The cryptocurrency sector has experienced significant advancements, but there is growing awareness among industry experts that exchanges, market makers, and custodians must operate as separate entities for businesses to succeed. This concept, commonly practiced in traditional finance, has often been overlooked in the cryptocurrency industry. It poses a major problem that the industry needs to address, as highlighted by Caitlin Long, CEO and founder of Custodia, a US bank specializing in digital assets. According to Long, the industry needs to segregate custodians to prevent incidents like the collapse of FTX, where the exchange accessed customer assets to solve financial problems.
The collapse of FTX serves as a prime example of the dangers of combining the roles of custodians, exchanges, and market makers. Margaret Rosenfeld, the chief legal officer at Cube.Exchange, explained that FTX’s downfall occurred because it acted as a custodian with its own market maker. When the market maker, Alameda Research hedge fund, began losing money, FTX accessed customer assets in an attempt to resolve the issue. This conflict of interest, known as “founder’s risk,” is prevalent in the cryptocurrency industry, as market makers are necessary for providing liquidity, but it creates significant concerns over the misuse of customer funds.
Fortunately, businesses in the cryptocurrency sector are learning from past mistakes and working towards better practices. Custodia, for example, is a segregated custodian that plans to connect with exchanges such as the New York Stock Exchange in the future. They aim to build integrations that ensure secure and regulated operations. Similarly, BitGo, a regulated digital asset custody provider, has been advocating for a market structure that separates custodial activities from trading. They established the “Go Network” settlement platform, allowing institutional clients to trade while keeping their assets in custody. This separation creates checks and balances to detect and prevent fraud, ensuring the protection of user funds.
Another crucial aspect of separating custodians from exchanges is de-risking the institutional market structure. Matt Ballensweig, the head of Go Network, explained that assets stay with BitGo Trust, a regulated bank, while APIs facilitate asset availability for trading on exchanges without physically transferring the assets. This partnership with exchanges like Bitstamp allows institutional clients to trade safely without taking undue risks. By keeping assets segregated from exchanges, the institutional market structure becomes less susceptible to operational risks and increases overall safety.
To further enhance security and customer control, Cube.Exchange leverages multi-party computation (MPC) wallets. This approach ensures that users remain the custodians of their assets, eliminating founder’s risk. When users want to buy, sell, or trade digital assets, Cube.Exchange uses APIs to enable such transactions while ensuring funds remain in users’ wallets. By employing advanced web3 technology, funds never pass through exchanges, enabling direct wallet-to-wallet transfers.
As the crypto space continues to evolve, it becomes crucial for each digital asset business to define its specific role and adhere to that structure. Ballensweig emphasized the importance of assigning tasks to the appropriate entities, allowing exchanges to focus on their trading roles and liquidity providers to specialize in providing liquidity. This delegation of responsibilities prevents situations like the collapse of FTX and ensures the efficient and secure functioning of the cryptocurrency sector.
Building a new market structure for the cryptocurrency industry requires significant effort and regulatory compliance. BitGo, for instance, not only prioritizes separating and securing assets but also aims to make assets usable for settlement, deployment to exchanges, and generating yield through partnerships with money market funds. Despite the challenges, dedicating time and resources to establish a robust market structure will yield positive results in terms of increased security and customer confidence.
The numerous debacles involving unregulated exchanges over the past 18 months have shed light on the toxicity of their business models. Yves Longchamp, the head of research at AMINA, a licensed Swiss crypto bank, emphasized that customers’ assets were not segregated from the exchange’s balance sheet, resulting in the downfall of both the exchanges and customers’ liquidity. These incidents highlight the necessity of implementing regulated practices and separating the roles of custodians, exchanges, and market makers.
It is imperative for the cryptocurrency sector to recognize the importance of separating exchanges, market makers, and custodians. By doing so, the industry can establish a stronger and more secure market structure that safeguards user funds and prevents conflicts of interest. Businesses like Custodia, BitGo, and Cube.Exchange are taking the lead in adopting these practices and setting a new standard for the industry. As the crypto space continues to evolve, implementing these changes will contribute to the long-term success and sustainability of the sector.
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