Exchange Tokens

What are Exchange Tokens?

Centralized exchanges are centerpieces in the crypto industry and have garnered some of the highest historical valuations in both private and public markets. Despite their core function in the space, we have seen that they can be highly cyclical, and their performance is most often dependent upon price action. Further, the business model and value proposition have been revealed to be quite simple: provide users with access to crypto trading 24/7, 365 days a year, while charging a fee for providing a liquid and secure market for cryptoassets. Leaving aside any ancillary offerings offered by the cadre of existing exchanges (think staking, custody, wallet services, etc.), the commoditized nature of these exchanges has resulted in a global battle for liquidity and customer loyalty among the growing set of companies offering exchange services.

This competition for liquidity and customer loyalty is at the heart of exchange token adoption. While the use case can differ by token, at its core, an exchange token is a digital asset native to a centralized exchange and issued by the entity that operates the platform. The tokens usually provide holders with some utility or incentive to hold and transact on the exchange, such as lower trading fees, rebates, and exclusive offers. The term exchange token usually refers exclusively to tokens issued by centralized exchanges rather than governance tokens typically issued by decentralized exchanges.

It’s important to distinguish that while the tokens are related to the exchange, they do not represent ownership of equity or debt related to the exchange’s operations. There is no legal claim on the cash flows of the exchange as there is with equity, leaving tokenholders subject to the whim of exchange management. It costs exchanges next to nothing to generate a token, sell a portion of it to their clients, and keep a significant amount of the supply on their balance sheet. While not a negative in and of itself, this dynamic creates potential opportunities for abuse depending on the objectives of the exchange’s management team.

Top Exchange Tokens and Value Accrual

Management teams leverage exchange tokens to incentivize increased trading activity and contributors to the exchange ecosystem. The token price reflects market perspectives about the exchange, as holders believe that the platform’s growth could make holding the related token more valuable. The logic is that as activity grows on the exchange, so will demand for the token. While this can be a potential growth driver for teams aligned with holders, it can also create a moral hazard for exchange operators that abuse their control over supply and tokenomics (we’ll expand on this in later sections). Make no mistake, they are called centralized exchanges for a reason, and any decision over an exchange token’s underlying governance is at the complete discretion of its issuer.

There are two levers exchange management can pull to accrue value to their native token: platform utility and profit-sharing. Where tokens fall on the broad spectrum of utility and profit-sharing dictates their intrinsic value. As the table below shows, not all exchange tokens are created equal. Some tokens trade based on tangible benefits and value flows from the exchange’s operations, and others purely on speculation about future events.

Figure: Attributes of Top Exchange Tokens by Market Cap^[1]

Increasing Utility Drives Demand for Tokens

While all provide trading discounts, utility beyond that varies widely. One common platform benefit includes access to an exchange’s launchpad, usually tied to holding requirements for the native token. Yet access to Binance, Huobi, and KuCoin’s Launchpad can be seen as more valuable due to past projects’ better relative performance. Tokenize XChange’s $TKX is the best example of a token with value derived purely from future expectations, as its existing model lacks utility and value accrual. $TKX does not currently have launchpad access, a native blockchain, or clear value accrual mechanisms beyond staking rewards on a network that has yet to be launched.

Some Companies are Increasing Utility Outside of the Exchange

Relying on the exchange’s operations imposes a ceiling to how much value can flow to a token from an exchange, capped at either the growth of their market share or the team’s willingness to share profits. This has led to the most forward-looking exchange tokens aiming to provide value capture beyond the exchange’s operations. Given these platforms already have traffic from a large base of native crypto users, they are in a prime position to siphon this traffic into a layer-1 ecosystem denominated by their native token. Binance pioneered this model, with $BNB initially starting with value accrual based on a burn metric from exchange operations and then evolving to the Binance Smart Chain (BSC), where $BNB was used to pay for gas. Now the burn mechanism is based on its native chain activity, and $BNB’s potential adoption isn’t limited to users of the exchange but to an entire ecosystem of teams building value on BSC.  

Many top exchanges by volume are also racing to grow their layer-1 ecosystems, including OKX, Crypto.com, and KuCoin. They hope to replicate Binance’s success at expanding their respective token’s utility and value capture. While all have had limited success with these initiatives, their tokens still command high valuations based on the exchange’s operational success. Establishing a growing layer-1 ecosystem would unlock demand for their tokens beyond use on the exchange, as they would be used to pay for gas in their respective ecosystems. It would evolve value accrual from being bottlenecked by the management team’s actions to scaling with the value created by teams building successful products on their native chains. Ultimately they aspire to drive customer loyalty by sharing the upside in the exchange’s growth and potential success at creating a decentralized ecosystem beyond the business.

Equity-like Profit-sharing Features Allow Holders to Share in Financial Upside

In the competitive business of attracting trading activity, exchanges offering native token discounts and platform benefits have become table stakes. Beyond these features and the perception of issuer operations, exchange tokens derive intrinsic value through value accrual mechanisms. The table above shows that most exchange tokens have a buyback and burn instrument to create deflationary pressure on their supply. The metric used to determine the amount burned varies by the exchange but is typically tied to either trading volumes or the exchange’s financial results. These buybacks accrue value to tokens in the same way that share buybacks boost shareholder returns. While the buy-and-burn programs establish a value flow from the exchange to token holders, it is only there as long as the management team decides it should be.

Case Studies

The Fall of FTT

It is well known that FTX began to unravel shortly after CoinDesk’s article questioning the alarming amount of FTT (FTX’s exchange token) sitting on sister company Alameda’s balance sheet. CEO of Swan Bitcoin Cory Klippsten sums it up nicely, “it’s fascinating to see that the majority of the net equity in Alameda’s business is actually FTX’s own centrally controlled and printed-out-of-thin-air token.” While the exchange’s collapse went beyond the exchange token and was indeed a case of outright fraud, the failure illustrates how mechanisms behind exchange tokens can be abused to mislead its holders.

FTX raised $10 million from $FTT’s initial exchange offering in 2019, selling $17% of the 350,000,000 total supply to private sale investors (Round 1 & 2 below). While the chart shows allocation by use case,  up to 86% of the $FTT supply was under the control of FTX/Alameda. This allocation would not be the last time FTX used $FTT to mislead investors.

In addition to the price action moving as a proxy to the exchange’s health, FTX engaged in a ‘‘buy and burn’’ campaign, through which a portion of FTX revenue was used to buy and burn $FTT supply. The investment case was that as trading activity on FTX increased, so would $FTT price. That investment case played out for a while, as $FTT went from its ICO price range of $0.10 – $0.80 to an all-time high of $84.76 on September 9th, 2021, mirroring FTX’s apparent parabolic growth as an exchange.

However, what the CoinDesk article revealed, and what soon became apparent to the rest of the market, was that this supposed value transfer to the $FTT token worked both ways. While they signaled value accrual to $FTT through the burn campaign, the low float led to the value of tokens on FTX’s and Alameda’s balance sheet increasing beyond what could be liquidated.

FTX and Alameda used this dynamic of poor price discovery to their advantage. Alameda took the value of their illiquid $FTT holdings and used it as collateral to lever up their ill-advised bets on the broader crypto space through loans from FTX. The loans exposed FTX customers and $FTT token holders to price risk since these loans were funded by FTX customer deposits. Thus, the exchange’s solvency began to depend on $FTT’s price trading high enough to meet Alameda’s collateral requirements. Once one of $FTT’s biggest holders began to express a potential selling event, $FTT and, subsequently, the value of Alameda’s collateral began to spiral. FTX became insolvent as Alameda defaulted on its loans after a massive sell-off, and its $FTT collateral was worth a fraction of what it had used for collateral to borrow from FTX depositors.

BNB’s Rise to Dominance

While FTX’s $FTT is the poster child for how not to operate an exchange token, Binance pioneered the playbook on successfully building an exchange token flywheel with $BNB.    

Binance raised $15 million in 2017 through a public ICO. They sold half of the $BNB token’s 200 million total supply to ICO participants, 10% to angel investors, and kept a 40% allocation for the team. Half of the team’s allocation was vested immediately, while the rest vested over four years. Initially, investors in the ICO bought at an average price of $0.15 per $BNB to fund Binance branding, marketing, and platform development. Binance was also one of the first exchanges to offer discounts on trading fees if they were paid with the exchange’s native token.

As the platform grew, it added additional utility to its exchange token. Binance created a launchpad for new token offerings, using initial exchange offerings (IEO) to sell tokens directly to traders on the platform. Demand to participate in these IEOs is exceptionally high as some of the top-performing new assets have come from Binance’s launchpad. Currently, IEO allocations are determined by a lottery system, where the probability of winning allocation depends on the number of $BNB tokens held for the last 20 days.  

Figure: Average ROI since IEO by Exchange   

Initially, $BNB was launched as an ERC-20 token on Ethereum. In April 2019, Binance migrated the token to its own native public blockchain, the Binance Chain. This migration accompanied the launch of a Binance-branded DEX built on the Binance chain using Tendermint and the Cosmos Software Development Kit (SDK). Further protocol development led to the chain evolving as a standalone Layer-1 smart contract platform with a native ecosystem. Thus the value of $BNB began to reflect not only Binance’s operational health and utility as a trading platform but the expansion of the entire Binance Chain ecosystem. As the ecosystem expanded and more native BSC projects gained traction, demand for $BNB grew since it was required to pay network transaction fees. 

Figure: BNB Price and Binance Smart Chain TVL  

In addition to creating utility for the token, the team initially ensured there were mechanisms for profit-sharing. Binance’s quarterly token burn mechanism was the most prominent of these. Binance initially said they would use 20% of quarterly profits from the exchange to buy and burn $BNB from the open market until half of the supply, or 100 million tokens, had been burned. Due to $BNB’s fixed supply, this made the token deflationary. In the summer of 2019, they announced they would prioritize burning the team’s 80 million token allocation, or 40% of supply, worth $2.4 billion at the time of the announcement. Binance continues to evolve the token burn mechanism as the token utility changes, recently announcing a verifiable autoburn formula to reach its long-term goal of burning half the supply.

Overt Centralization

While these burn mechanisms should theoretically be accretive to the price, the constant changes to the model indicate how Binance’s team has complete control over the protocol. One of blockchain’s most promising value propositions is the promise of decentralization. Binance has been known to deprioritize decentralization to bring protocol upgrades to market. In fact, Binance has one of the least decentralized chains in the market, illustrated by a recent pause and rollback by the limited on-chain validators in response to a recent hack.

The performance of an exchange token such as $BNB will always be tied to the perceived health of the centralized exchange, which ultimately has complete control over what happens to the protocol. Recently Binance has had a string of bad news, including the aforementioned hack and, most recently, questions around its solvency given a highly criticized proof of reserves report. Nevertheless, they pioneered the model of successfully creating value for an exchange token. Early investors were rewarded for investing in a token tied to what would eventually become the world’s largest and most profitable exchange and one of crypto’s fastest-growing layer-one ecosystems. Token utility exists on a spectrum, and as Binance proved, a team adept at innovating and evolving can drive incremental demand by adding utility to its token. It is uncertain whether the team will be able to keep driving this demand, and concerns around Binance’s solvency warrant caution, as any negative news would surely translate to negative price action.

Assessing Risks

In addition to utility, many quantitative metrics can help assess exchange token risk, both to the token price and exchange operations. As exchanges compete for a limited amount of liquidity, one key consideration is their market share of the trading volume, which tends to drive the volume of buybacks either directly or through revenue. Consideration for trading volume must be nuanced because the exact metric used for token burns doesn’t matter as much as the total amount and the nominal level of deflation that results.

Figure: Top Exchange Token Supply Dynamics^[2]

The most considerable risk facing an exchange token comes from the issuer itself. Due to their highly centralized nature, exchanges have been known to make significant decisions regarding token supply dynamics and value accrual without token holder input. Thus investors must account for the amount of supply initially allocated to the exchange and how much of the remaining supply (FDV) the exchange owns relative to the float. Exchanges with the largest supply allocations, such as Crypto.com and MEXC, can and will change their token models at their discretion. Crypto.com is the most prominent example, having pivoted its token model several times.    

Recalling the fall of $FTT, two red flags that could have potentially tipped off investors before the collapse was the amount of outsized supply allocated to entities controlled by FTX or Alameda and the amount of $FTT on their balance sheet. Balance sheet information wasn’t previously available, but customers have begun to demand transparency from exchanges regarding their holdings and liabilities following the FTX fiasco. While the table above is only as reliable as the publicly available information and DeFiLlama’s wallet labeling abilities, the metrics can be useful to make directional estimates without having perfect data.

When an exchange’s total holdings are comprised of high amounts of its own token, there is an increased risk of insolvency depending on price action from its native token. The table above shows that some of the largest exchanges by market share also have an alarmingly high percentage of holdings in their native tokens, including market leader Binance. This is why transparency is critical. Binance has been heavily criticized for releasing an audit with limited scope in assets (BTC only) and leaving much to be desired on the liabilities side. Extensive holdings of native tokens alone are not indicative of malfeasance, but in an ideal world, the holdings should be in excess of any liabilities the exchange has to customers. While there have been improvements in exchange transparency through continued progress of proof of reserves, this is an incomplete picture without proof of liabilities.

Finally, it is likely most exchange tokens would be considered securities in the U.S. The SEC recently accused FTX’s $FTT sale of constituting an investment contract, making $FTT security. They claimed investors in the initial sale bought hoping to profit off “FTX’s core management efforts” and compared the “buy-and-burn” program to stock buybacks. This risk only applies to exchanges that sell tokens to U.S. residents, but many of the most valuable exchange tokens have similar mechanisms to $FTT. Should they be classified as securities, it would be a massive headwind that could limit their adoption and growth in crypto’s biggest market.

Conclusion

Operating outside or in unclear regulations, without public audits, and highly centralized, exchange tokens are certainly higher on the risk spectrum than other types of tokens. Their derived value comes from decisions exchange teams make about where token dynamics fall on a broad spectrum of utility and profit-sharing. While $BNB’s team successfully evolved token value capture beyond the exchange ecosystem, it remains to be seen whether other exchanges are able to use the same Layer-1 playbook to replicate their relative success.      

[1] OKB is OKC’s exchange benefits token, separate from its native chain OkChain’s token OKT. Woo Network does not have trading fees, and its revenue is derived from payment for order flow.

[2] Exchange market share as of Q4 ‘22. FTX Balance % issuer holdings are shown at pre-crash levels for illustrative purposes. OKX % holdings are shown as range estimates. Prices as of 1/12/23.