Segregation of Exchanges, Market Makers and Custodians Necessary for Crypto Businesses to Thrive

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The cryptocurrency sector may be advancing, yet industry experts are becoming aware that exchanges, market makers and custodians must act as separate entities in order for businesses to succeed. While it’s common to keep financial actors separated within traditional finance, this concept has often gone overlooked within the cryptocurrency industry.

Caitlin Long, chief executive officer and founder of Custodia – a chartered U.S. bank specializing in digital assets – told Cryptonews that many individuals within the cryptocurrency space are unaware of how unusual it is for market makers, exchanges and custodians to operate as the same entities. “This is a major problem the industry faces. I truly believe that, especially custodians, should be segregated so we don’t have shenanigans like FTX happening again,” she said.

To put this in perspective, Margaret Rosenfeld, chief legal officer at Cube.Exchange –  a hybrid crypto exchange – told Cryptonews that the collapse of cryptocurrency exchange FTX occurred because financial actors were not kept as separate entities. She said:

“The biggest issue with FTX was that the exchange acted as a custodian with its own market maker. When Alameda Research hedge fund began losing money – which was the market maker on the exchange – FTX accessed its customer assets in an attempt to solve the problem.”

Rosenfeld added that although market makers are needed to provide liquidity for crypto exchanges, she pointed out that this creates a conflict. “We call this ‘founder’s risk.’ If someone is going to be a custodian of customer assets, the platform must be a highly regulated entity to ensure that those running the business will not misuse customer funds.”

Crypto platforms begin to separate financial actors 

Fortunately, businesses operating within the cryptocurrency sector are paying attention to previous misshapes to ensure better practices moving forward.

For example, Long explained that Custodia is a segregated custodian, yet there are plans to plug into venues like the New York Stock Exchange in the future. “We will have exchanges coming on our platform, but first we need to build those integrations to get this up and running,” she said.

Mike Belshe, chief executive officer of BitGo – a regulated digital asset custody provider and financial services company – told Cryptonews that BitGo has been advocating for years that a market structure is needed that fully separates custodial activities from trading. According to Belshe, such a separation will provide the checks and balances needed to detect and prevent fraud, while enabling the protection of user funds.

In order to ensure this, BitGo established a settlement platform known as “Go Network”  in June of this year that allows its institutional clients to make trades while their assets remain in custody. Matt Ballensweig, head of Go Network, told Cryptonews that Go Network came about following the collapse of FTX to serve as a solution to make customer assets usable on exchanges without having to send assets to the exchanges themselves. “Assets stay put on BitGo Trust, which is a South Dakota regulated bank. Application program interfaces (APIs) are then used to make assets available for trading on exchanges without the assets moving on the exchanges themselves,” he explained.

GM

Just a reminder, separating trading and custody creates a system of checks and balances that keeps digital assets safe. pic.twitter.com/6othdbGkJa

— BitGo (@BitGo) November 13, 2023

Ballensweig added that BitGo partners with cryptocurrency exchange Bitstamp and others, allowing institutional clients the ability to safely trade on various platforms. He said:

“Through our APIs, Bitstamp is able to recognize that client assets are there. Clients can then trade without taking any risk. BitGo takes the exchange account assets and does the atomic settlement. These avenues have started to de-risk the institutional market structure because now assets can stay segregated from exchanges. Assets are not moving as frequently on-chain either, so there is also less operational risk.”

Ballensweig believes that many crypto businesses are aiming to tackle the same issue as BitGo, which is to keep custodians separate from exchanges and other financial entities. This point in mind, Rosenfeld explained that Cube.Exchange leverages a multi-party computation (MPC) wallet to ensure that users remain the custodians of their assets. “We don’t take custody of assets, removing the exchange from any founder’s risk,” she said.

Moreover, when users want to buy, sell or trade digital assets, Rosenfeld explained that Cube.Exchange uses APIs to enable these actions while ensuring that funds stay in users’ wallets. “Funds never go through exchanges. They are moved directly from wallet to wallet using advanced web3 technology,” she said.

Crypto businesses must work hard to ensure success in the future

As the crypto space advances, Ballensweig believes that each digital asset business will need to take on a specific role and stick to that structure. He said:

“Let the exchanges play the role of the exchange and let liquidity providers play the role of liquidity providers. This is about delegating out certain tasks so that those equipped to do things can do them well. This will prevent situations like FTX again.”

Yet this may be easier said than done. Ballensweig shared that hard work is required in order for a regulated custodian to overlay the utility elements mentioned. “We are not only trying to optimize for the separation and security of assets – we now need to safeguard and make assets usable for settlement, to be deployed to exchanges, to be yield generating through partnerships with certain money market funds and more,” he said.

Although time and effort is required to build out a new market structure for the crypto sector, the results will likely pay off. Yves Longchamp, managing director and head of research at AMINA – a licensed Swiss crypto bank – told Cryptonews that the various crypto exchange debacles of the last 18 months have shown that the business models provided by unregulated exchanges were toxic. He said:

“Customers’ assets were not segregated from the balance sheet and instead were at the disposal of the exchange, ultimately leading to the downfall of the exchanges, the market, and the customers’ liquidity. The crash of crypto in late 2022 and early 2023 is a prime example of the necessity of separation; it would be unwise to disregard this lesson when aiming for a sustainable future for the industry.”

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