Translation: BlockingBitpushNews Mary Liu
This month marks the one-year anniversary of the Terra-Luna event and the six-month anniversary of the FTX crash. These events represented the beginning and climax of a chain reaction of failures among other crypto projects, severely shaking people’s confidence in cryptocurrency and arguably causing the most terrifying survival crisis in the 15-year history of the crypto industry.
Although there has been a recovery this year, with Bitcoin up nearly 65% year-to-date, these historical events are still worth pondering and considering how the crypto industry can be better rebuilt.
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First, we should acknowledge that these events were not failures of blockchain technology, but rather the result of poor risk management and corporate governance, with some failed companies engaging in fraud. The market continues to recognize the integrity and innovation potential of blockchain, with the large influx of funds into decentralized exchanges after the FTX crash and the positive response to the Ethereum transition to proof of stake (PoS) and the Shapella upgrade.
However, despite these developments, centralized digital asset exchanges (CEXs) will continue to remain relevant and wield significant influence as a key entry point for the asset class, especially as their maturity and institutional adoption rates increase. After all, they remain the dominant platform for digital asset trading.
According to data from DefiLlama, as of mid-May 2023, CEXs accounted for almost 90% of all trading volume on centralized and decentralized exchanges. Despite investor confidence being shaken last year, the outlook for CEXs remains bright.
However, what the industry does need to address is the many weaknesses that come with interdependence and the kind of “fast action and breaking of conventions” spirit of early days. To weather this trust crisis, CEXs need to address the need for better investor protection, risk controls, and prudent governance structures.
CEXs Will Continue to Exist
Managing a digital asset portfolio is complex in operation, and investors need a comprehensive set of capabilities, such as custody, trading, investment products, advisory, and efficient fiat deposit and withdrawal channels. In this regard, many CEXs integrate these solutions into one platform, greatly reducing the technical complexity of owning and managing different blockchain-native tokens. The value proposition here is clear when considering alternatives: investors managing multiple wallets and directly participating in multiple liquidity pools across different blockchains. Although some investors are capable of doing so, the high learning curve suggests that CEXs will still be the preferred platform for many.
Investors who actively manage their investment portfolios may also want to rebalance their asset allocations between traditional and digital assets on a regular basis. Therefore, the fiat on and off-ramp infrastructure layer in CEX is critical, especially during market volatility.
Security and safety are other advantages that CEX can offer. Although the industry has long been known for the slogan “not your keys, not your coins,” according to Chainalysis data, 18% of all cryptocurrencies stolen by hackers in 2022 came from CEX, with the rest coming from decentralized applications. While CEX still has a long way to go in better protecting customers from network breaches, they are relatively safer. As the industry works to regain trust and strengthen its network security systems, the security gap between CEXs and decentralized applications is expected to continue to widen.
Finally, one often overlooked benefit of CEXs (especially those that serve high net worth and institutional clients) is the peace of mind that comes with having a “customer service hotline” in case of problems. This is especially true for investors who manage assets on behalf of clients, such as family offices and hedge funds. Horror stories abound of bitcoin worth millions being locked in wallets and unable to be retrieved, and investors will find value in working with centralized exchanges (CEXes) that provide dedicated hotlines or account managers.
Rebuilding Trust Through Asset Segregation
While CEXs may continue to exist, one area in which such platforms must improve is the segregation of customer and company assets. Reviews around this issue are now more prevalent than ever. Policymakers such as US Treasury Secretary Janet Yellen believe that asset segregation is a key area that needs to be addressed in future regulatory frameworks, largely to prevent cases like the FTX mixing customer funds from happening again, which led to significant losses for many retail investors when the exchange went bankrupt.
Prior to the collapse of FTX, the Monetary Authority of Singapore (MAS) proposed new regulations in an October 2022 consultation paper requiring cryptocurrency platforms to segregate their assets from those of their customers, and sought industry feedback on whether cryptocurrency platforms should appoint independent custodians to protect customer funds.
Therefore, CEX should reconsider the term “one-stop service”. While having a seamless front-end user interface between custody and trading makes sense, investors’ assets should be separately held by external and qualified custodians, such as banks or registered broker-dealers, on the back-end. CEX should seek and publish independent auditor attestations to verify that the assets are indeed segregated and that robust risk and governance requirements are in place.
Instilling Trust in Trustless Systems
When Satoshi Nakamoto published the groundbreaking Bitcoin white paper in 2008, they envisioned a monetary system that no longer relied on blind trust. However, the entry point for most investors to access digital assets today—the exchange—still operates in a way that is almost opaque.
The events of 2022 have shown that for the industry to move forward, investor protection, transparency, robust governance structures, and delivering value to customers must be at the forefront of how exchanges are established and operated. CEXs that embrace these values will find themselves with a competitive advantage as investors increasingly rely on trusted centralized platforms to manage their digital asset portfolios.
As we continue to rebuild, the industry may return to its roots: an industry born from a vision of a fairer, more transparent, and more efficient financial ecosystem.