentiators, such as reward points for using certain exchanges or lower fees for valued customers, as airlines have long used to retain loyal “frequent fliers.”
Product differentiation enables sellers to set prices above marginal costs. However, seeing this, new companies will enter and steal market share from incumbents, driving down incumbents’ profits, even if price remains unchanged. If entry intensifies price competition, profits would fall even faster.  As long as consumers place a high value on variety, then entry into this monopolistically competitive markets will not be excessive. At the simplest level, customers can be segment between institutional traders and retail traders, creating the need for products that address the distinct needs of these two large customer segments. Institutional traders likely value liquidity and speed of execution more so than retail who may place a higher value on user experience. We see this differentiation with Coinbase which operates GDAX for institutional traders and Coinbase for retail traders. Similar differentiation exists in the market for fiat currency exchanges, with products such as Bloomberg terminals developed for institutional clients and e-trade for retail.
 Besanko, Dranove, Shanley, and Schaefer, Economics of Strategy (Wiley), 6th edition
- Date of publication:
- Wed, 02/14/2018 - 15:19
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