Hybrid Exchange Design amidst Cliched Exchange Market Dynamics

Key Takeaways

• Trading experience is both the most fundamental experience and the most frequent event in all crypto activities.

• However, (centralized) exchanges where most crypto assets are traded do not support trading in a trustless manner and do not align with the philosophy of crypto technology, which is based on fault-tolerance systems. te

• The infrastructure of exchanges must support reliable trading methods, and establishing a HEX(Hybrid Exchange), like Cube.Exchange, can be a good approach to adhering to this philosophy while also providing a seamless trading experience.

1. Crypto Trading Needs Crypto-Native Infra

People use and trade crypto assets for various reasons. Some see them as an investment vehicle, many view them as an innovative financial technology, and others consider them a tool for communication beyond the internet. Regardless of such reasons, the crucial point is that at the top of the funnel leading to the adoption and utilization of crypto assets is the 'trading experience.' In the crypto space, which offers the idea of fully digitizing and exchanging value on a reliable network, trading is both the fundamental crypto experience and the most frequently occurring event.

However, we need to revisit whether such transactions are carried out in a 'trustless manner' as intended by the design of the crypto space. The fact that trading transactions are the most frequent events means that the most assets are concentrated where these transactions occur.

Despite the claim that crypto technology is a fault-tolerant system designed to enhance stability by addressing concerns about single points of failure, we increasingly find ourselves compromising the essence of crypto for the sake of convenience. As a result, we have witnessed numerous unfortunate incidents, both large and small, where assets allocated to exchanges have been mismanaged or stolen.

Given the boundless potential of crypto industry, if we optimistically assume that it will continue to attract the interest of an increasing number of diverse groups, more people will hold crypto assets in the future. These assets will flow into the on-chain environment and be utilized organically, thereby expanding crypto adoption.

For this funnel to be stably established and for the industry to grow organically, it is essential that: 1) exchanges, which are the initial points of taking crypto assets and can organically connect on-chain and off-chain environments, must fundamentally have a trustworthy (trustless) trading infrastructure, and 2) on top of this infrastructure, additional elements that enhance the trading experience—such as asset diversity, ample liquidity for each asset, and better price discovery—must be built in. This ensures that traders can quickly trade the assets they want at the desired prices - the pillars in the figure above represent the main factors that crypto exchanges should consider in order to achieve these two goals.

2. Hybrid Exchange Can Best Deliver the Crypto Trading Experience

However, it has not been easy to establish an exchange that meets all these conditions simultaneously. A prime example illustrating this challenge is the gradual collapse of FTX in 2022. FTX, which was the second-largest centralized crypto exchange (CEX) in the world at the time was mismanaged and inappropriately accounted for company assets and customer deposits by using them for loans and investments through Alameda Research, a hedge fund founded by FTX founder Sam Bankman-Fried. This underscored the critical importance of exchanges operating transparently and supporting customers in managing their assets directly (i.e., self-custody).

Another interesting point from this case is that, despite a temporary surge in interest in decentralized exchanges (DEX) due to the situation, the use of CEX soon returned to previous levels. This suggests that traders either found the trading experience on DEX significantly lacking and chose not to use them, or they ultimately preferred the more familiar and convenient trading experiences of CEX, valuing aspects such as price discovery and capital efficiency over security and transparency*.

*This concept is well known as the "exchange trilemma." The exchange trilemma refers to the difficulty a trading platform faces in simultaneously achieving more than two of the following characteristics: scalability, decentralization, and capital efficiency.

Exchanges capable of supporting a trustless trading experience should have more dominance to eliminate the unhealthy risks lurking throughout the industry but, if traders opt for choices that do not sacrifice their trading experiences, the remaining approach is to design a new market structure that continuously evolves to meet the needs of its users.

Exchanges built with this approach are called “Hybrid Exchanges (HEX)” and are gaining new attention. The core of HEX's infrastructure is to execute a series of trading logics such as order matching off-chain, and to have settlements that upload transaction records and balances on-chain. This way, it aims to take advantage of both CEX and DEX (or mitigate the shortcomings of each).

Certainly, the term "HEX" is still a relatively unfamiliar concept across the industry, and there is no unanimous consensus on its definition yet. For instance, some may refer to an exchange as a HEX simply because it allows the integration of non-custodial wallets with a CEX, or because it offers the experience of integrating order books from both CEXs and DEXs to enhance price matching algorithms. These may be parts of HEX, but as previously mentioned, considering the premise that the entire process of trading crypto assets should operate in a trustless manner, it seems somewhat inappropriate to label an exchange that offers such limited functionalities as a HEX.

3. Case Study: How Cube.Exchange Is Built from the Ground Up

3.1 Primer on Cube.Exchange

Source: Cube.Exchange

According to the preceding definition of HEX, Cube.Exchange stands out as the most well-established exchange in terms of infrastructure design. Cube.Exchange features an off-chain order matching system and an on-chain settlement powered by MPC technology. It was created with the vision of "building a compliant exchange for traders of all types and sizes.” As its name suggests, HEX requires a variety of experts from both the crypto and non-crypto sectors, covering technical and regulatory aspects. The founding members of Cube.Exchange are well-rounded, including key infrastructure developers from Solana and traditional finance sectors, as well as veterans in digital assets and regulations. Cube.Exchange is built on the core principles of transaction speed, security, and transparency, aiming to provide a trustworthy trading environment and an institutional-level trading experience.

3.2 Structure of Cube.Exchange

Cube.Exchange is structured differently from traditional exchanges as it is based on HEX. To help you better understand each component, let's first briefly go over the transaction flow on Cube.Exchange.

1. Create a Cube Client Account through OpenAI; other authentication methods will be supported in the future.

2. Complete the KYC process.

3. Users generate a collection of distributed keys that make up the ownership of the MPC Vaults with Cube.Exchange and entities called 'Guardians,' who are responsible for settling transaction histories on-chain.

4. Deposit assets into an MPC (Multi-Party Computation) Wallet within the MPC Vaults and place orders for desired assets on the centralized matching engine.

5. When orders are matched on the centralized limit order book, the corresponding order is reflected in the balance within the MPC Vaults.

6. After the order is verified by the Guardians, it is posted on the settlement layer called CubeNet.

7. The settlement layer calculates the collected settlements at specific intervals and transfers funds directly using a Threshold Signature Scheme (TSS) to appropriately distribute funds to the respective traders according to the net settlement - if the net settlement process is not completed within 48 hours, the user can be assisted in transferring funds from their MPC Vaults if they have provided a Key Share to the Guardians.

8. Once the signature sharing for transactions is completed, the settlement layer submits these transactions to each blockchain.

9. (The process for withdrawing assets is similar to steps 5-6.)

3.2.1 Scalability & Instant Finality

Solana App Chain and Web2 Technical Stack

The necessary processes for fiat currency linkage during deposits/withdrawals, KYC/AML processes, matching engine logic, multi-chain support, account management, and other key frontend features in the above transaction flow are mainly implemented off-chain using a combination of traditional Web2 technology stacks. Meanwhile, the custody and payment layer is separated from this stack and implemented as an app chain through a separate Solana Virtual Machine (SVM) module known as Solana Permissioned Environments(SPE)*. This dual-layered structure is essential because it allows the exchange to process each transaction in a trustless manner while ensuring immediate finality, thereby maintaining a seamless trading experience for traders.

* Currently, Cube.Exchange settles to Bitcoin, Ethereum, Dogecoin, Litecoin, Bittensor, Solana, virtually any Bitcoin fork, and plans to support more Layer 1 networks in the future.

Meanwhile, the settlement layer built through SPE ensures the transaction processing performance of Solana mainnet while allowing for customization of all aspects of the technical stack to best fit the protocol requirements. This includes the consensus mechanism, validator set, development framework, gas policies, and detailed business logic for regulatory compliance. This results in superior performance compared to other exchanges or protocols that adopt similar designs.

3.2.2 Self-Custody & Security & Transparency

Guardians & MPC Vaults (with Account Management)

The most powerful elements that enable Cube.Exchange to securely safeguard users' assets within the above structure are the introduction of MPC Vaults and the Guardian network.

Firstly, the user initiates DKG (Distributed Key Generation) with the guardians to jointly create an MPC vault in a dealer-less, trust-less, manner. Each participant of the DKG ultimately receives a ‘shard’ of the generated private key. This allows users to arbitrarily define the number of shards required to approve wallet transactions or to activate account recovery options with some of the shards. As seen in the transaction flow above, Cube.Exchange implements MPC technology in the form of MPC Vaults to manage users' funds. This ensures that the exchange's core functions, such as transactions and fund withdrawals, can be securely performed.

Cube.Exchange/ also supports a process through MPC Vaults to resolve situations where users have had some of their key shares stolen or lost. When such an event occurs, users can report it on Cube.Exchange. The loss information is then disclosed to the Guardian Council, and processes such as KYC are initiated to re-verify the user's identity. Upon successful completion of this process, a new Key Share or a new MPC Vaults is generated for the user. In the latter case, additional Key Shares are distributed to the Guardians and Cube.Exchange. The user's digital assets are also transferred from the previous MPC Vaults to the new one.

The Guardian Council is responsible for participating in almost all aspects of user transaction settlements and account management. They have the authority to prevent users from attempting to withdraw assets or to freeze the MPC Vaults in cases where the user is involved in illegal activities and their account is restricted by Cube.Exchange for some reason. Currently, the Guardian Council includes the Solana Foundation, Everstake, Triton One, JuicyStake, and Kiln*. Each Guardian earns a proportionate share of 5% of the net transaction fees as a minimum guaranteed amount for each net settlement event.

* The qualifications for becoming a member of the Guardian Council can be found in the Cube.Exchange litepaper.

3.2.3 Regulatory Compliance

Additionally, Cube.Exchange strictly enforces the KYC process for users to access all features on the platform. To operate its services legally in more jurisdictions, Cube.Exchange plans to comply with regulations and obtain necessary licenses - as of early this year, Cube.Exchange has met the relevant requirements or holds licenses in countries such as Poland, Canada, and Australia.

3.3 Other Key Features for Enhancing Trading Experiences

Source: Cube.Exchange

As previously mentioned, Cube.Exchange successfully combines the advantages of DEX and CEX, particularly relying on a robust HEX infrastructure that enables transactions to be completed instantly. Consequently, it is adding various features to ensure a trading experience that does not fall behind that of Web2 exchanges, including an improved UX/UI, enhanced capital efficiency, and better price discovery.

Gorilla Jump & King Maker

Source: Cube.Exchange

• Algos that enable automatic buying and selling of assets with a single click by pre-setting parameters that include preferred terms.

Bundles

Source: Cube.Exchange

• Enable users to trade sets of various assets grouped together based on specific criteria, facilitating efficient and scalable investment in particular asset classes.

Depth-chart trading & Equalizer

Source: Cube.Exchange

• Provide transparent insights into market conditions, aiding in better price discovery.

Reward system for community loyalty

Source: Cube.Exchange

• Users can earn points based on their activities within the platform, which can be exchanged for various rewards, including distributions from the listed token reward pools.

API access for developers & traders

• The platform offers an API that allows for the development of various tools and applications on the  Cube.Exchange infrastructure.

3.4 Challenges & Consideration

Cube.Exchange has been officially launched for less than six months, compared to other well-established exchanges in the industry. At this early stage, Cube.Exchange faces several key challenges and considerations.

First and foremost, securing user loyalty is crucial. Cube.Exchange must compete directly with already established CEX and DEX platforms. The concept of HEX is relatively new, and people are generally reluctant to move away from the exchanges they are accustomed to. Furthermore, for ordinary small investors, the concepts and procedures required to trade on HEX might seem complex and daunting compared to the perceived benefits.

Secondly, localization of the area where the service is to be implemented is also a crucial consideration. Localization here means thoroughly considering laws and regulations, language, culture, trends, and even login methods when launching the service in a particular country. Regulations, in particular, can vary significantly from one country to another, so HEX must flexibly adjust its operations according to the target market and be prepared to handle the ongoing complexities and operational costs that arise from this process.

Additionally, quickly listing trendy assets and continuously supporting them with ample liquidity is extremely important. Given the crypto industry's sensitivity to trends, having abundant liquidity and a diverse range of assets is one of the competitive advantages that can be relatively easily leveraged compared to other major exchanges.

Finally, ongoing management of asset types is a critical factor. Like any CEX, a HEX is responsible for listing and delisting tokens based on their own specific criteria, so traders must trust their decisions. Cube.Exchange should strive to establish trust with its users by transparently disclosing a reliable asset listing policy.

4. When Is the Prime Time for HEX? The Sooner the Better!

It has been almost 16 years since the advent of Bitcoin, which signaled the rise of blockchain technology, and nearly 10 years since the first appearance of smart contract platforms that have once again set the world abuzz. Observing the rapid evolution of crypto technology within this relatively short period, whether it becomes integrated into various institutional frameworks as an asset or supplements existing infrastructure as decentralized technology, it is increasingly clear that crypto technology is becoming more familiar in our daily life.

And regardless of any of these scenarios, it remains a fact that exchanges are the primary channels where the supply and demand of crypto assets first materialize. This presents two major implications for the industry's development - firstly, despite the ongoing discussions around stringent regulatory guidelines on a global scale, the ability of exchanges to conduct various businesses targeting a large user base suggests that they will continue to be the business model best suited to exploring product-market fit (PMF). Secondly, exchanges will inevitably bear significant responsibility and play a crucial role in the adoption and integration of the web3 industry into existing sectors. In other words, the exchange business is not only a highly competitive industry but also a vital area that connects off-chain and on-chain.

Currently, most crypto assets are primarily traded on CEXs due to their superior accessibility compared to others. Fundamentally managed by a single entity, CEXs must continuously adapt to the myriad regulatory guidelines that vary across countries. This constant need for adjustment incurs significant economic and temporal costs, particularly when trying to implement innovative initiatives that could connect with on-chain processes. To make matters worse, the influx of new users during this ongoing process is likely to be concentrated on CEXs, further burdening their infrastructure.

To create a more robust funnel from receiving crypto assets to utilizing them on-chain, innovation is needed at the initial stages of crypto adoption. The design of a HEX, which ensures a reliable and fast trading experience, can lay the foundation for more efficient development within the existing exchange market. Starting with current HEX platforms and Cube.Exchange, it is hoped that the term HEX becomes more widely recognized in this market, eventually sparking a wave of innovation in the dynamics of the crypto exchange industry.