“Today there are over 300 centralized cryptocurrency exchanges in the world. Almost all of these centralized exchanges also act as custodians,” Alex Mashinsky, CEO of Celsius Network and one of the inventors of VoIP (Voice Over Internet Protocol), told me.
While cryptocurrency exchanges allow customers to trade cryptocurrencies for other assets, some of the biggest exchanges in the world also act as both exchanges and custody holders.
What exactly does this mean? According to a blog post written by Miko Matsumura, cofounder of Evercoin Exchange, a custodial exchange holds the private keys to a user's digital assets. A non-custodial exchange does not hold users keys. In the cryptographic asset space, whoever controls the private key is 100% in control of the asset. If you don't have the key, you have no technical standing or recourse whatsoever.
While it’s clear that custodial solutions (products offered by third party providers of storage and security services for cryptocurrencies) have become one of the latest innovations to emerge within the cryptocurrency ecosystem, a number of problems tend to occur when major crypto exchanges also serve as custody holders for users.
Centralized exchanges are subject to a tremendous number of problems simply because they contravene one of the cardinal laws of cryptocurrency - the owner of the private key is also the owner of the asset. The biggest exchanges like Binance, OKEx and Huobi take control of user funds and use them for market manipulation. Instead of having the custodian working for the customer, they have their own interests at heart. Custodial exchanges are like the fox guarding the henhouse, Matsumura told me."
According to Matsumura, when digital assets are stored on a centralized exchange, users no longer own their crypto. Instead, they own the right to trade or withdraw it, leading to a number of issues.
“The problem is that once crypto exchanges take custody, everything they do is hidden from view. Recently, Huobi used user EOS tokens to get payments to vote for their own block producers. This was visible on the blockchain. Who knows what other abuses are taking place behind closed doors,” Matsumura continued.
Centralized Exchanges Remain Highly Unregulated
Another problem facing centralized exchanges that act as custody holders is the lack of regulations.
“Like a bank, a custodial exchange is empowered by their onerous user agreement to use user funds for whatever purpose they see fit. Like a bank they can lend out user funds, but unlike a bank they are largely unregulated and they do not provide interest payments,” Matsumura said.
Moreover, unlike banks regulated under The FDIC (Federal Deposit Insurance Corporation, an independent agency of the United States government that protects against the loss of your insured deposits if an FDIC-insured bank or savings association fails), many centralized crypto exchanges do not provide insurance for digital assets being held. This means that if an exchange gets hacked, users will not be able to get their assets back.
However, it is notable to point out that last month crypto exchange, Gemini, obtained insurance coverage for digital assets it holds in custody. The Gemini Trust Company, co-founded by Cameron and Tyler Winklevoss, said in a press release that its insurance will be provided through a consortium of insurers arranged by global professional services firm, Aon. This insurance comes on top of the Federal Deposit Insurance Corporation-insured dollar deposits that the exchange holds.
Still, according to Mashinsky, “A lot of what the crypto community is seeing in traditional crypto markets is just a rebirth of bad ideas from the 1800s, all being used to take advantage of the fact that regulations don’t cover loopholes.”
We are seeing a lot of conflict of interest concentrated most with exchanges where people don’t understand that these entities don’t act in their best interest. Due to the lack of transparency and regulations, there is a lot of stuff happening that would be illegal if it happened on the NYSE, for instance. The idea of separating custodian share trading and so on all derived from the fact that if you look at the collapse of the Lehman Brothers, all of this goes back to why the federal reserve bank was created. Simply put, you can’t let the cat guard the milk, Mashinsky said."
Keeping Your Crypto Safe In The Hands Of Others
While many people in the crypto community share the opinion that centralized exchanges make terrible custody holders, there are other solutions that can be utilized.
For instance, Matsumura believes that one solution is to separate custodial services from exchange services. BitGo is a good example of this model.
“This could be separated at the regulatory layer, or simply that users can become more sophisticated about how their funds are being abused and migrate to better solutions themselves,” Matsumura said.
And according to Paul Puey, CEO and Co-Founder of Edge Wallet, a certified custodial solution such as BitGo, combined with a user-controlled key in multi-sig, could also be a good long-term solution.
Cryptocurrencies are disruptive specifically because they eliminate the middleman in the ownership and transfer of funds. Utilizing custodians eliminates 100% of the value proposition of crypto, from accessibility, utility, and even the promise of a fixed and promised inflation rate. If our world used crypto primarily through custodians, we will inevitably see leveraged accounts, fractional reserve, and the effective currency inflation that we were trying to prevent. Partial custodial solutions, where companies hold only one of several keys needed to spend crypto, will be the future of custodial solutions. This will prevent any leveraging of assets, will require fundamentally different business models for custodians, and will help provide the benefits of security against loss and theft, Puey told me."
Finally, switching towards a decentralized exchange model could also be a safer alternative for storing crypto assets.
Centralized exchanges in crypto act like old world stock markets exchanges. These are old world solutions placed on new worlds. We don’t need old style centralized solutions to make a trade. The risk of having these centralized exchanges take custody of your money is not only high, but unnecessary. One of the reasons why exchanges make terrible custodians is because it’s unclear if they are fiduciaries towards those who park their money. Custody should be a segregated function in my opinion. Most exchanges are not even insured. So you lose your crypto if the exchange gets hacked. Frankly, the trading world should be aware that they can make trades using non-custodial decentralized exchanges. There is no need to rely on centralized exchanges to make trades. Once the world is more familiar with this, there will be what I call 'the great liquidity migration’ away from centralized exchanges, Sam Tabar, AirSwap Strategist, told me."