The cryptocurrency sector is growing rapidly, but there is a critical issue that many industry experts are now acknowledging – the need to separate exchanges, market makers, and custodians as separate entities. While this practice is common in traditional finance, the cryptocurrency industry has often overlooked it. Caitlin Long, CEO and founder of Custodia, a chartered U.S. bank specializing in digital assets, emphasized that this is a major problem facing the industry. She believes that custodians, in particular, should be segregated to prevent incidents like the collapse of cryptocurrency exchange FTX from happening again.
Margaret Rosenfeld, Chief Legal Officer at Cube.Exchange, a hybrid crypto exchange, pointed out that the collapse of FTX occurred because the exchange acted as a custodian with its own market maker. When Alameda Research hedge fund started losing money, FTX accessed its customer assets in an attempt to solve the problem. This combination of roles creates a conflict of interest and exposes customers’ funds to risks.
Fortunately, businesses in the cryptocurrency sector are learning from past mistakes and implementing better practices moving forward. Custodia, for example, is a segregated custodian and plans to integrate with venues like the New York Stock Exchange in the future. This approach ensures that customer assets remain separate and protected. BitGo, a regulated digital asset custody provider and financial services company, has been advocating for a market structure that fully separates custodial activities from trading. They established the “Go Network” settlement platform, allowing institutional clients to trade while their assets remain in custody. This helps prevent fraud and safeguards user funds.
Keeping trading and custody separate creates a system of checks and balances that keeps digital assets safe. It reduces risks associated with misusing customer funds and prevents situations like the collapse of FTX. By delegating specific tasks to specialized entities, exchanges can focus on their role, and liquidity providers can focus on providing liquidity. This division of responsibilities prevents conflicts of interest and ensures that each entity performs its task effectively.
Various cryptocurrency businesses are developing new solutions to separate custodians from exchanges and other financial entities. Cube.Exchange, for example, leverages a multi-party computation (MPC) wallet to ensure that users remain the custodians of their assets. They don’t take custody of assets, eliminating the founder’s risk associated with exchanges. With advanced web3 technology, users can buy, sell, or trade digital assets directly from their wallets, bypassing exchanges and minimizing risks.
Building a new market structure for the cryptocurrency sector is not an easy task. It requires hard work, optimization for the separation and security of assets, and the development of utility elements for settlement, deployment to exchanges, and yield generation. However, the effort will likely pay off in the long run. Unregulated exchanges have shown that their business models were toxic, as customers’ assets were not segregated and were at the disposal of the exchange. By implementing a regulated and segregated structure, the industry can ensure the safety and liquidity of customer assets.
The cryptocurrency industry must recognize the critical importance of separating exchanges, market makers, and custodians as separate entities. Lessons from past incidents like the collapse of FTX highlight the risks of consolidating these roles. By implementing segregation, developing new solutions, and building a regulated market structure, the industry can safeguard customer assets, prevent fraud, and create a more secure and efficient environment for cryptocurrency trading and investment.