Reducing Exchange Risk Via Off-Exchange Settlement
Well, the crypto market feels alive again. As of the time of publication, we’ve got BTC pushing through $44K, volumes and volatility steadily on the rise, and a bevy of positive catalysts sitting on the horizon.
While this is all tremendously exciting, as we emerge from the crypto winter, we must not forget lessons that led to the freeze and we must proceed with restrained enthusiasm. During the prior bull cycle, risk management frameworks and execution were glaringly insufficient, and that story played out in the wake of FTX’s stunning collapse. It’s critical to remember that counterparty risk, especially as it relates to exchanges, is still one of the largest and most serious crypto risks.
For a several reasons - lack of solutions, passive yield opportunities, and capital efficiency for certain trading activities - crypto exchanges have historically operated both as “exchange” and “custodian”, requiring customers to hold their funds on exchange. Even before the FTX collapse hammered the point home, in any situation, holding assets on exchange was far from ideal and dramatically increased the potential risk of catastrophic fund losses. It’s why many traditional institutions won’t touch crypto on exchange: the risk of posting direct collateral is too large.
While the exchanges may be the biggest businesses in crypto, they can be quite shaky. That vertical will continue to undergo increasing consolidation, as evident in the recent Binance settlement. FTX’s downfall won’t be an isolated incident; Binance will not be the last exchange to face major fines; and new exchanges will emerge as dominant players. However, amidst this consolidation period, must traders and investment management firms bear the brunt of exchange counterparty risk?
Traders will always need to keep margin on exchange. More and more, the answer leans toward a resounding “No”. An excellent solution to mitigate exchange counterparty risk is off-exchange settlement (“OES”). Let’s break down what a robust OES solution looks like. Starting with the “who”, there are typically four main parties involved in the OES framework:
Exchange - trading/executing venue;
Custodian - a regulated and insured entity with best practices, SOC certifications, audited, on-chain proof of client assets, and based in a strong jurisdiction with strong balance sheet;
Trader - Exchange and Custodian client;
Trusted Third Party - a regulated, reputable entity providing dispute resolution, if necessary.
And how should it basically operate?
The Client keeps assets with the Custodian;
The Custodian “locks” the funds in two wallets: a majority in the Client’s wallet (multi-party control between Client, Custodian, and Trusted Third Party) and a substantially smaller amount in a “settlement” wallet (holding Client and Exchange assets and wholly controlled by Custodian);
The Exchange provides proxy capital on exchange to mirror the funds held by the Custodian, allowing the Client to trade using the secured capital as trading margin;
The Custodian settles trading PnL on periodic basis for both Client and Exchange.
Of course, there are essential considerations when selecting an OES solution. Clients must inquire about:
Suitability of solution - Does the solution fit your trading needs?
Technology/Security - How robust and responsive is the technology? What are IT security and loss of key procedures?
Reputation, History, and Stability - Is the entity reputable and well-respected? Do they have a proven track record of strong business practices? Is the entity itself a financially stable business? Is it audited?
Regulation/Insurance - Is the entity regulated/insured in well-respected financial jurisdiction?
Price.
At present, leading OES products have been developed by crypto-native companies. Depending on your specific requirement, consider products from the following groups:
Copper ClearLoop - integrated with Deribit, Bitfinex, OKX, ByBit, and other smaller exchanges; integrated with more than 50% of daily exchange liquidity; recently partnered with other major custody players such as Koimanu and BitGo; assets held in a bankruptcy Trust structure in the UK, addressing the insolvency risk of ClearLoop participants.
Fireblocks - integrated with Deribit and Huobi.
Ceffu - integrated with Binance.
Anchorage - developing a spot exchange solution.
Fidelity - developing a spot exchange solution.
Zodia - has indicated some forthcoming release; details are yet to be announced, but is backed by a strong balance sheet (Standard Chartered).
Tradelink - Ledger Enterprise.
The elephant in the room on this list is Ceffu, which is the only OES that presently integrates with Binance, the largest exchange by daily average volume. Ceffu was launched by Binance, and its relationship with Binance is murky at best, and almost certainly not a completely independent third party relationship.
Although Binance has been a long-standing leader, its volumes have been slumping compared to other leading crypto exchanges for some time now. This trend is partially due to Binance’s reluctance to participate in a truly third-party OES solution, prompting many traders to reduce their exposure and move it elsewhere. Following last week’s settlement with US courts, Binance is anticipated to continue losing market share, contributing to a more balanced exchange liquidity.
OES solutions are not perfect (outside of Illmatic, perfection probably does not exist), but they are rapidly improving and markedly reducing exchange counterparty risk. Where might we like to see more improvement on the OES side?
Cross Margining - Auto-balancing positions across exchanges for greater capital and operational efficiency.
Settlement Speed - Faster settlement speeds reduce PnL risk exposure.
Participation of all reputable exchanges with meaningful volumes in one or more solution.
Increased availability of high-quality custodians to foster greater price competition and offer custodian diversification, further mitigating counterparty risk.
By the way, the progress of OES solutions isn’t just a win for the crypto industry or for traders and investment managers looking to minimize risk. It’s also remarkably advantageous for exchanges themselves. The OES solutions provide a true bridge for waves of volumes (and fees) from institutional clients unwilling to accept exchange risk. We mentioned catalysts earlier, and that would be a huge one: all major crypto exchanges on more than one OES solution. That would be a wonderful Christmas present.
And while we are talking holidays and in the spirit of the upcoming New Year, allow Valmar to cast a few OES predictions:
If not already on OES platforms, existing exchanges will continue to migrate to them to avoid extinction (both from volumes and regulatory perspective).
New, emerging exchanges will join OES as a matter of course.
Both trends will result in further growth of OES.
A major traditional-finance Custodian will enter the crypto custodial market at some point and such a move will be one of the most important keys to unlocking trillions of dollars of capital still on sidelines.
Leading crypto custodians will continue to partner to combine best technology, access, and service. Such a consolidation will be critical to their survival once TradFi custodians begin to make the leap.
Have questions about keeping your capital safe and secure? Valmar is here to help and advise. Please do not hesitate to contact us. Control your capital in volatile markets and temper your enthusiasm on the way up. Let’s keep it moving up, safely and settled.