Singapore, 1 March 2023 - Centralised Exchanges (CEXs) have functioned as trusted intermediaries that facilitate the buying and selling of cryptocurrencies and most crypto users are holding their assets in CEXs with approximately 99% of asset transfers occurring on centralised platforms. However, this poses a risk towards the security of users’ assets.
Although CEXs offer speed and convenience, traders often have to deposit their funds in an account controlled by the exchange, which can also be risky as evidenced by the significant losses suffered by numerous trading firms post FTX. Since FTX’s collapse in 2022, crypto market makers and asset managers have rapidly cut exposure to CEXs and demanded for exchanges be separated from settlement and custody, just like how the TradFi world operates.
A New Paradigm, Separation of Functions
The separation of trading, clearing, and settlement functions is a longstanding model in the traditional financial industry. These functions, typically handled by different independent entities, help increase transparency and reduce the risk of fraud and misconduct. This in turn helps to build trust among market participants and contributes to the overall integrity and stability of the financial system.
In the crypto world, however, these functions are combined under one roof by CEXs. Unlike traditional stock exchanges, crypto CEXs perform much more than just being a platform to match buyers and sellers. They custody and control client funds, act as a counterparty to trades and also provide lending/borrowing services, all with little regulatory oversight. Instead of being a neutral party to transactions, this multifaceted role of CEXs raises major conflict of interest issues. FTX’s dramatic demise has clearly proven that CEXs should not dominate all these functions and hold that much power over other market participants.
DEXs or CEXs?
Some crypto-native experts are touting decentralised exchanges (DEXs) as an intriguing alternative. While many believe in DEXs as the eventual future of trading, DEXs and CEXs will have to co-exist for a long while. DEXs are still in their infancy and come with various drawbacks such as slow transaction speed from network congestion, security risks surrounding lost keys, limited functionality, lack of user-friendliness, and high adoption barriers, leading users back to the usage of CEXs.
Many market participants have realised the risks associated with CEXs' concentration of power and are now demanding independent wall street-style middlemen, specifically third-party custodians and prime brokers. While there have long been calls for alternatives to the flawed all-in-one business model of crypto exchanges, few, if not none, middlemen were successful in chipping away at the exchanges’ power, which might soon change. With increased pressure, there is now greater willingness from exchanges to accept this new paradigm.
The Separation of Trading, Clearing and Settlement
With all the uncertainties in CEXs, investors turn to custodians. In November 2019, Cobo was the first custodian that introduced the Loop network, an off-chain settlement network that allows all parties in the Loop to transfer and settle instantly, without fees.
Cobo’s Loop onboarded its first batch of exchanges despite the lack of a strong push factor for them to join the Loop. Unsurprisingly, Loop did not become the de-facto solution for crypto trading given centralised exchanges’ outsized bargaining power. There were little external pressures or incentives for these exchanges to relinquish their duties in custody and clearing and settlement to third parties, and give up control over clients’ funds.
On the back of the impasse between centralised exchanges and investment managers post FTX, Cobo upgraded the Loop network and worked on launching SuperLoop to help rebuild trust and restore trading activity.
Cobo’s SuperLoop is an off-exchange custodian and settlement network, allowing traders to trade directly on supported exchanges, with credit secured by collateral held under Cobo’s custody, locked only before the trade.
As Changhao Jiang, CTO and Co-Founder of Cobo, once said, “in this time of uncertainty, it is extremely important for custodians and exchanges to provide a sense of security and trust towards asset managers. SuperLoop provides this trust by ensuring that traders have full control over their assets while trading among exchanges.
With SuperLoop, investors and organisations can make use of Multi-Party Computation (MPC) custody solutions to co-manage their funds with an independent custody platform, and at the same time, trade these funds on crypto exchanges that are integrated with clearing and settlement networks hosted by that custody platform.
Therefore Cobo’s SuperLoop minimises counterparty risk by removing the need to pre-fund on exchanges before trading, and maximises capital efficiency by enabling funds to be deployed without the delays and risks of on-chain transfers, ultimately allowing users to have full control over their assets.
Settlement networks are a benchmark in TradFi and there is no reason for the digital asset industry not to adopt it. Independent custodians can play a big role in enhancing and protecting the integrity of the system in the crypto sphere. Momentum for real change is finally building up and in the near future, it is highly likely that centralisation and decentralisation will coexist.
About Junde
Junde Yu is the Head of Global Sale at Cobo,the world’s only licensed omni-custody platform, Cobo offers a full suite of solutions from centralized custody (HSM-based) to co-managed custody (MPC-based), and fully decentralized self-custody (based on smart contracts as well as a purpose-built custody blockchain)
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