In the aftermath of the recent fraud and bankruptcy case involving FTX, once a major cryptocurrency exchange, the crypto industry must earnestly reflect: Why is crypto industry encountering such situations repeatedly? Is it truly necessary for traders to bear the counterparty risk of an exchange when dealing with digital assets? While the collapse of FTX caught many off guard, crypto-investors witnessed similar incidents before. Can this be prevented from happening again?
Key Takeaways:
- Off-exchange settlement solution enables institutional investors to maintain their collateral, used for leveraged positions, away from the exchange platform.
- Off Exchange Settlement (OES) as the most effective approach to mitigate counterparty risk for traders who must maintain margin on an exchange.
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Why do we need off exchange settlement?
In the early days of the cryptocurrency space, several well-established, regulated exchanges resisted the obligation to safeguard their clients’ assets.
Custodianship came with regulatory and legal complexities, substantial security and IT expenditures (as they inevitably became prime targets for theft), and, all too frequently, security breaches resulting in losses (sometimes affecting customers, but usually impacting exchange stakeholders). However, they had to take the responsibility to manage risk for thousands of retail clients within the volatile, emerging crypto markets. These losses were seen as a cost of conducting business, as there were no sensible infrastructure alternatives to relieve them of this burden.
Over time, some exchanges found ways to transform the cost center of “client asset custody” into an innovative business segment, often more lucrative than running the exchange itself: rehypothecation of customer assets. This could be achieved through various means, ranging from less risky to more perilous:
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Option No. 1:
If you’re a regulated exchange with strong banking relationships and positive nominal interest rates, sell all the stablecoins deposited by your clients, purchase short-term government debt, and accumulate the earned interest.
Option No. 2:
Develop lending and borrowing markets for customers to lend and borrow their assets to and from each other, provide matching algorithms, margining, and risk management systems, and charge trading fees. This is not far from what an exchange should be doing.
Option No. 3:
Offer interest on assets held at the exchange to customers, while also providing a borrowing facility for margin traders. Implement margining and risk systems, and charge a profit-maximizing spread between the two. This is akin to the previous option but involves less market activity, fewer arbitrageurs, and more optimized spreads. It’s no longer purely an ‘exchange’ but more of an ‘internal’ lending desk, as you can ensure that all assets remain within the platform.
Option No. 4:
Provide higher yields on assets held at the exchange and utilize those assets for market-neutral investments outside of the exchange’s ecosystem. This clearly deviates from the exchange’s core mandate, as customers effectively lend money, at a fixed interest rate, to a market-neutral trading entity masquerading as an exchange.
Option No. 5:
Offer higher yields (albeit not unreasonably high to avoid suspicion) and use these assets for highly speculative directional investments. Similar to option no. 4 but significantly riskier for depositors.
The legality of each approach is subject to debate and hinges on factors such as the Terms of Service presented to customers and the legal framework and jurisdiction in which the exchange operates (as well as how it markets its services). Much of it exists in a legal gray area, but the fundamental rule of acting ethically has always been: Would you feel comfortable explaining this to your clients? If not, it’s likely that you are not acting appropriately. Interestingly, we have yet to see an exchange openly acknowledge practices akin to options 4 and 5, except during bankruptcy proceedings and in courtrooms.
Upsides of off exchange settlement transactions:
There are five major advantages of exchange settlement transactions:
Minimize Counterparty risk
Off exchange settlement platforms enable two parties to finalize a trade and settle off the order book. In pre-arranged transactions, off exchange settlement platforms function as a validating third party, supporting prompt settlement and reducing counterparty risk.
Prioritizing Compliance
Off exchange settlement platform’s KYC onboarding and AML requirements apply to both parties involved in a transaction, guaranteeing legitimacy and security for all sides of the transaction.
Confidential Settlement
Only the counterparties possess knowledge of transaction information. Trade details remain undisclosed within the off exchange settlement platform’s market data feed.
Competitive Pricing
Off-exchange settlement platforms impose no minimum trade size and are accessible at a market-competitive price. For clients seeking enhanced service and control, Off exchange settlement platforms also provide a white-glove solution.
Engineered for Speed and Security
Off exchange settlement platforms enable near-instantaneous execution of bitcoin and other cryptocurrency trades (or within an approved Settlement window). Both parties must have their accounts fully funded for the asset transfers to be processed.
Off exchange settlement procedure
An ideal Off exchange settlement process involves four key entities:
Exchange: A trading venue subject to standard regulation.
Custodian: A regulated entity that adheres to best practices, holds SOC certifications, undergoes audits by the Big 4, provides on-chain proof of client assets, and operates from a robust jurisdiction.
Trader: A client of both the Exchange and the Custodian.
Trusted Third Party: A regulated and reputable entity used to facilitate dispute resolution.
Off exchange settlement workflow
A Off exchange settlement workflow typically comprises three fundamental steps:
Step 1: The client entrusts assets to the Custodian.
Step 2: The Custodian ‘locks’ the funds in one of the client’s wallets in favor of the Exchange, as per the client’s instructions.
Step 3: The Exchange replicates these funds on its platform, enabling the client to use the locked capital as margin for trading.
Role of Wallets in an Off-exchange settlement process:
An ideal Off Exchange Settlement (OES) solution necessitates the provision of two primary wallet types by the Custodian, each reflecting distinct control over the assets:
Multi-Party Wallet:
This wallet enables transaction signing by 2 out of 3 designated signers—namely, the Custodian, Client, and Trusted Third Party. It is designed to house the majority of the Client’s assets available for trading on the crypto-exchange.
Settlement Wallet:
This wallet is under the exclusive control of the Custodian and serves the following purposes: holding a portion of the Client’s assets available for trading on the Exchange and holding some of the Exchange’s assets.
The Custodian bears the responsibility of settling profits and losses (PnL) resulting from trading operations on a periodic basis (as required by either party, daily, hourly, or potentially even on a minute-by-minute or tick-by-tick basis) for both the Client and the Exchange.
Role of required balance in an Off-exchange settlement process:
Client
The client is accountable for maintaining sufficient margin across the Multi-Party and Settlement Wallets to cover their positions on the Exchange. Failure to do so will result in position liquidation, similar to the current practice of posting collateral to the Exchange.
Furthermore, the client must uphold an ample balance in the Off exchange settlement Wallet, subject to a margin call and a defined remediation period. Failure to inject additional margin into the Settlement Wallet during this period will also lead to the liquidation of positions.
Exchange
The exchange bears the responsibility of maintaining an adequate capital reserve in the off exchange settlement wallet. Any deficiency in this regard should trigger an alert from the Custodian to the Client. At this point, the Client may opt to close out positions on the exchange and retrieve the collateral held in the Settlement Wallets.
Role of settlements in an Off-exchange settlement process:
Frequent off exchange settlements play a crucial role in preventing the accumulation of counterparty risk and facilitating efficient collateral management across venues, especially in volatile markets. Consequently, off-exchange settlements and risk assessments of required balances should occur at regular intervals (e.g., every minute).
Off exchange settlements within the Settlement Wallet are automatically executed by the Custodian through a dedicated ledger. As previously mentioned:
- If the Client’s balances fall below the required thresholds in the Settlement Wallet, the Custodian issues a margin call to the Client.
- Should the Exchange’s balances dip below the adequate levels, the Custodian notifies all Clients engaged in trading on that specific exchange.
Under normal operational circ*mstances, the Client and the Custodian would jointly transfer funds from the Multi-Party Wallet to the Settlement Wallet following a margin call. Similarly, the Custodian would return surplus collateral from the Settlement Wallet to the Multi-Party Wallet when it accumulates, such as in cases of positive PnL, and when the Client requests such a return.
Current Off-exchange settlement Solutions
As of September 2023, the following represent some of the most prominent competing solutions in the market, each offering distinct variations of Off-exchange settlement:
Fireblocks
Ceffu (previously Binance Custody)
Fidelity
Liminal
Conclusion
Off-exchange settlement is a success for exchanges, traders, and custodians alike. Exchanges are relieved from the burden of custodial responsibilities, traders reduce their exposure to counterparty credit risk from exchanges, and custodians can charge fees for safeguarding assets.
A secure trading solution on exchanges is imperative for the crypto industry’s prosperity. To earn the confidence of traditional finance, comprehensive and resilient protection of investors’ assets through off-exchange settlement is essential.
