Learning from FTX: The Necessity of Self-Custody and Hybrid Exchanges in Crypto
As an analyst looking back at the aftermath of the FTX collapse and the ensuing media frenzy, it has become apparent that this event brought about unforeseen and far-reaching consequences for our industry. The harsh reality is that this incident served as a catalyst in exposing the inherent flaws of centralized exchanges (CEXs). Moving forward, how we address these issues will shape the future of our market.
If we don’t make significant improvements, the new monetary system will merely replicate past errors. It’s crucial for our sector and developing technologies to demonstrate to the world that effective decentralization can be achieved.
Compliance is the starting point
As a researcher studying the financial industry, I cannot stress enough the importance of taking heed from the FTX case regarding the risks of disregarding corporate compliance. One key takeaway from this situation is the necessity for improvement in this area. We must be more diligent in monitoring financial transactions and ensuring that exchanges are built on a sturdy foundation. With over $9 billion worth of customer funds missing from FTX, it’s clear that greater attention to regulatory frameworks and compliance procedures is essential. By implementing stronger measures, we can establish trust and security for the continued growth of the CEX market.
As an analyst in the wake of the FTX debacle, I firmly believe that prioritizing compliance and transparency is crucial for any organization. The FTX incident serves as a stark reminder of the importance of robust corporate governance. This includes implementing effective cash controls, adhering to HR protocols, establishing approval mechanisms, ensuring accurate financial reporting, and conducting both internal and external audits. By doing so, we can minimize risks, build trust with stakeholders, and maintain a strong reputation in the industry.
Yet better regulation is just a good start.
Regulation alone is not enough
After FTX’s downturn, legitimate exchanges accelerated their marketing efforts for their regulated custodial solutions. In the US, these exchanges are required by law to keep customer assets separate from their own funds to guarantee that the funds are used only in accordance with users’ permissions.
Regulators are becoming more rigorous in implementing new rules, but this doesn’t completely eliminate risks. Traditional finance, with its stringent regulations intended to prevent centralized collapses, has still experienced numerous cases of mismanaged risk. The failures of Bear Stearns, Lehman Brothers, and more recently, Credit Suisse, serve as stark reminders of the perils of over-relying on human intervention.
Simplifying this, regulation by itself may not be sufficient. Malicious entities can still cause significant damage if they have direct control over the financial resources.
Self-custody is the key
A key takeaway from the industry that’s often debated is self-custody of Bitcoin. The Bitcoin whitepaper serves as a reminder of the fundamental concept: if you hand over your private keys to exchanges or other intermediaries, you lose control over your digital assets.
Previously viewed as a trustworthy cryptocurrency exchange, FTX was known for its efficient operations and secure environment for transactions. It had gained a favorable reputation within the industry and was highly regarded. However, behind the scenes, there existed a hidden loophole. Alameda Research, the trading firm associated with FTX’s collapse, could access a clandestine exit allowing them to withdraw vast sums of customer funds. While advantageous during market upswings, Alameda’s extensive use of leverage intensified losses in bearish conditions. Confronted with margin calls during the crisis, disposing of collateral posed a significant risk for substantial value depreciation.
The sudden and unexpected downfall of the world’s second-largest cryptocurrency exchange, FTX, left a significant mark on investors. The exchange, once highly regarded, experienced a dramatic turnaround in fortune almost overnight. The public’s attention was drawn to this development due to the negative optics and extravagant marketing expenses of FTX.
Regrettably, the transparency that came with FTX’s operations misleadingly gave customers the belief that their investments would be safeguarded from risky maneuvers akin to those employed by Alameda Research. Contrarily, the SEC revealed after FTX’s bankruptcy that FTX had effectively granted Alameda Research an open-ended credit line, resulting in substantial losses for retail investors in FTX, amounting to billions of dollars.
As a crypto investor, I’ve learned a painful lesson: keeping your cryptocurrencies on any and every centralized exchange comes with risks. It was just as shocking as it was damaging to realize this. The evidence became clear when numerous platforms abruptly halted withdrawals without prior notice due to the threat of a bank run. In these situations, everyone rushes to withdraw their funds at once, but the centralized exchange, acting like a traditional bank in this scenario, cannot handle the overwhelming demand.
Self-custody is crucial because it allows you to maintain full control over your assets, minimizing the risk of losses. However, if a crypto exchange collapses, retail investors should expect more than just a fraction of their assets after a long wait. They deserve instant access to their entire crypto holdings at any given moment. Although regulation and compliance are essential for exchanges, innovative approaches are arising, combining centralized funds management with self-custody solutions.
Shifting the paradigm with hybrid models
Regulations cannot completely safeguard financial platforms from collapsing. This is because users relinquish control of their assets to trusted third parties in regulated exchanges for safekeeping. Nevertheless, the potential for a significant transformation lies within reach. Could decentralized exchanges (CEXs) provide fully self-custodial solutions instead? This way, users would retain complete control over their assets without relying on intermediaries.
As a market analyst, I’ve observed an intriguing development in the crypto space: the rise of hybrid exchanges. These platforms represent a thoughtful fusion of centralized (CEX) and decentralized exchanges (DEX). By combining their strengths, we can foster innovation and enhance security for assets.
In a more natural and easy-to-read way: The hybrid exchange model offers a significant solution by combining trustless risk management and self-custody through code instead of human intervention. This approach addresses concerns and ensures effective risk management. Hybrid exchanges provide regulatory compliance along with decentralized features, enabling users to interact directly with cryptocurrencies using smart contracts in secure wallets. The users retain control over their funds without the need for custodians. All these functionalities are accessible through user-friendly interfaces similar to CEXs, leading to an advanced trading system that eliminates the vulnerabilities of both CEXs and DEXs, making hybrid crypto exchanges potential game-changers in the industry.
A wake-up call for crypto
During the ongoing FTX trial, it’s important to remember that upheavals like this are not uncommon in various industries. For instance, the financial sector, including Wall Street, has faced comparable scandals and crises in the past. Recall the Enron Scandal and Bernie Madoff Ponzi Scheme from the early 2000s.
Despite serving as custodians in the crypto industry, we cannot disregard this incident as merely a technical glitch. Scandals of this nature can significantly harm our industry’s reputation, hindering our progress. The crypto sector is continuously developing and improving, but it’s essential to explore more refined solutions.
Hong Yea serves as the founder of GRVT, a cryptocurrency exchange that empowers users with self-custody. Prior to establishing GRVT, he held significant roles at prestigious financial institutions: serving as an executive director at Goldman Sachs and a banking associate at Credit Suisse for over nine years in total.
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2024-04-28 16:28