The past 2 months have been chaotic for the digital asset industry, with the world’s second largest exchange having fallen and around 8 billion dollars worth of assets lost. Trust in the industry has been compromised, and it is now up to strong players to collaborate and act to restore confidence. However, doing so will not be easy – both exchanges and other critical service providers like custodians need to work together to take the right steps, with the united goal of improving user protection.
How do we rebuild and reaffirm trust in centralized exchanges (CEXs)?
One of the biggest outcomes of the FTX fallout for the digital asset industry has been the demand for increased transparency from centralized exchanges. For starters, users and institutions are demanding proof of reserves and liabilities, and exchanges specifically must adopt stringent third party auditing procedures. Global exchanges such as Binance and OKX have already taken these first steps, but there is more that can be done in order for such firms to maintain their competitive positions in the market.
In general, there are two models that CEXs can follow. The first option would be for exchanges to continue being centralized while following strict rules and guidelines as modeled by traditional finance. Such rules/guidelines would include asset segregation and financial auditing. The second option would be to integrate the advantages of blockchain technology/DeFi with the CEX model to create a hybrid model. This would result in products such as escrowed smart contracts, decentralized clearing processes, and ultimately a space where exchanges are merely intermediaries to digital assets with clients in full control of their own assets.
It seems the most likely path from this point is the hybrid model – where exchanges integrate the advantages of decentralized technology as part of their business model. Although this model already does exist in the form of decentralized exchanges (DEXs), many users remain skeptical due to technology or security related concerns, and DEXs have not earned the trust of the entire crypto ecosystem just yet. With industry development however, users will eventually feel safer and protected interacting with such platforms, and this hybrid model could become the new norm. Not only would this benefit retail users, it would also positively impact institutional investors as well as counterparties involved with exchanges.
What does the relationship between custodians & CEXs moving forward look like?
Moving forward, it is necessary for CEXs to collaborate with independent licensed custodians. Although exchanges have traditionally also provided custodial services aside from many other services, repeated incidents such as FTX have shown the need for exchanges to start outsourcing particular services. At this stage of the market, both CEXs and custodians must understand each other’s business models with the united goal of providing the best possible client experience and protection.
Several exchanges have already started collaborating with independent digital asset custodians to offer a safer experience to their users. OKX, for example, states plans to integrate several independent custodians for clients to choose from when trading on their platform. For other exchanges to regain consumer confidence and maintain market share, it is important that they follow the same path towards transparency and security. Integrating the technology with a smooth user experience will take time, but it will be necessary in response to market demand.
What do custodians provide to institutional as well as retail investors, and what does it mean to be a qualified custodian?
The custodian business model has existed for a long time – as long as traditional finance itself. However, being a qualified custodian, especially in the digital asset space, can mean a very different thing. A qualified custodian ensures that its clients’ assets are always protected no matter the circumstances, by adhering to strict procedures and policies, as well as having safety net layers for worst case scenarios. Some criterias to consider when evaluating a digital asset custodian include legal and technological asset segregation practices, provision of 1:1 proof of custody systems, and the adoption of appropriate insurance policies.
When one’s assets are held in custody, these assets remain under the respective individual’s ownership – meaning, these assets are never a part of the custodian’s balance sheet. Most individuals are not aware that when they deposit their funds into an exchange, they essentially become the exchange’s unsecured creditors, with their funds being recorded as part of the exchange’s balance sheet. This same issue is also what has caused the fall of big firms this year such as FTX, Three Arrows Capital and Celsius.
Investors can rest assured that when their assets are held in custody by a licensed service provider, the ownership of their assets are never transferred. Additionally, the assets can never be used for purposes other than what the investor instructs.
Institutional investors in particular usually hold a significantly large amount of funds which calls for additional precautionary measures. Large AUMs are not only more difficult to manage, they can also easily become targets of internal/external attacks too. Such investors need to outsource digital asset professionals to custody their assets on their behalf, and eliminate all/most risks associated with the ecosystem. It is additionally beneficial if the custodian they work with flexibly adapt to the rapidly changing market, and make the assets available to the institutional investor when needed.
What does institutional interest in both CEXs and custodians look like today?
The influx of institutions that have entered the digital asset ecosystem this year alone shows interest remains high – if anything, they’re seeing current conditions as a good time to explore digital assets. However, they are taking the required steps to adjust to on-going market events. Institutional investors, just like retail ones, are putting more pressure on exchanges for increased transparency, and in general are looking for ways to lower counterparty exposure in the market.
With the recent turn of events, independent licensed custodians like Hex Trust are seeing high inflows of clients who wish to firstly transfer their assets (previously held on exchanges) to cold storage solutions. Other highly demanded services include fiat custody and OTC services to minimize settlement risks. Institutions in particular, are in need of trustworthy and credible custody service providers as they often hold significantly larger amounts of funds.
How should digital asset firms engage with regulators in the short & long term?
As industry professionals, digital asset firms should see it as their responsibility to consistently educate and communicate with regulators. Implementing rules and policies for a new asset class comes with a string of challenges, and knowledge of best practices and required procedures, as well as how blockchain technology can be leveraged to increase transparency, mitigate risks or implement asset segregation, should come from digital asset firms themselves.
Just like traditional finance, regulators need to understand the need for independent custodians in the blockchain space. Particular jurisdictions are still behind on understanding this need, or the need for separate regulatory regimes for custodians themselves. These regulations should be in place not just to control the companies in the industry, but more with the motive of creating a user-centric protection mechanism.