Crypto exchange tokens have emerged as a significant innovation in the cryptocurrency sector, providing centralized crypto exchange platforms with a way to raise funds.

However, these tokens and schemes also come with significant risks and challenges, particularly concerning market manipulation and the financial implications of buyback pledges, a new paper by the Bank for International Settlements (BIS) says.

The paper, released on July 25, examines the role of crypto exchange tokens and their broader impact on the crypto market. It analyzes the state of the sector, focusing on the primary characteristics of these tokens, their promises, benefits and the challenges they present.

The rise of crypto exchange tokens

Crypto exchange tokens are blockchain-based assets issued by crypto exchanges to support and enhance their platforms.

Prominent examples include Binance’s BNB and the FTX’s controversial FTT.

These tokens often provide their holders with discounts on transaction fees, access to certain premium platform services, and higher staking rewards.

The most common scheme is to offer traders a discount if they use the tokens to pay for fees on the trading platform.

Another popular scheme is to require traders to maintain a certain dollar amount of tokens to qualify for discounts. Some exchanges may also offer alternative benefits such as lotteries or advance access to offerings of new tokens.

A key feature of crypto exchange tokens is the buyback pledges where the issuer promises to repurchase tokens using a share of their revenues.

Such pledges are designed to make exchange tokens more attractive to investors by reducing future token supply and driving price appreciation.

Crypto exchange tokens often form the backbone of several of the largest crypto exchanges. They act as an important funding source for centralized crypto exchanges, and support the launch or continued operation of these exchanges.

Crypto exchange tokens rose in popularity in 2021 with many of the world’s largest centralized crypto exchange having launched their own tokens to raise funding or to foster customer loyalty. At times, exchange tokens have had a combined market value that exceeds US$100 billion.

Disruptions and scandals

Despite their benefits, crypto exchange tokens have been at the core of some of the biggest scandals and disruptions in the crypto industry.

For example, in 2019, crypto exchange Bitfinex launched a token called UNUS SED LEO (LEO) after losing US$850 million held by its Panama-based payment processor, Crypto Capital Corp.

The issuance, which successfully raised approximately US$1 billion in just ten days, was met with significant controversy and skepticism, with critics arguing that the token launch was a means for Bitfinex to mask its financial issues without addressing the underlying problems.

Another example is the FTX exchange and its FTT token. FTX was a cryptocurrency exchange founded in 2019 that quickly became one of the largest and most influential exchanges in the world. FTT was the native utility token of the FTX exchange used for various purposes, including fee discounts and as collateral for trading.

The token played a significant role in the collapse of FTX by creating a false sense of financial stability and masking underlying vulnerabilities. When doubts about FTX’s financial health surfaced, the value of FTT plummeted, triggering a liquidity crisis.

The risks and challenges associated with crypto exchange tokens

The BIS paper identifies several risks and challenges associated with crypto exchange tokens. One of the main risks is the high cost of buyback programs.

Buyback pledges, where an exchange commits to repurchasing its tokens, can potentially make crypto exchange tokens more appealing to investors and increase the amount of funds the exchange can raise.

However, the cost of a buyback program may be higher than the return required by investors. This wedge may make conventional capital markets a more cost-effective funding source compared to token issuance and their buyback pledges.

Another significant challenge highlighted by the BIS is the risk of market manipulation. Investors may take advantage of an exchange’s buyback commitment by manipulating the supply of tokens the issuer can repurchase. Manipulation of the token supply by investors can increase the cost of buyback pledges to exchanges even further.

For example, a large investor could potentially benefit by restricting the number of tokens available to other market participants by permanently freezing (or “burning”) part of their token holdings so that the exchange would be prevented from ever completing the buyback program.

Such an action would force the exchange to continue the buyback program ad infinitum, while continually driving up the price and the market capitalization of the tokens.

Crypto exchange tokens are an expanding market that’s dominated by BNB, the token of the Binance exchange. BNB is primarily used to pay for trading fees on the Binance platform, offering users discounts compared to using other payment methods.

Beyond fee discounts, BNB also serves various functions within the Binance ecosystem, including participation in token sales on the Binance Launchpad and transactions on the Binance Smart Chain (BSC).

BNB currently has a market capitalization of more than US$76.7 billion, making it the fourth largest cryptocurrency in the world, behind only bitcoin, ether and tether, data from Coinmarketcap show.

Featured image credit: edited from freepik