The cryptocurrency sector may be advancing, yet industry experts are becoming aware that exchanges, market makers, and custodians must act as separate entities in order for businesses to succeed. In traditional finance, it’s common to keep financial actors separated, but this concept has often gone overlooked within the cryptocurrency industry. The collapse of cryptocurrency exchange FTX serves as a stark reminder of the risks associated with not separating these entities. It is crucial for the future growth and stability of the industry that market makers, exchanges, and custodians operate independently.
Many individuals within the cryptocurrency space are unaware of how unusual it is for market makers, exchanges, and custodians to operate as the same entities. This creates a major problem as it blurs the lines between different roles and increases the risk of misuse of customer funds. The collapse of FTX occurred because the exchange acted as a custodian with its own market maker. When the market maker started losing money, FTX accessed its customer assets in an attempt to solve the problem. This conflict of interest exposes customers to unnecessary risks and undermines the trust and stability of the entire ecosystem.
Market makers are crucial for providing liquidity to crypto exchanges, but this also creates a conflict known as “founders’ risk.” If someone is going to be a custodian of customer assets, the platform must be a highly regulated entity to ensure that those running the business will not misuse customer funds. It is essential to establish a regulatory framework that separates custodial activities from trading, providing the necessary checks and balances to detect and prevent fraud and protect user funds.
Fortunately, businesses operating within the cryptocurrency sector are learning from past failures and taking steps to ensure better practices moving forward. Custodia, a chartered U.S. bank specializing in digital assets, is a segregated custodian that plans to integrate with venues like the New York Stock Exchange. This segregation of roles ensures that customer assets are protected and reduces the potential for misuse.
BitGo, a regulated digital asset custody provider and financial services company, has been advocating for the separation of custodial activities from trading for years. They have established the “Go Network” settlement platform to allow institutional clients to trade while keeping their assets in custody. This approach prevents assets from moving frequently on-chain, reducing operational risk and enhancing overall security.
Many crypto businesses, including BitGo, are working towards the goal of keeping custodians separate from exchanges and other financial entities. By leveraging technologies such as multi-party computation (MPC) wallets and advanced web3 technology, these businesses ensure that users remain the custodians of their assets. Cube.Exchange, for example, enables users to buy, sell, and trade digital assets directly from their wallets, without going through exchanges. This approach eliminates the risk of founders’ misusing customer funds and enhances overall transparency and security.
As the crypto space continues to advance, it is crucial for each digital asset business to adopt a specific role and stick to that structure. Exchanges should focus on providing a platform for trading, while liquidity providers should solely focus on providing liquidity. By delegating specific tasks to specialized entities, the industry can prevent situations like the collapse of FTX from happening again.
However, building a new market structure for the cryptocurrency sector is not an easy task. It requires hard work and dedication to optimize the separation and security of assets while also ensuring their usability for settlement and yield generation. Despite the challenges, the results will be worth it, as the various crypto exchange debacles of the last 18 months have shown that the business models provided by unregulated exchanges were toxic. Customer assets were not segregated, and exchanges had control over such assets, ultimately leading to the downfall of exchanges and the loss of customer liquidity.
It is essential for the cryptocurrency industry to recognize the importance of separating custodians, exchanges, and market makers. By doing so, businesses can ensure the protection of customer funds, enhance transparency and security, and improve the overall stability of the ecosystem. The lessons learned from past failures serve as valuable reminders of the risks associated with not adhering to these principles. Moving forward, regulatory oversight and the adoption of specialized roles will be key in building a robust and trustworthy cryptocurrency market.