It’s not a good time to run a centralized crypto exchange.
Less than a year has transpired since the FTX collapse and much of the crypto landscape is a smoking ruin. Financial institutions are still working on enterprise blockchain solutions to recreate crazy crypto’s efficiencies in their own operations, but that’s not “crypto”. The fraudulent or just dumb business models in the centralized-crypto world may yet snare more exchanges. Decentralization champions are puffing their chests, feeling like their moment has arrived.
Stephan Lutz, CEO of BitMEX, a centralized crypto exchange specializing in derivatives for professional investors, says there’s a reason why his venue is still standing.
“The downturn will extinguish those players without a real-world use case,” he told DigFin.
On first blush this is a strange thing for a BitMEX executive to say, given the exchange’s colorful history in the annals of crypto, where real-world cares went to die.
The exchange was set up in 2014. It wanted the most aggressive traders of the world’s most volatile asset class, and it got them by advertizing 100x leverage. Two years later it pioneered the perpetual swap, so that traders never had to close a position. It further attracted activity by offering higher ‘maker’ rebates to traders bringing liquidity to the exchange.
BitMEX was instrumental in making crypto “the wild west”. Its founders, Arthur Hayes, Ben Delo and Samuel Reed, became billionaires. They operated from Hong Kong but the holding company, 100x Group, was domiciled in the Seychelles – a place, Hayes joked, where favors could be bought for “a coconut”.
But times got tough. Other centralized exchanges (CEXs), notably Binance, emerged in spot markets and used that dominance to bully their way into derivatives and other business lines. They used their flow to offer more attractive maker/taker fees.
Rise and fall
Most egregiously, crypto exchanges set up proprietary trading desks that, in FTX’s case, was illegally trading customer assets as its own. BitMEX had its own prop desk, Arrakis, which took advantage of its then-dominance of bitcoin futures to trade on its own account. Arrakis attracted unwelcome attention (economist Nouriel Roubini attacked it via Twitter), and was phased out in 2020; its remnants live on as an internal treasury desk.
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That wasn’t the only attention-grabbing faux pas. BitMEX’s three founders found themselves in hot water. Their footloose ways, including ignoring traditional know-your-customer protocols and “jokes” denigrating various regulators triggered the Commodities and Futures Trading Commission to sue them for violating the US Bank Secrecy Act.
The trio of founders eventually pled guilty to willfully failing to install money-laundering controls, in February 2022. They paid fines and served probationary sentences at home.
That wasn’t the end of it. In January 2021, with the founders embroiled in their legal problems, BitMEX hired Alexander Hoeptner as CEO. He came from Germany where he had run a new digital exchange in Stuttgart.
Under his star-crossed term, BitMEX decided to revive its fortunes by broadening its remit and taking on its usurpers. It was going to go into spot markets, mass retail, custody, and vending data.
Lutz, a fellow German, joined a few months later as CFO, with the mandate to build out the exchange’s finance and compliance teams to support this expansion. He also oversaw an improvement in the exchange’s market surveillance toolkit.
The strategy didn’t work. Lutz said: “The events of 2022 [eg, the FTX collapse] made it clear to us that we didn’t want to do this. We saw the other exchanges were far ahead of us. So we reverted to serving professional crypto derivatives traders.”
Back to basics
The exchange slashed headcount. It had about 150 employees at the start of 2021. It was up to 400 people by late 2022. Today it has about 170 employees.
One of those who left was Hoeptner. He stepped down in October 2022 (before FTX imploded). Coindesk reported in December that the departure was acrimonious, with Hoeptner suing the company over allegations of wrongful termination. The case is still winding its way through Singapore’s courts.
Lutz is now running a stripped-down exchange with a renewed focus on its original user base. But BitMEX is also a place that has gone back to its innovative roots. If it began as crypto’s wild child, BitMEX is maturing as a place trying to make trading as efficient as possible. And that has implications for traditional finance, not just for crypto traders.
Let us return to Lutz’s contention that centralized crypto exchanges will only flourish if they deliver real-world utility.
What’s the real world?
He sees only three such uses that are possible today, and a fourth he hopes comes about.
First, a digital asset that can serve as a unit of account and, ideally, a store of value. This might be Bitcoin. It could be a stablecoin, although crypto diehards disdain the idea of building around the US dollar. (Arthur Hayes is now promoting the idea of a stablecoin backed by Bitcoin and bitcoin futures.) Lutz acknowledges Bitcoin can’t be a currency or a payment system, but it could set prices for Web3 businesses.
Second, Ethereum and maybe its imitators acting as a coordinator of distributed computing power (Vitalik Buterin’s “virtual Ethereum machine”) and an executor of smart contracts.
Third, blockchain for identity proofs in the Web3 economy.
Add these up and you could create financial infrastructure suited for cross-border transactions. In developing countries lacking a proper legal and financial system, these uses could also fill the gaps at home.
Looking ahead, Lutz says the key use case that is missing but needs to develop is governance. The model is the DAO, the decentralized autonomous organization, which Lutz describes as governance coordination for cross-border activity. But DAOs have yet to scale beyond simple or frivolous projects.
What DLT can do
Within this vision for crypto’s relevance, centralized exchanges will continue to provide a necessary service, helping users who aren’t sophisticated enough to self-custody and rely purely on decentralized venues. Most users still need an entity that can help recover lost keys or restore accounts. They may even come to use their old-fashioned banks for access to Web3 services.
Lutz is no stranger to either TradFi or crypto. He has a career in traditional capital markets and payments. Before joining BitMEX, he was a PwC consultant advising central banks and commercial banks on distributed-ledger technology, a specialization of his going back to 2012.
“I’m amazed by what DLT can bring to traditional finance,” he said. “I’m a believer in the technology.”
This institutional background made him the go-to person to strengthen BitMEX’s financial controls, compliance functions and surveillance capacity. Once the US government targeted the founders, BitMEX moved to put in mandatory KYC and AML checks and sanctions enforcement.
Lutz says these controls are one reason why BitMEX continued to lose market share during the boom years: “We had a millstone around our neck.” Today it ranks eighth for daily volumes among crypto derivative exchanges, far behind the likes of Binance or OKX, according to CoinMarketCap.
It’s all about UX
The exchange has fought back by focusing on technology and improving its customers’ experience.
“Our product development has narrowed to more humble work,” Lutz said. “We are focused on continuous improvements, not on making some big thing that changes the world.”
That includes working to have the lowest latency in the crypto market. This used to just mean trading speeds. Earlier this year BitMEX also shortened settlement cycles from eight hours (the industry standard) to ten minutes. This means traders, who must post margin, can settle their bets regularly throughout the day (or night). “It’s instant P&L realization,” Lutz said.
Another feature begun this year is futures contracts on tokens that have yet to list on spot exchanges. This lets tokenholders hedge themselves before an initial exchange offering. Pre-listed contracts create a new market in themselves. And they are good predictors of what the actual listing price will be.
The most interesting product, though, is to enable individual traders to band together and operate akin to a large institution’s trading desk. The meme-stock craze of 2022 demonstrated the power of individual stock traders to band together to move markets. But those people still made trades as individuals. And they used Reddit or Discord chatrooms to spread rumors that could enable pump’n’dump schemes – the sort of activity that crypto exchanges don’t want to be associated with.
BitMEX’s messaging service is more like a Bloomberg or Symphony chat, but aimed at its limited user base of professional traders. These people can consolidate their trades and share an account with sizeable volume. If it’s large enough, the group can get maker rebates on BitMEX, which frees capital to conduct more sophisticated strategies. For example, they can coordinate so that one person might manage the long end of a trade and someone else handle the short, while a third is delta neutral. Tightly coordinated teams of savvy individuals can start to compete against the big market makers, crypto funds, and bank desks.
“It’s all about the front end a better experience,” Lutz said.
The future of CEX
The main objective of these product rollouts is, of course, to grow BitMEX’s business. But there is a broader phenomenon. TradFi wants both the innovations of DLT as well as the comfort of recognizable products and markets. BitMEX’s features seem aimed to achieve both.
Link this front-end product development for traders back to the longer-term building of use cases in crypto finance – units of account, smart-contract networks, identity. Now DLT becomes the rails for cross-border activity. For people living in developed markets with rule of law and reliable institutions, this may never matter much for domestic payments and transactions. But in developing countries – the Global South – it could be transformational.
BitMEX isn’t trying to become a be-all, end-all DLT player, but by focusing on practical iterations for derivatives traders, it is helping the broader industry move towards that bigger picture – while carving out a place for centralized crypto exchanges.