The Inherent Flaws of Current Cryptocurrency Exchanges
Ever since the Mt. Gox scandal in Feb 2014, hacks and thefts have been prevalent among cryptocurrency exchanges. The most recent, and known, one happened in Jan 2018. In this case, about $500 millions worth of customers’ digital asset were stolen from another Japan based exchange Coincheck. Other than these widely reported incidents, I keep hearing stories about hacks and thefts among cryptocurrency exchanges that are not revealed to the public. Other than usual hacks, I began to hear more about insiders’ jobs such as employee using customer’ digital assets and, more importantly, exchange executives directly embezzle customers’ digital assets that are under exchange’s custodianship.
Such things are no strange to me. In the early 1990s, when the Chinese stock market first appeared, such things happened all over the map. At the time, customers’ fund was managed by security brokerages. There was no strict regulation specifying that a brokerage cannot use its customers’ fund for its own purpose. This loophole was fully exploited by brokerages. Embezzlement of customers’ trading fund was rampant. Some brokerages were forced to go under when they later could not pay back embezzled fund. The security brokerage I used to work for survived several days before it was going to be closed, with the help of a large investment by the standard at the time. Such incidents were finally stopped when the Chinese Securities Regulation Commission ordered to have customers’ trading fund managed by banks.
The situation of current cryptocurrency exchange is much worse in terms of monetary amount and customers affected.
Current criticism focuses on external hack thefts and internal staff’s greed. While these are all causes for the current situation, they fail to address the issue at a deeper level, that is, the soundness of the cryptocurrency market structure. In my opinion, current cryptocurrency exchange has centralized too many functions that are performed by different business entities in regulated security markets. This makes it very vulnerable to all kinds of risks and is also not good for the stability of the cryptocurrency market. These business entity types are listed below.
Investment bank A cryptocurrency exchange has to use its own criteria and method to select a token to list. In this role, it is doing the underwriting work done by investment banks.
Securities brokerage Cryptocurrency started as a technology invention. It did not start as a financial instrument. It first got traded by funs. All a trader needs is a trading platform on which it can trade with other funs. There was no need for a middleman to perform any service to make the trade go through. Even after the trading volume goes much higher and lots of more people get involved, there was still no need for a middle man. Traders trade directly with each on the platform. The exchange maintains customers’ accounts and does all the bookkeeping, work typically performed by brokerages.
Clearing house A cryptocurrency exchange also does all the clearing work. A trader may trade on different exchanges. But he has to maintain his trading asset in accounts in different exchanges. His trading capital is therefore fragmented. He also has to meet capital requirements of different exchanges. His trading capital therefore is deeply underutilized.
Asset custodian In a regulated securities market, securities are registered and maintained in a central depository organization. This organization holds the golden copy of all securities in the market. In US, this organization is Depository Trust & Clearing Corporation. In China, this organization is China Securities Depository & Clearing Corporation. Whereas in the cryptocurrency market, an exchange holds all of its customers’ digital assets. Essentially, it plays the role of an asset custodian.
An unregulated and heavily centralized cryptocurrency exchange is definitely prone to have many problems. This is why we see all kinds of problems such as: “air coins” are listed on an exchange, trade matching mechanism is opaque, and customers’ assets are “stolen”. As more regulatory bodies begin to manage this industry, this heavily centralized body is definitely going be separated to be more like regulated securities market structure.
While regulatory requirements can definitely address existing issues, a long term and more thorough solution is also available to be applied. That is the distributed ledger technology.
It is a consensus that one direct application of DLT in the securities industry is post trade clearing. DLT can make clearing more in sync with trading, and also more efficient and secure since it does not need a centralized clearing house in the middle. Every one knows that it is only a matter of time before DLT replaces the current centralized clearing house. The Australian Securities Exchange made an audacious and a very admirable decision to use DLT in its new clearing system in December 2017. Not to be left behind, the Canadian Securities Exchange made the decision to apply DLT in a new clearing system in February 2018. Other major global securities exchanges are actively studying the feasibility doing the same thing. It is expected that sooner or later, securities exchanges are going to migrate to a clearing solution based on DLT.
Our DAEX project is using DLT to provide a clearing solution for the cryptocurrency industry. Distributed clearing solution based on DAEX will serve multiple centralized cryptocurrency trading exchanges. Such a market structure is similar to that in a regulated securities market. By separating trading and clearing, the cryptocurrency trading market is more robust to changes and risks, and customer’s assets are safer and can be utilized more efficiently. We believe that DLT will be used in post trade clearing, regardless whether the underlying asset is a traditional security or a cryptocurrency. We just would like to be the early adopters in applying it in the cryptocurrency industry.
