Bitcoin exchanges may not be ready for the big time

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Someday soon, crypto-enthusiasts think big financial firms will buy and sell bitcoin like any other asset: stocks, bonds, gold, whatever. But trading on this scale involves volumes and scrutiny that the most popular cryptoasset exchanges today may not be prepared to handle. Although they got in on the action early, these exchanges face costly technology upgrades or ugly meltdowns as activity increases and major exchange operators muscle in on the market.

The homegrown technology used by many cryptocurrency exchanges is coming under strain, and not for the first time. The major platform in bitcoin’s early days, Mt. Gox, was originally designed for trading ”Magic: The Gathering” cards. It led the way until hackers stole from its customers, helping drive the exchange into bankruptcy.

Now, some bitcoin platforms are reaching their limits amid the cryptocurrency euphoria, according to an industry expert who has examined the venues. While declining to single out a particular exchange, the person said the venues generally haven’t been stress tested. Although systems upgrades are underway, best practices in the field are far from standardized.

Institutional investors would “welcome overall a more sophisticated exchange presence,” Bank of America Merrill Lynch analysts wrote last month. Although there are many trading platforms, “by and large these do not offer the same quality of technology as the large global exchange groups.”

Conversations between cryptoasset platforms and sellers of matching engines designed for the exchange industry have taken place, but a technology executive says that bitcoin startups couldn’t stomach the price tags. The systems can cost anywhere from $500,000 to $10 million a year, depending on the size of an exchange. Top-tier systems are equipped with things like surveillance detection for market manipulation and specialized order types. Battle-tested exchange systems like these are for sale from companies like Nasdaq and a unit of London Stock Exchange Group.

CME Group and Cboe Holdings—the big Chicago exchange operators planning to launch bitcoin futures—developed their own trading platforms over their long histories. And while established exchanges are not immune to technology meltdowns, they’re familiar to regulators and have been tested in market panics. They’ve spent time tuning circuit breakers and tweaking collateral requirements to manage big price swings, based on experience.

“It’s not the size of trades that causes problems for an exchange—it’s usually the volume,” said Mark Hemsley, president of Cboe Europe.

Size of the prize

While still relatively small, bitcoin trading volumes are growing quickly. Bitcoin averages about $1 billion to $5 billion in trading across all exchanges each day, according to Cboe’s stock markets trade about $60 billion on a typical day. More than $6 trillion in interest-rate futures change hands each day.

The big Chicago exchanges have already had a major impact on cryptoassets, even as they await regulatory approval to launch bitcoin-linked derivatives. Bitcoin’s price rose above $7,000 for the first time when CME Group said it will launch bitcoin futures by the end of the year. Cboe is also planning to offer bitcoin futures, which allow traders to bet on the price of the asset at a variety of dates in the future.

Adam White, head of GDAX, the Coinbase platform designed for professional traders, says derivatives will be good for the entire industry, with regulated cryptoasset exchanges like GDAX and Gemini the main beneficiaries from increasing spot bitcoin volumes.

For exchanges, trading cryptoassets presents some unique challenges. Unlike with stocks or derivatives, bitcoin transactions can’t be reversed by the exchange. And several major incidents at bitcoin venues have had nothing to do with stability amid heavy volumes. In the case of South Korea-based Bithumb, hackers used stolen personal information to break into customer accounts, according to the BBC. Hackers also stole about $69 million from Hong Kong’s Bitfinex, which as of last month will no longer allow US customers to use the platform.

The key players

In the US, Coinbase says it has more than 12 million users and by several measures is the country’s biggest cryptoasset exchange. It’s backed by major venture capitalists like Andreessen Horowitz as well as the New York Stock Exchange. Even so, the platform has suffered growing pains. This year, it has received hundreds of customer complaints, according to the Consumer Financial Protection Bureau’s database. US financial watchdogs are also reportedly probing the exchange after a short-lived flash crash following a large trade order caused its systems to buckle. (A type of glitch, to be fair, that has hit traditional exchanges as well.)

White of GDAX says companies like Coinbase, which has more than 200 employees, are making crypto-trading more professional. Its technology was built in-house, though it looks to NYSE for best practices. Customer accounts have been attacked, but White says the company’s custody holdings have never been breached.

Gemini, the digital asset exchange started by the Winklevoss twins, suffered outages lasting more than 10 hours in August, according to the company’s blog. It could become a major cog in the derivatives market because its prices will be used in the Cboe’s futures contract. (The CME futures contract features an index based on prices from several exchanges, including Coinbase.)

“This is not the first scaling challenge we’ve encountered, and it won’t be the last,” Gemini said on its blog. ”We’re continuing to improve our performance and infrastructure monitoring so we can anticipate potential problems more quickly in the future.”

For now, much of the existing institutional trading—such as wealthy bitcoin investors and corporations—takes place away from the exchanges via over-the-counter (OTC) transactions, according to Bobby Cho, head of OTC trading at Cumberland, a unit of proprietary trading firm DRW. He says having new exchanges that grew up specifically for bitcoin and other digital assets isn’t necessarily a bad thing, and that he sees signs the platforms are upgrading to deal with surging volumes.

Even as the bitcoin startups evolve, it’s possible the professionals will mainly stick to OTC and derivatives markets. If CME and Cboe’s futures gain approval, it will be easy for major institutions to buy and sell bitcoin derivatives because trading will take place in markets they already use heavily. And those futures contracts will be settled in cash, meaning investors are paid in dollars instead of bitcoin when contracts settle, which removes another hurdle for heavily regulated companies to get involved in cryptoassets.

“This could be a market where the futures market is bigger than the underlying market,” Cboe’s Hemsley said.