How do exchanges make money?

[Steve Sokolowski]

There have been several shakeups in the exchange industry lately. Allcoin, which stole customers' money from us in August, is finally getting attention in the community for its deceptive practices. Cryptsy recently raised its withdrawal fees significantly. Poloniex continues to aggressively expand into margin trading in its core markets. Despite these changes, however, it's still not clear how any altcoin exchange can turn a profit.

Let's examine Cryptsy's finances before these recent changes, because they are common in the industry. Before raising its fees, Cryptsy charged around 0.25% per trade, although frequent customers paid less. The small margins require incredible volume to turn even the tiniest profit. For example, the "LTC/BTC" market on Cryptsy has a daily volume of around 115 bitcoins. At 0.25%, Cryptsy earned just $67 per day on its most profitable market. After Dash and Ethereum, the volume of the markets drops off precipitously, such that it's difficult to figure out how Cryptsy earned more than $300/day in trade fees.

Cryptsy does earn money in withdrawal fees, and charges even more for withdrawals now. The withdrawal fees can be substantial: at 0.001 per withdrawal (a figure far inflated over the actual cost of using the bitcoin network), even on our withdrawals of 2 bitcoins per day Cryptsy made twice as much money on our withdrawals as they did on our trades. If the average person waits until they accumulate 2 bitcoins to withdrawal, that means that Cryptsy earns $900/day in trade and withdrawal fees. The figures would be higher if customers took frequent or smaller withdrawals, but those gains are likely offset by the withdrawals in other currencies, for which Cryptsy charges far less.

What can $900 pay for? A customer service representative can be hired for $12.50/hr, or about $100 per day in pay, plus an additional $50 in taxes, insurance, building maintenence, computers, desks, phones, and so on. The average computer programmer according to Google makes $76,140, or about $300.00/day, plus the same 50% in overhead. Therefore, $600 of the $900 in revenue is paid to support just one customer service representative and one developer. The other $300 needs to be split between all the servers, bandwidth, and power - and CEO Paul Vernon's profit, at the very least. Legal fees and compliance costs are not even considered.

It's difficult to argue that an exchange can be run with just two employees, but even if it were possible, it is diffficult to justify running an exchange to earn just $300 per day. Owners of exchanges don't work 9-to-5 jobs; if they are like us, they work at least 70 hours per week. Unlike us, however, they have a significant risk in that they could misunderstand money transmitting regulations or forget to file some paperwork, and their entire year's profits are lost to fines. Given that they hold so much money, they also have a huge risk of theft or bugs that could wipe out the majority of their profits. The probability of these negative events needs to be considered in the expected value of their earnings.

The evidence suggests that exchanges are barely profitable, face significant risks, and will have difficulty holding on in a period of price stagnation when volume is low. I suspect that we will see at least one or two of the big exchanges shutting down or selling out soon. If you had the choice between running an exchange, or obtaining a standard 9-to-5 job at a traditional software firm, and both pay the same, which choice would you make? Would you work 30 extra hours per week for free, with the risk of going bankrupt or getting fined for noncompliance at any time? Or, would you let someone else deal with all that and spend your free time and financial security on new adventures and hobbies? As you can see, the bar for continuing in the exchange business is very high, which is why we can expect to be surprised that even exchanges that make moderate profits will fold in the coming months.

[coinaday]

Excellent analysis.

Also note that Cryptsy has added a 0.5% withdraw fee for NYAN and many other coins. For me, this is a major red flag but not enough to entirely discontinue immediately. I'm certainly still rooting for them to do well. If their volume expands significantly, then all (or most, or the ones I care about) of their coins could also all gain significantly. On the other hand, this article was recently pointed out to me: http://coinfire.io/2015/10/04/federal-i ... -underway/

Any thoughts on Cryptopia? We (NYAN) are looking at getting listed on there through their voting process. I don't really know anything about them, but they seem fine so far.

Any exchanges in particular that you think are secure and stable?

I'm thinking more and more about trying to build adoption of CATE: I think atomic cross-chain transactions should help to make the work an "exchange" needs to do far simpler: a large network of exchanges could co-operate on listing services and be able to match transactions securely and easily for a wide range of pairs, and with an especially interesting setup, wouldn't even need to hold customer coins (the customer could be sent a transaction to sign and broadcast or return within a certain period of time, which could be done automatically or manually by the customer of course).

I'm sure some customers and exchanges will continue with significant customer deposits, but given the history of cryptocurrency exchanges to date, the idea of being able to trade without having to trust an exchange seems very appealing.

[Steve Sokolowski]

Hey coinaday,

Great to see you here! Welcome to everyone from Nyancoins!

Chris investigated Cryptopia several months ago and ruled them out because they did not have a private API. Now that you pointed them out again, though, he went back and discovered that they had implemented the API since he last looked.

We're going to spend Saturday working on Cryptopia to get it added to the system. Thanks for this great tip. You've just made everyone a lot more money as profitability will increase due to the ability to send coins to additional exchanges.

Thanks,

-Steve