How a CEX Burn Might Work

Twitter: @4lex_4sh4w_TR

Twitter: @4lex_4sh4w_TR

One misunderstanding in Terra Classic community discourse around the burn tax comes up very frequently: the actual mechanics of how centralized exchanges (CEXs) operate, and what those mechanics mean for the viability of the 1.2% tax. As we’ll see results come in over the coming days, let’s review how CEX transactions actually work and how they differ from taxable (on-chain) transactions.

How a CEX works

A crypto CEX is a centralized database for trading USD paper certificates for a cryptocurrency like LUNC, instantly redeemable for the real thing if you choose to send that currency off-exchange to an actual wallet, like MetaMask, Keplr or Terra. So when you trade LUNC on Binance, you aren’t trading LUNC on-chain. You’re buying an off-chain certificate, a record in a Binance internal database, which says you have to take delivery of LUNC. These off-chain transactions can be subdivided into unleveraged transactions (“spot”) and leveraged (“margin”) transaction types.

The exchange maintains precise price equivalence between its own LUNC certificate and on-chain LUNC by having an on-chain wallet. Every time a new trader deposits fiat into the exchange and uses that fiat to buy LUNC, the exchange buys LUNC on-chain and deposits that LUNC into its on-chain wallet. However, if one Binance trader on the CEX sells 1000 LUNC to another trader on the CEX, no on-chain transaction occurs. The Binance computer just internally credits the buyer’s account with 1000 off-chain LUNC certificates and deducts them from the seller. There is zero interaction with the Terra Classic chain for any “spot” transaction unless it reflects a conversion from fiat into LUNC, usually from a new depositor.

It’s very similar to two traders trading an ETF like GLD, in which no physical gold actually moves anywhere. The only time any gold moves anywhere is when a new investor subscribes to a newly issued share of GLD, and the ETF then goes out and buys the physical gold ASAP to reflect the new net holdings.

Margin transactions — which account for the vast majority of off-chain volume for almost any cryptocurrency — add another level of internal complexity. If you and I trade 1000 LUNC, and we both trade on 4:1 margin (200 LUNC of equity, 800 LUNC borrowed), we’re trading a paper certificate for 200 “spot LUNC” and a floating fiat loan valued at 4x the 200 spot LUNC position. CEXs manage their margin risk across their many thousands of individual accounts, and try to maintain somewhat neutral net margin exposure (for every $X dollars of margin loaned on the long side, they try to loan $X dollars of margin on the short side, thus taking double the fees for zero net directional exposure). This is called “cross-margining.” It’s a high-wire act of credit risk management as the CEX constantly balances credit risk and credit concentrations across thousands of different customers.

Lending money on margin is a profitable business for CEXs because it multiplies trading fee revenue, but it’s also high-risk. Large, sudden directional movements in a spot price can wipe out a lot of margin traders on the wrong side very quickly, and if those moves continue further, the CEX will suddenly have massive directional exposure to the side of margined traders who haven’t been liquidated. So when a ticker like LUNC goes up 600% in a month, completely disconnected from other crypto assets, amidst heavy margin trading, you will see news like “KUCOIN SUSPENDS FURTHER MARGIN LENDING ON LUNC.” They’re doing that because one side of their previously-balanced book of net margin exposure just got completely blown out and their internal risk systems are screaming CUT EXPOSURE NOW before the exchange hemorrhages any more money to the winning side of a violent and unexpected gamma squeeze.

The point is that CEX margin lending is a) a high-risk business with high overall profitability but savage drawdowns, and b) completely off-chain. Protocol governance has no interaction, and no tax-collection leverage, on the vast majority of on-CEX trades.

Now, in practice, some of these CEXs have other practices that create more on-chain interactions. One popular CEX practice involves “partitioning” one on-chain wallet into many different wallets to a) reduce hacking / security risks, b) subdivide between staked and unstaked crypto, and c) other functions. These transfers could apply to both spot and margined transactions, but they could also be easily controlled or batched to be made significantly less frequent.

TLDR: the vast majority of both spot and margin CEX transactions never register with the parent blockchain, which drastically reduces the parent chain’s leverage to extract economics from those transactions.

Implications for the 1.2% tax

When LUNC goes to CEXs and demand a cut of their off-chain transactions, it’s demanding a cut of either fiat (USD) transactions referencing a LUNC paper derivative, or a margin agreement between the CEX and its customers that’s USD, but references something called LUNC. Trading crypto on margin (probably 80%+ of CEX volume) is an especially risky, complicated risk-management process that isn’t just “free money” to the CEX.

So when a protocol goes to a CEX and say, “give us a piece of your margin business!”, it’s as if you were selling “I <heart> NYC” T-shirts in Texas, you were making okay money, and the NYC tax collector suddenly showed up demanding that you pay sales tax to NYC because your T-shirt says “NYC” on it. The CEX isn’t going to tell us to go F*** ourselves — that’s not a part of the PR crisis management vocabulary — but it would think to itself, “Unless you have any leverage to make me do this, I’m not going to do it.” Furthermore, trading volume is massively skewed towards your largest whale clients who trade very frequently and hate the idea of paying 1.2% taxes on every trade. Your top 20 whales are much more important to you than a few thousand retail traders leaving.

Anyway, the community can make its own judgment of the probability of CEXes cooperating with such a request. Let’s call it P(CEX_yes).

Regardless of what the CEXes do, we know the decision to tax on-chain transactions in this manner will create (medium | high | very high) costs to on-chain ecosystem development. We can all have our opinions on what that cost is but it’s clearly not low. Call this C(tax).

The community needs to weigh P(CEX_yes) * [benefit(CEX_yes) — C(tax)] vs P(CEX_no) * C(tax). If P(CEX_no) is very high, that should be a key consideration in the ongoing cost/benefit evaluation of the tax within the protocol governance process.

Let’s say Binance, Huobi, Gate.io, and Kucoin (BHGK) tell us politely to go fly a kite (that’s how I read their public statements, especially the terrible Kucoin AMA on Friday). OK, what now? We flex our leverage, we tell people to move their money to other exchanges if they support the community (actually, we should be telling them to move their money on-chain if they really support the community, but removing from BHGK would be a step in that direction, I guess).

Does that actually make a dent in BHGK’s volumes? If it does, there is some chance that BHGK’s public stance would change, since we have demonstrated clear leverage. If it doesn’t, the community should probably admit at that point that they have no further leverage to influence BHGK’s behavior, and have thus incurred a very high protocol cost for very little protocol gain.

At that point, the cost of waiting around, hoping something changes, and hanging on to “the CEXes might still cooperate” is (medium | high | very high), and P(“CEXes might still cooperate”) is virtually zero. So that’s a separate cost/benefit judgment the community will need to make.

What’s most important for our token and our community at the end of the day is to look at the world as it is (instead of the world as we wish it to be) and make the most informed, cold-blooded risk/reward calculation it can as to whether this policy delivers benefits commensurate with its costs.