In this article, I discuss the pros and cons of exchange tokens (ETs) as an investment. The focus here is not the native tokens of decentralized exchange protocols like 0x but instead the tokens issued by centralized exchanges like Binance, Huobi, and many other exchanges. The first step in deciding whether a token is a good investment is to understand its goal, its mechanics, and its market fit. In this article, these sides are discussed in detail.

Exchange tokens started to emerge around the middle of 2017. They are categorized as utility tokens and their goal is to give some advantages to the exchange users. For example, these tokens can be used as a way to reward market makers who create liquidity in the exchange, they can also be used to lower trading fees or to give exchange users some governance rights. Different exchanges utilize different subsets of these features for their tokens. Since some of these ETs has achieved great success, the attention they get is on the rise.

Exchange Tokens have achieved amazing ROI for investors. Sources: https://info.binance.com/currencies/binance-coin, https://www.huobipro.com/ht/points/, https://assets.kucoin.com/kucoin_whitepaper_en.pdf

Binance’s BNB is a great example of ET success. It has been a clear win for its holders. Its price has increased over the previous few months which witnessed a bear market for almost all other cryptocurrencies. BNB is currently trading at an All-Time High (ATH) in terms of BTC and slightly lower than the token ATH in USD terms. According to BNB price chart, BNB has achieved more than 10x ROI for holders who bought the coin just 7 months ago and more than 105x ROI from the ICO price which was less than a year ago.

Binance BNB price performance. https://coinmarketcap.com/currencies/binance-coin/

Exchange Token Mechanics

Exchange tokens are designed to provide multiple advantages to the token holders. The most common advantage is trading fees discount. Binance offers a yearly-declining discount for all users who use BNB as the way to pay trading fees. Huobi offers a tiered discount on trading fees for Huobi Token (HT) holders. The amount of the discount depends on the user’s HT balance and can be up to 50 %. Alternatively, KuCoin exchange gives 50% of the exchange daily trading fees to the holders of KuCoin Shares (KCS) as a daily dividend.

The other common advantages are governance rights and airdrops. Exchanges allow their ET holders to have a say in some exchange related matters like new coin listing. In addition, the exchanges reward users by giving them ET airdrops when they perform deposits of newly listed assets. This kind of airdrops has proved to be useful for both increasing liquidity of newly listed assets and also increasing the user base of the ETs.

In addition to the direct benefits that ET holders gain, exchanges apply multiple strategies to boost the price of their ETs. The most common strategy is token buy-back. Exchanges promise to use part of their profits (up to 20%) to buy back the tokens from users and, in some cases, burn the bought-back tokens. Both Binance and Kucoin promise to reduce the supply of their ETs from 200M to 100M via the buy-back program.

Another smart strategy that Binance uses to boost BNB price is “the conversion of small balances to BNB” feature. Many of Binance users receive small amounts of different coins as a result of the exchange referral program. These balances can be too small to be traded on the exchange. However, Binance allows users to convert these small balances only into BNB once per day. Aggregation of these conversion processes over a large number of Binance users creates buy demand on the BNB token pushing the price higher.

Correlation of ET price and exchange performance

Although exchange tokens are not legally defined as equity shares by the issuing exchange, the ET value is obviously coupled to the exchange performance. BNB significant gains are a direct result of the great success of the Binance exchange in attracting users. Binance is currently the largest cryptocurrency exchange by daily trading volume. A similar observation can be made about Huobi’s HT.

TVEV ratio for BNB and HT during 2018. Source: Coinfi

There is a number of attempts to quantify the relationship between the ET price and the performance of the exchange. One of these approaches is the token-value-to-exchange-volume (TVEV) ratio proposed by Coinfi in their analysis of ETs. The TVEV metric is simply obtained by dividing the total market cap of the ET by the 24H exchange trading volume. As the TVEV ratio is changing within a small range, it indicates a strong correlation between the ET price to the exchange performance. Large increases in the ET price, hence the corresponding TVEV ratio, are usually related to positive news about the exchange. A significant example of that is the rapid increase of BNB price in June 2018 since the news of Binance launching a $1 billion investment fund.

Another approach to relate ET price to the exchange performance was explored in this article. In that analysis, the BNB token price was related to the number of visitors to the exchange website. A drawback of this approach is that it doesn’t consider the other ways to access the exchange like the mobile app or through APIs.

Exchange Token Risks

Although ETs have achieved amazing ROI for investors, there are a number of risks involved.

A major concern is regulatory compliance. Currently, all major ETs are marketed as utility tokens which make them, according to a large number of experts, exempted from securities laws. However, for multiple reasons, ETs are the closest thing we have right now to “tokenized equity shares” or “tokenized securities”. In fact, KCS is marketed as “shares” in KuCoin exchange. Classification of ETs as securities would make investing in them a more complicated process. Although I cannot claim to be a securities law expert, there are a number of reasons that make ETs very similar to stocks in public companies.

ETs currently play a significant role in exchange ecosystem allowing owners to have exclusive benefits (discounts/dividends) just by owning the token. This resembles dividends from stock ownership. The price of an ET can be proven to be tightly coupled to the exchange performance and exchange plans to add new services or expand its operation to other areas. This again resembles how stock prices are related to public companies performance. Governance rights entitled to ET holders are similar to voting rights of stockholders. Currently, these governance rights are not legally binding. However, this may change in the future as competition between exchanges increases.

Another threat that could significantly affect exchange token valuation is security incidents. A major security incident the size of Coincheck’s theft in Jan 2017 can send the corresponding ET into turmoil. Although multiple cryptocurrency exchanges have had security incidents in 2017, it seems major exchanges like Binance are taking appropriate security measures to prevent such accidents.

A third risk is the quick shifts in the crypto market. Quick changes in exchange popularity could have significant effects on the ET valuation. A platform like Poloniex that used to be a leading crypto exchange less than 18 months ago is currently at the 37th place by daily market volume. If a similar situation could ever occur to Binance, its token price could see a sharp and quick decline.