In the cryptocurrency industry, everyday words take on a whole new meaning.
A cryptocurrency is not really a currency as the word is usually defined, it’s more of an asset. The term ”cryptocurrency custody” refers to safekeeping, bookkeeping, holding funds, or any combination of the three. Furthermore, “cryptocurrency exchanges” do not really function as traditional exchanges, but rather as a combination of an exchange, clearing house, custodian, and prime broker.
Be aware of what to expect from cryptocurrency exchanges, because it will likely differ greatly from what you would experience with a traditional exchange.
There are two types of exchanges: decentralized and centralized. While we tackled the issues with decentralized exchanges in a previous article, this time we will be directing our attention to explaining how a centralized exchange actually works.
What is a centralized exchange:
Today’s blockchain industry is a marketplace where the exchange acts as a trusted third party. More specifically, centralized exchanges take on the role of custodians of users funds, as opposed to decentralized exchanges, where clients hold their own funds.
A typical centralized exchange, which holds the fiat and the crypto-assets of its clients, can be considered both an exchange and a custodian. Because they are intermediaries between all buyers and sellers, they also act as central clearing houses. Last but not least, for those exchanges that provide tools for leverage and margin trading, they are functioning as a prime broker.
Today, most people that would like to convert their fiat to digital assets must go through centralized exchanges, as they have become the conventional gateway into the world of crypto.
What’s the big deal?
For a lot of people, allowing a cryptocurrency exchange to hold their funds is okay. But that’s not even an option for certain types of investors, including institutional investors.
The main issue is the counterparty risk of centralized custody.
How it works:
Using a centralized exchange means that when you’re depositing funds into your account at the cryptocurrency exchange, you’re literally “giving” it money — your cash goes from your bank account directly to the exchange’s bank account, and your Bitcoins go from your wallet to a wallet controlled by the exchange. What you see as your balance is actually the result of a database entry updated by the exchange itself: all the funds in the exchange are commingled — often with the exchange’s own funds — and the cryptocurrency exchange is the only source of truth when it comes to clients’ balances.
In summary, centralized exchanges hold their clients’ funds under their name, yet they maintain full power over them. Client fiat funds sit in bank accounts owned by the exchange, under which they have power of attorney, almost giving them unilateral control.
Meanwhile, their clients’ cryptocurrencies are essentially combined and stored within large wallets (see the example of Kraken, etc).
Essentially, an exchange is one large bank account under the exchange’s name, one large wallet controlled by the exchange, and a centralized internal database that holds the balances.
This last component is critical: the fact that all the funds are pooled together in a bank account and/or a cryptocurrency wallet makes it the exchange’s responsibility to be the keepers of the records of ownership.
By maintaining the balances within this database, the exchange issues IOUs which are tradable between the different actors of the exchange and redeemable when they want to withdraw their funds.
However, this is where it gets tricky. As a trader, you never really own the funds you leave on the exchange — remember, they are held either in a bank account or a wallet which belongs to the exchange. You only truly get full ownership of your cash or coins once you withdraw them from the exchange. The amount of funds you can withdraw is subject to what the internal database maintained by the exchange tells you to have. And that’s a huge risk.
Hacking a centralized cryptocurrency exchange: behind the scenes
When you hear of an exchange being hacked and funds being stolen, it’s actually very often that this database holding the balance is getting hacked and tampered with. A thief manages to get access to the database, changes its balances and withdraw the funds. Easy. A centralized exchange hack has most of the time nothing to do with the blockchain technology: it is simply the hack of an internal balance holding all the funds of the clients.
That’s a huge counterparty risk for investors, institutional or not.
An odd legal framework …
This setup is reflected in how cryptocurrency exchanges are regulated — if they are at all. In the US, they are regulated either as:
- A Limited Purpose Trust Company, i.e. a bank which cannot lend to its client but can store their funds. Ex: Gemini, ItBit
- A Money Transmitter, i.e. a company which transmits funds from one client to another. Ex: Coinbase, BitFlyer US
In addition, cryptocurrency exchanges operating in the state of New York or with New York residents must register with the NY Department of Financial Services and get a BitLicense.
We are very far from a traditional exchange regulatory system (National Exchange license or Alternative Trading System license, both delivered by the SEC) for the simple, but incredibly important reason that cryptocurrency exchanges hold their clients’ funds, while traditional securities exchange do not.
…for an odd financial structure
The basis of modern financial markets is the mitigation of counterparty risk. Ever since the Securities Act of 1933, modern finance has put in place barriers to the risk one investor takes when trading with a structure, in order to favor investments and allow the financial markets to grow and blossom.
In particular, the financial markets have pushed for three very important concepts:
- Only appropriate entities should hold funds and financial instruments on behalf of clients. Those entities are banks and qualified custodians. Their processes are designed to keep their clients’ assets safe from loss or theft, and these entities are heavily regulated and controlled.
- Counterparty risk should be centralized on one or several dedicated entities known as clearing houses. A Central clearinghouse has one job in secondary markets: centralizing the counterparty risk buyer A can have towards seller B by being the middleman in the transaction. By no means, a traditional exchange takes this responsibility and risk. Clearing houses are controlled by incredibly strict risk metrics and heavily regulated, as they are at the center of the whole stability of a financial market.
- All transaction data should be reconciled by a second source of truth.Just like the Bitcoin network allows trustless interactions, organized financial markets allow you — in theory — to make transactions with anyone without risking this person to not deliver their part of the trade. As such, exchanges, clearing houses and custodians spend a lot of time and energy reconciling each other’s data and making sure that transactions are correct. This ensures an investor pays the right price in a trade, and is not getting fooled by any of the participants in the trade lifecycle
The precise reason why these three rules were implemented in the traditional markets is to protect investors and allow them to trade without being afraid of losing their principal — which is essentially what is happening today in the cryptocurrency market.
Looking at how the current market is structured:
- Five-year-old companies are holding billions of dollars worth of funds on behalf of customers
- Counterparty risk is centralized by companies which are executing trades, holding funds, providing financing and leverage and trading for their own accounts on their platform
- There is only a single source of truth when it comes to trading on exchanges
No wonder then that institutions are cautious about cryptocurrency trading with the current setup; The risk is enormous.
The solution: a hybrid system
While replicating traditional financial markets would be a waste of the advantages blockchain-based assets like Bitcoin provide, trading platforms should adopt the market structure and the different processes of the financial industry in order to bring institutional investors to the market.
This has been LGO Markets’ mission and goal since the beginning. We have built a digital asset trading platform which leverages the benefits of the blockchain technology and the safeguards of the traditional financial infrastructure at the same time. In particular:
- LGO Markets is a non-custodial trading platform: we are not holding our clients’ funds in any manner
- We have built a traditional T+1 post-trade settlement process, where the proceeds of a trade are in the clients’ own accounts and wallets within one day
- Our order book is provably transparent thanks to the blockchain technology
- The trade process is exactly the same as for any other traditional markets: trades are executed on LGO, and cleared and settled with our regulated partners. Funds are stored at third-party custodians.
Neither centralized nor decentralized, LGO’s infrastructure allows institutional investors to trade digital assets without having any counterparty risk, using the same processes they have always had trading other assets, and with a provably transparent price.
Centralized exchanges are not a viable solution for institutional investors who wish to enter the cryptocurrency market. The counterparty risk of centralized custody of their assets is too large.
LGO will bring together the benefits of both decentralized and centralized exchanges in a unique hybrid exchange. We will prevent any type of crypto hack or theft by giving our users full control of their funds. This new asset management approach will enable LGO to renew institutional investors’ confidence in the crypto market by being demonstrably fair and in compliance with traditional financial standards.