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. This concept has often gone overlooked within the cryptocurrency industry, with market makers, exchanges, and custodians often operating as the same entities. This lack of separation has led to major problems, as seen in the case of the collapse of cryptocurrency exchange FTX. When the market maker on the exchange, Alameda Research, began losing money, FTX accessed its customer assets in an attempt to solve the problem. Such a situation creates a conflict of interest and puts customer funds at risk.
Fortunately, businesses operating within the cryptocurrency sector are paying attention to previous misshapes to ensure better practices moving forward. For example, some companies are taking steps to segregate custodial activities from trading. Custodia, a chartered U.S. bank specializing in digital assets, plans to plug into venues like the New York Stock Exchange in the future while maintaining segregation as a custodian. BitGo, a regulated digital asset custody provider, has established a settlement platform called “Go Network” to allow institutional clients to make trades while their assets remain in custody. By keeping custody and trading separate, these companies aim to provide checks and balances to detect and prevent fraud, while ensuring the protection of user funds.
BitGo’s Go Network serves as a solution to make customer assets usable on exchanges without having to send assets to the exchanges themselves. Assets stay with BitGo Trust, a regulated bank, while APIs are used to make assets available for trading on exchanges without physically moving the assets. This approach reduces operational risk and keeps assets segregated from exchanges. Other companies like Cube.Exchange leverage multi-party computation (MPC) wallets to ensure that users remain the custodians of their assets. Funds never go through exchanges but are moved directly from wallet to wallet using advanced web3 technology, minimizing risk.
As the crypto space advances, it’s crucial for each digital asset business to take on a specific role and stick to that structure. Exchanges should focus on exchange-related activities, while liquidity providers should handle liquidity provision. By delegating tasks to those best suited to handle them, the risk of conflicts of interest and mishandling of customer funds can be minimized. This is an important step in preventing situations like the collapse of FTX from happening again.
Building a new market structure for the cryptocurrency sector requires time and effort. Regulated custodians must not only optimize the separation and security of assets but also make assets usable for settlement, deployment to exchanges, and yield generation through partnerships with money market funds. Despite the challenges, the results will likely pay off. The various crypto exchange debacles of the last 18 months have shown that the business models provided by unregulated exchanges were toxic. Segregating customer assets from the exchange’s balance sheet is essential to protect the market and the liquidity of customers.
The cryptocurrency industry needs to recognize the importance of separating exchanges, market makers, and custodians as separate entities. By keeping these roles distinct and implementing checks and balances, businesses can better protect customer funds and prevent conflicts of interest. As the industry continues to evolve, it’s essential to learn from past mistakes and adopt better practices to ensure the long-term success and stability of the cryptocurrency sector.