The Need to Separate Exchanges, Market Makers, and Custodians in the Cryptocurrency Industry

The cryptocurrency sector is evolving rapidly, but industry experts are realizing the importance of separating exchanges, market makers, and custodians for the success of businesses. Unlike traditional finance, where financial actors are typically kept separate, the cryptocurrency industry has often overlooked this crucial aspect. This article analyzes the challenges posed by the lack of separation and highlights the steps that businesses are taking to address this issue.

The Problem of Operating as the Same Entity

Caitlin Long, CEO and founder of Custodia, a chartered U.S. bank specializing in digital assets, emphasizes that many individuals in the cryptocurrency space are unaware of how unusual it is for market makers, exchanges, and custodians to operate as the same entities. This lack of segregation can lead to significant problems, as demonstrated by the collapse of the cryptocurrency exchange FTX.

According to Margaret Rosenfeld, chief legal officer at Cube.Exchange, FTX’s downfall occurred because the exchange acted as a custodian with its own market maker. When the market maker, Alameda Research hedge fund, started losing money, FTX accessed its customer assets in an attempt to solve the problem. This conflict of interest between being a custodian and a market maker highlights the need for separation to protect customer funds.

Fortunately, businesses in the cryptocurrency sector are taking note of previous mishaps and aiming to implement better practices. Custodia, for example, is a segregated custodian with plans to integrate with venues like the New York Stock Exchange in the future. This demonstrates a commitment to separation while still offering access to exchanges.

BitGo, a regulated digital asset custody provider, has been advocating for a market structure that fully separates custodial activities from trading. To achieve this, BitGo established the Go Network settlement platform, which allows institutional clients to make trades while their assets remain in custody. By keeping assets segregated from exchanges and minimizing on-chain movement, BitGo reduces operational risk.

Maintaining Custodial Independence

Cube.Exchange leverages a multi-party computation (MPC) wallet to ensure that users retain custodial control of their assets. The exchange does not take custody of assets, eliminating the founder’s risk. To facilitate buying, selling, or trading digital assets, Cube.Exchange uses APIs that enable direct wallet-to-wallet transfers using advanced web3 technology. This approach maintains control and security while avoiding exposure to exchange vulnerabilities.

The Importance of Defined Roles

As the cryptocurrency space progresses, it becomes crucial for each digital asset business to assume a specific role and adhere to that structure. Exchanges should focus on their core function, while liquidity providers play their role effectively. This delegation helps prevent incidents like the collapse of FTX by ensuring that tasks are handled by those equipped to handle them.

Building a New Market Structure

However, creating a regulated custodian that provides utility services requires significant effort. The focus must shift from merely securing assets to making them usable for settlement, deployment to exchanges, and yield generation through partnerships with money market funds. Building a new market structure for the crypto sector takes time and dedication, but it is necessary to prevent future debacles.

The numerous crypto exchange failures in the past 18 months have exposed the toxicity of business models offered by unregulated exchanges. These exchanges did not segregate customers’ assets from their balance sheets, ultimately leading to the downfall of the exchanges and the loss of customers’ liquidity. Recognizing the importance of regulation and asset segregation is vital for the long-term viability of the cryptocurrency industry.

The need to separate exchanges, market makers, and custodians in the cryptocurrency industry is becoming increasingly evident. By implementing segregation, businesses can ensure the protection of customer funds, detect and prevent fraud, and create a more robust market structure. As the industry adapts, regulatory measures and innovative solutions like segregated custody and secure settlement platforms will shape a safer and more reliable cryptocurrency ecosystem.