TL;DR
The struggle of small and medium-sized crypto exchanges: Since the revision of financial regulations in 2021, small and medium-sized cryptocurrency exchanges have suffered from suspension of KRW trading and business losses. This situation has accelerated the winner-take-all phenomenon in the market.
Structural problems in the market: 1) user exodus to overseas exchanges, 2) functional limitations, and 3) liquidity dispersion due to individual order book operations have structurally reduced the competitiveness of small and medium-sized Korean exchanges.
Korean crypto market dominated by top players: While the market is consolidating around top exchanges, there still may be room for growth for small and medium-sized exchanges.
Crypto prices have risen, yet non-major exchanges remain at risk
South Korea's cryptocurrency exchange market has been facing serious challenges recently. This is largely due to the “Act on Reporting and Usage of Specified Financial Transaction Information”, which was revised in 2021. Since the amendment, it became mandatory for virtual asset service providers (VASPs) to receive licenses before they can continue operations. Furthermore, exchanges also had to acquire real-name bank accounts to support KRW transactions.
As a result, small and medium-sized (SME) cryptocurrency exchanges that were unable to secure a real-name bank account had to stop supporting KRW trades. This put further put them at a disadvantage as investors gravitated towards exchanges with convenient trading experiences. As a result, many exchanges such as Coinbit and Cashierest, which did not support KRW trading, were unable to withstand the accumulated deficit and went out of business. Hanbitco, in its effort to support KRW trades, even partnered with Gwangju Bank. However, their request was denied by the financial authorities, making it difficult to operate real-name accounts. As such, many non-major cryptocurrency exchanges are finding it increasingly difficult to continue operations. This is especially unfortunate as the market has been showing a general recovery recently.
In light of these circumstances, the future stability of numerous cryptocurrency exchanges remains uncertain. Many are approaching the renewal deadlines for their Virtual Asset Service Provider (VASP) licenses. With financial authorities imposing stringent criteria, including the necessity for reserves exceeding 3 billion KRW (around 2.28 million USD), few exchanges are anticipated to successfully renew their licenses. These economic challenges further highlight the instability of the South Korean cryptocurrency exchanges and dampen business enthusiasm. Under these circumstances, the Financial Services Commission expressed concerns on November 21st about the potential damages associated with the closure of crypto exchanges and called for operators and users to exercise caution.
Small and medium-sized exchanges are undercapitalized
According to the results of the Financial Services Commission's survey of virtual asset operators in the first half of 2023, cryptocurrency market operators that are unable to support KRW trading are facing significant challenges. As the prices of major coins rose in 2023, market capitalization and KRW deposits increased compared to the second half of 2022. Some exchanges' operating profits also increased as a part of this price increase. However, 10 out of 21 SME cryptocurrency market operators are continuing to face difficulties in their business operations, as they have no transaction fee revenue.
In particular, the Q3 2023 disclosures show that all but one of the largest exchanges, Upbit, posted operating losses. Even Bithumb, the second-largest exchange by volume, has taken steps to revitalize lagging trading volumes, such as eliminating trading fees. This resulted in an operating loss of around 600 million KRW (around 456 thousand USD), following the previous quarter. Coinone, Korbit, and Gopax have not released their Q3 disclosures, but results are expected to be similar.
The problem is that beyond operating losses, some exchanges have fallen into capital losses. Capital erosion means that the value of a company's assets is less than its liabilities (debts), indicating that the company's net worth (assets minus liabilities) is negative. Capital erosion negatively affects a company's 1) financial health, 2) management stability, and 3) business competitiveness. Once a company is recognized as insolvent, it is difficult to receive investment or continue business. In fact, 18 out of 21 exchanges that do not support KRW trading are in a state of 'complete capital erosion' (negative total capital).
In order to improve this situation, businesses need to 1) sell assets, 2) increase capital, and 3) improve revenue. This is easier said than done. In reality, many do not have any liquid assets, and increasing capital is difficult due to the current market conditions. This leaves the option of increasing trading volume and improving revenue structure through fees, but it is difficult to increase trading in a market dominated by large exchanges such as Upbit and Bithumb.
Further complications
1) Illegal operations of foreign exchanges in the Korean market
One of the main challenges facing small and medium-sized cryptocurrency exchanges in South Korea is the illegal operation of foreign exchanges in the country. Large international exchanges, such as Binance, have been able to circumvent local regulations to serve Korean users. This gives them a competitive advantage over local exchanges by freely offering not only a wide range of cryptocurrencies but also advanced features such as futures trading, which are restricted in Korea. They also offer low fees for large investors, or "whales," that are proportional to trading volume, encouraging them to move to overseas platforms.
2) Limited features compared to international exchanges
Another significant problem faced by small and medium-sized Korean crypto exchanges is the limited functionality they offer compared to international exchanges. International exchanges offer a wide range of financial instruments, advanced trading features, and additional services, giving users a broader range of trading options and an enhanced experience.
Small and medium-sized Korean exchanges, in contrast, provide spot trading in a restricted environment. Moreover, the essential features needed to support this trading are even more limited. For example, even major Korean exchanges such as Upbit have only recently started to offer P&L calculations, which shows that Korean exchanges are lagging in supporting basic trading features compared to global competitors. These functional limitations are significantly weakening the competitiveness of small and medium-sized Korean exchanges and negatively impacting their long-term survival.
3) Individual order book systems
One of the biggest challenges faced by small and medium-sized crypto exchanges in Korea is individualized order book management. Each exchange maintains its own trading system, which leads to liquidity dispersion across the market. This makes it difficult for SME exchanges to execute trades quickly, which in turn forces them to offer unfavorable trading conditions to investors. Large exchanges, on the other hand, leverage their high trading volumes and liquidity to offer better prices and faster trade execution. This structural difference makes small and medium-sized exchanges less competitive and is ultimately the main cause of accelerating market concentration.
And yet, the Korean market continues to grow
Despite the challenges faced by the smaller exchanges, South Korea's cryptocurrency market continues to heat up. This enthusiasm is evident in a unique phenomenon known as the 'kimchi premium'. This is a phenomenon where cryptocurrencies traded in South Korea are priced higher than in overseas markets. This shows no signs of stopping, with SEI Coin in August and MINA Coin in October recording a 70% kimchi premium.
While it would be ideal for all exchanges to operate successfully in such an active market environment and for the market to grow as a whole, in reality, this is not the case. Due to the fragmented liquidity caused by individual order book operations, there will inevitably be a winner-take-all situation where the exchange with the most investors will dominate the market. However, even the largest exchanges are still limited in their basic functionality. If underdog exchanges were to rebuild from the ground up, actively expand their services by adding features such as staking, and continue to debate legal restrictions, they may still have a fighting chance.
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