Hybrid crypto exchanges will inevitably reign in the market

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As we see a resurgence of interest in cryptocurrencies, prices approaching all-time highs, and prominent individuals and institutions discussing the industry, establishing a solid cryptocurrency exchange is vital.

Cryptocurrency traders’ standards for an exchange are higher than ever. They’re looking for a slick user experience, architecture that supports high throughput and low latency, and top-notch security. The latter is especially important considering the industry is still recovering from the collapse of FTX and its domino effect on other businesses in the space.

While centralized exchanges are great at creating beautiful user interfaces and intuitive user experiences, they also work quickly by storing users’ funds on their behalf. As the industry has seen many times in crypto history, funds that users do not control can be mismanaged by fraudulent actors. Additionally, CEXs have the authority to restrict access to accounts, such as freezing funds or stopping withdrawals. As the crypto adage goes: If you don’t have the keys, you don’t have the funds.

Decentralized exchanges, on the other hand, give users full control over their funds with self-custody. They leverage blockchain technology and smart contracts to make trustless trading and payments. However, this architecture can be cumbersome and complex for users to navigate. It comes with tradeoffs in throughput and latency, lack of advanced trading features (like advanced order types and conditions), and can also incur significant fees to pay gas for payments on a blockchain.

A new group of crypto entrepreneurs are thinking about exchange architecture differently. They aim to combine aspects of centralized and decentralized exchanges by building on the best of both worlds. Enter the hybrid crypto exchange.

A better trading engine for a better crypto investor

Last cycle CEXs, including Coinbase and Binance, built their businesses by copying the UI of broker platforms and mimicking the mechanics of broker platforms and the UI of fintech apps. They focused on user-friendly UI, robust mobile apps, competitive fees, and a comprehensive selection of coins and tokens.

Centralized trading infrastructure offers the high throughput and low latency that the world demands for crypto trading. Digging deeper, high throughput and low latency provides better liquidity as market makers can requote faster. It also allows for more efficient margin usage as a centralized risk engine allows the exchange to offer higher leverage. Centralization enables advanced trading features and logic, such as advanced order types and conditions.

In addition to performance, it also gives exchanges more control over compliance. CEXs control what access customers have to their platforms and can manage the access of those users by implementing robust blockchain analytics, financial crime, and compliance programs. In the wake of FTX, lawmakers and enforcement agencies have begun to crack down on the industry, imposing large fines and even jail time on businesses and entrepreneurs found to be in violation of regulations.

So, in summary, this is why the hybrid exchange model inherits the bright side of centralization. The trading architecture is largely kept centralized. The UX is also inherited from CEX, as DEXs lack features like simple account creation, which eliminates the need for users to already have a wallet before interacting with the exchange. DEXs are also limited in terms of on and off ramps, fee abstraction, and advanced trading analytics. A strong feature set on top of a polished user experience is critical, especially when another group of crypto traders enter the space at what seems like the beginning of a bull run.

So far, it seems like a perfect victory for centralization. The question is: what do hybrid exchanges inherit from decentralized ones? The answer is simple: the fundamental feature that ensures trust in crypto trading. And centralization has a dark side.

Give keys to users

Hybrid exchanges still leverage DEX concepts by using blockchain technology to secure funds. Users store their funds themselves and transactions are finalized on the blockchain at various periods. Another important feature is the on-chain verification of transaction logic, which will prevent operator fraud. Therefore, trust is provable and transparency is immutable.

Operator fraud is one of the most significant risks in crypto. CEX’s control over funds is useful for compliance reasons, but it also gives them the power to limit access to accounts, such as freezing funds or withholding withdrawals. The collapse of FTX has certainly raised concerns about an operator’s access to user funds. Still, FTX wasn’t the first or only exchange to mismanage user funds and question the CEX model. One of the first crypto exchanges, MtGox, completely shut down and filed for bankruptcy in early 2014 after a theft that went undetected for many years and drained the exchange of over 850,000 Bitcoins (BTC). In 2018, Canadian exchange QuadrigaCX went bankrupt and was later revealed to be a Ponzi scheme, causing losses of approximately $190 million in user funds.

Such examples highlight the importance of trustless on-chain settlement, where users hold the keys to their own coins rather than trusting their keys to a completely opaque centralized entity.

Scaling technology to reduce costs

In the derivatives market, traders often trade in large volumes, which can rack up significant fees. There are no free trades. CEXs and DEXs charge fees for trading, but DEX users incur an additional cost to settle all of their trades on a blockchain. These fees fluctuate depending on the overall usage of the blockchain at any given time. Earlier this year, in March, Ethereum transaction costs skyrocketed to a nearly two-year high due to increased speculation in meme tokens.

The hybrid exchange approach simplifies the fee structure as the transaction is centralized and relies on layer-2 technology to increase scalability while keeping transaction fees low. Rollups are one such scalability solution that processes transactions on a separate network before separating transaction data into groups to be sent and placed on the main chain.

Now is the time to go hybrid

In a maturing and increasingly competitive market, blending features of centralized and decentralized exchange architectures is an obvious choice.

The speed, usability, and design of CEX will help users of all levels of technical knowledge to trade cryptocurrencies. And the security provided by implementing some aspects of DEX will create an ecosystem of trust and reliability that gives users peace of mind.

The hybrid crypto exchange is poised to be the winning business model in the next bull run, emphasizing that it’s not always about reinventing the wheel, but about putting the pieces together creatively. This is not a one-size-fits-all industry; there will be no one-size-fits-all solution.

Ruslan Fakhrutdinov

Ruslan Fakhrutdinov is a former McKinsey consultant and former Head of Crypto Operations at Revolut. Ruslan played a key role in the development of a number of crypto products. He was responsible for the P&L of one of the company’s largest and most profitable divisions, generating a gross profit of £220m in 2021. Ruslan left the fintech giant in 2023 to set up his own venture, hybrid crypto exchange X10.