Futures Contracts and the Future of Exchanges: How New Technology Creates New Opportunities
By: Kirill Shilov
Tags: Blockchain, Bitcoin, Software Development, Artificial Intelligence, Cryptocurrency

Early cryptocurrency exchanges sought ways to emulate the traditional exchanges, perhaps as a means to bring familiarity to a budding and mysterious asset class. However, this has often stifled innovation despite the virtually unlimited potential offered by the cryptocurrencies’ underlying technology. More recently what is emerging is a new generation of exchanges offering tools to transact new world assets.

Developments like CME and CBOE, that list futures contracts on Bitcoin, and traditional asset managers working to bring Bitcoin ETFs to investors (most recently Van Eck) don’t show any signs of slowing down, but they are still trying to shape the future of digital assets through a decades-old lens. This is all about to change.

Centralized Versus Decentralized

Prior to the past decade, all exchanges were mostly centralized and largely operated out of one physical location. Today, trading floors are waning, replaced by technology that prioritizes speed and streamlines the user experience. Examples include the Shanghai Futures Exchange, CME Group, and the New York Stock Exchange. These venues have centralized servers and route all orders through one point of entry to the central limit order book.

Coinbase, Binance, and Kraken have adopted a similar model when looking to create an exchange for cryptocurrencies, likely because they wanted people to feel comfortable trading these assets. These centralized exchanges (CEX), now all electronic with servers located in a central location, allow for global trading provided that one passes the registration process and KYC/AML checks.

When considering trading on a CEX, it is important to remember that your coins are held (custodied) by the exchange; your private keys are not in your possession because all transactions are recorded on the central order book located on their servers. If the exchange is hacked (like what happened with Coincheck), shutdown by a government entity, or if it just goes offline, you could potentially lose all your coins. The only time the blockchain is involved is when you withdraw these coins from the exchange and resume physical ownership.

Given these pain points, many traders are beginning to look towards decentralized exchanges (DEX) including IDEX and CryptoBridge. DEXs are available to anyone connected to the Internet and, since they use a public distributed ledger to record all transactions and maintain custody, you retain control of all your private keys.

By having no single point of entry, DEXs are far more secure and less prone to smash and grab hacks that steal hundreds of millions of dollars worth of crypto assets. Your funds cannot be seized by regulators and they will not be lost even if the servers go offline. Security is dependent on your wallets and where you store your private keys.

This all sounds great, right? Well, there’s a catch. The main attraction to trading on a DEX is also it’s biggest drawback: all transactions are recorded on the blockchain. Because of this, the same fees paid (ETH GAS) for any other ETH transactions also need to be paid on the exchange — for every single trade.

Costs vary, but they can add up if you make several trades per day, and some traders end up chipping their profits away. Here is one way this could play out: 10 trades earn you 0.01 ETH, but you spent .009 ETH for ETH GAS on each one. Instead of earning .10 ETH as you would on a CEX, you’ve spent 90% of your profits on ETH GAS and are left with only .01 ETH. Far less than optimal, and this does not even account for rising GAS costs in the event public blockchains begin to hit Transaction Per Second (TPS) limits.

Hybrid Exchanges: The Best of Both Worlds

Gripes about this model have led to the creation of Hybrid Exchanges (HEX) such as EverMarkets (EMX) and Eidoo.

EMX is a global futures exchange that will offer futures contracts on both digital and real world assets, ranging from commodities to crypto indexes, with plans to eventually include fixed income and other derivatives products. Upon initiating a trade on EMX, the exchange plans to hold funds in escrow wallets controlled by the smart contracts stored on the blockchain. Under this mechanism, funds would then be delivered to the recipient based on the price of futures contracts at time of exiting a trade on the exchange. Ultimately, these smart contracts would also prevent unauthorized access to funds and should make it harder for hackers to steal them.

Also, since EMX employs batch auctions instead of a central limit order book, they can provide fair access to virtually anyone around the world. This is because in the EMX model, no matter how big or how fast one is, everyone pays the same price. This eliminates speed advantages high frequency traders normally enjoy and lets institutions and retail traders compete at the same level.

Eidoo has a similar structure that focuses on trading cryptocurrencies instead of futures contracts. The exchange holds funds in smart contracts on the Ethereum blockchain that prevents access to them until the trades are settled. In order to alleviate blockchain flooding, Eidoo plans to use an off-chain order book and server to create a familiar front-end experience similar to a centralized order book while recording trades in batch transactions. Trades are only written to the blockchain when they are matched and executed.

Both of these venues are able to use code and smart contracts to replace a number of functions currently carried out by intermediaries (disintermediation). This leads to significantly cheaper and faster transactions with nearly real-time settlements.

The Path Forward

The advent of futures contracts completely changed traditional markets, and this transformation is now starting to be felt in the crypto markets as well. Being able to trade both cryptocurrencies and crypto futures on the blockchain is creating more trading and risk management opportunities with each passing day. .

The one major obstacle to rapid adoption, though, is the organization of a clearing house; the single most important part of any orderly futures market. Smart contracts can potentially handle a lot of the functions of a clearing house, and may eventually replace them. EMX and others are investigating bringing aspects of a clearing house onto the blockchain, but it’ll take more engineering and legal work to bring all the aspects of a traditional clearing house to the cryptocurrency space.

The real innovation, for now, is that a decentralized or hybrid exchange has a global footprint and can offer access to assets previously restricted to specific markets or regions. Looking to trade West Texas Intermediate (WTI) futures from Asia and Hang Seng Index futures from Europe, from one app with all the efficiency benefits of cross-margining? There’s a HEX for that. The engineering, regulatory and legal work enabling these innovations has the potential to be truly revolutionary.

Conclusion

Financial exchanges have played and will continue to play a vital role in the global economy, and as technological walls continue to crumble and regulations are updated in-response, trading venues will need to keep innovating to stay ahead of the curve. All global traders stand to benefit from the access, efficiency, and fairness that these next-generation exchanges have the opportunity to provide. For now, CEXs and DEXs will fight to keep their market position; but HEXs appear best positioned to provide fair, universal market access with lower costs and faster settlement times.

About the author:

Kirill Shilov — Founder of Geekforge.io and Howtotoken.com. Interviewing the top 10,000 worldwide experts who reveal the biggest issues on the way to technological singularity. Join my #10kqachallenge: GeekForge Formula.