Risks of Exchanges
The history of cryptocurrency exchanges has been marred by hacks and attacks. Most famous is the Mt. Gox hack that decimated the prices of all crypto assets. To understand why exchanges are often the targets of attacks, we must explore how they function. An exchange acts as a liquidity pool for users to go and trade their cryptoassets. They have an order book for both sides of an exchange pair (I.E. BTC<=>ETH). This order book is filled with buy or sell orders of x amount of ETH decending to the middle which can be seen as the agreed price at the time. See image. The height of each side of the order book is the liquidity. For example if the price is to fall .3% (.0656/.0658) on Binance, There would need to be roughly 250 BTC of sell trades working their way up down to that price. The 250 BTC of trades approaching the price of .0656 BTC is how liquid the sell buy side is.
Exchanges hold huge amounts of their user’s cryptocurrency in reserves. Much of these reserves on this graph are held as sell orders. But there is also crypto that is sitting in wallets, just being held. Some exchanges, often when getting started, will hold some funds in reserve for when liquidity runs thin. This ensures that they can fill more orders than they would be able to if they didn’t have that extra liquidity. Finally, there is a third way that liquidity flows from exchange to exchange. Arbitragers. If liquidity is thinner on one exchange than another, prices are usually affected more by orders than the more liquid exchanges. When this happens, a third party will purchase or sell the crypto for a discount or premium on the exchange that has been affected. This affects the liquidity because arbitragers must hold funds on various exchanges so that they can efficiently run their business.
Unfortunately, exchange hacks have become a fairly normal occurrence these days. A few months ago, a large hack on a Japanese exchange ended with $435 million of customer funds being lost. The exchange payed out all of the customer’s funds but has been under tons of scrutiny and has ceased all trading activity.
In the early days of crypto, it was deeply understood not to hold all of your assets on one exchange, but to spread them out between exchanges and cold storage, i.e. a hardware wallet. This foundational principle saved many users’ tails when exchanges went under or where hacked.
This is what we are replicating for our customers at Consensus Solutions. We give the option for our users to spread their funds across multiple exchanges and also to put their funds into cold storage. Our first product, Coinage.fund, is dedicated to risk mitigation for our customers. There will always be risks in investing, but we provide as much as we can to curb the foreseeable risks.
A side note on exchanges being hacked. It has become a standard practice for exchanges to pay out the amount that has been hacked. This has been seen time and time again with the major exchanges recently. We don’t guarantee anything, but we have seen a pattern developing. This is why we strictly vet the exchanges that we support. The two exchanges that we currently support, Binance and Bittrex, have a very good track record of keeping funds safe and when there are issues, paying out their customers affected. Check us out at coinage.fund. Create an account today!