Off-Exchange Settlement (OES): A New Pillar in Crypto Investment Security Architecture
Over half a billion was lost successively in the first half of 2024 by two centralized crypto exchanges, DMM Bitcoin and Wazirx, drilling home the urgent need for institutional investors to protect themselves from CEX counterparty risks.
Mitigating these risks involves safeguarding against exchange insolvency, hacks, and asset misappropriation.
A novel security solution has gained widespread adoption across the crypto space over the past two years to protect against exchange counterparty risk, from institutional investors to DeFi protocols: Off-Exchange Settlement.
The collapse of FTX in 2022 acted as a catalyst for the widespread adoption of Off-Exchange Settlement (OES). In a nutshell, OES allows entities to trade crypto assets with the ease of using an exchange, without actually being on one.
It has quickly become a cornerstone for any entity managing large funds that wishes to trade using crypto exchanges. Many investors now choose exchanges based on their ability to offer OES, and if an exchange does not provide this option, they are unlikely to maintain balances on those exchanges overnight.
In today’s article, we dive into OES architecture, how it protects against counterparty risk, and the other perks it offers clients, as well as tackle the thorny subject of how off-exchange settlements could themselves become new risk vectors.
To manage crypto assets and interact with exchanges, asset managers, institutions, and hedge funds have increasingly adopted the practice of transferring assets to hot omnibus wallets in recent years to simplify and speed up trading activities.
However, hot omnibus wallets carry significant risks, including substantial exchange counterparty risks, capital inefficiencies, and increased operational expenses.
Exchange Counterparty Risks — By consolidating assets in an omnibus wallet, users inherently take on the risk associated with the exchange’s financial health. Should the exchange face insolvency or other financial difficulties, the assets within the omnibus wallet could be compromised, leading to significant losses for the users.
Capital Inefficiency — Omnibus wallets often lead to capital inefficiency, primarily due to the network fees associated with asset transfers. Every movement of digital assets in and out of these wallets incurs a fee, which can accumulate substantial costs over time, particularly for high-frequency trading or large institutional investors.
Operational Cost— The management of omnibus wallets requires considerable operational resources. Exchanges must continuously monitor and secure these wallets, which are frequent targets for hackers due to the large volumes of assets they hold. Despite stringent security measures, the risks of operational errors or breaches remain.
Since the Mt. Gox debacle in 2014 to the FTX meltdown in 2022, and with DDM Bitcoin and Wazirx losing more than half a billion dollars to hacks this year, crypto exchanges have repeatedly proven that they cannot be trusted with significant amounts of funds.
The counterparty risks posed by crypto exchanges — often seen as the most efficient and convenient trading platforms for digital assets — are so high that they have significantly hindered institutional actors and asset managers from investing to their full potential in the crypto ecosystem.
Entities that manage funds on behalf of others cannot afford to gamble with the assets entrusted to them by taking undue risks. Instead, they are inherently risk-averse and tend to prioritize security above all else.
The FTX meltdown in 2022 was deeply traumatizing for the entire crypto community, but it was particularly devastating for institutional players.
It became clear that new methods were needed to access the convenience of centralized crypto exchanges without the associated counterparty risks.
This realization paved the way for the rise of off-exchange settlements, offering a safer alternative for trading digital assets.
OES: Eliminating Exchange Counterparty Risks
How Off-Exchange Settlements Mitigate Counterparty Risks
While off-exchange settlements offer numerous benefits to their users, their primary purpose is to provide a security solution that eliminates counterparty risk when trading on centralized exchanges.
How Does it Work
Off-exchange settlements refer to transactions and transfers of cryptocurrency assets that occur outside of traditional centralized cryptocurrency exchanges.
These settlements typically happen between private parties or through over-the-counter (OTC) desks, decentralized exchanges (DEXs), or private custodians.
These off-exchange transactions are settled without the need to use a public exchange order book, and they usually involve large sums of cryptocurrencies being transferred from one party to another.
They allow traders to engage in transactions with virtual balances on exchanges while the actual settlement is handled through the off-exchange settlement network.
This ensures that traders’ token balances are secured by the Off-Exchange Settlement (OES) system rather than being stored directly on crypto exchanges.
In summary, off-exchange settlement offers the trading convenience of a crypto exchange without the assets ever being held on the exchange itself, thereby eliminating exchange counterparty risk.
On paper, it sounds like a dream come true for institutional investors eager to expand their crypto investments and secure greater returns.
So, how does it actually work? How do off-exchange settlements mitigate exchange counterparty risks?
Mitigating Exchange Counterparty Risks
Off-exchange settlements serve as an intermediary between an exchange and an institution. While offerings can vary, most off-exchange settlement systems are structured in a similar manner, as outlined below.
The institution that wishes to use the OES must maintain its assets with an institutional custodian. The custodian secures the majority of the institution’s funds, usually in a multi-signature or multi-party computation (MPC) wallet, which requires approval from two out of three signers to authorize transactions. The signers include representatives from the institution, the custodian, and a trusted third party.
Off-exchange settlements use a “settlement wallet” in conjunction with a multi-signature or multi-party computation wallet to manage and settle trades between an institution and an exchange.
The crypto exchange partners with these off-exchange settlement providers to reflect the institution’s funds on their platform, allowing trading based on the assets secured in the wallet.
The settlement wallet, managed by the institutional custodian, holds funds from both the institution and the exchange.
Settlement Process — When the institution profits from a trade using the exchange’s margin, the custodian transfers the corresponding amount from the exchange’s contribution in the settlement wallet to the multi-sig/MPC wallet.
If the institution incurs losses, funds are moved from the institution’s portion to the exchange.
If the settlement wallet’s balance drops below the required levels, additional contributions are requested. Should the exchange fail to contribute, the custodian will instruct the institution to close its positions and return any remaining balance from the exchange to the multi-sig/MPC wallet, protecting the institution’s assets from exchange bankruptcy.
For instance, during the Coinflex bankruptcy in 2022, institutions using Copper’s Clearloop version of OES did not experience losses, according to Nickel Digital’s research.
Security Measures — If the institution fails to maintain the settlement wallet and the exchange is unable to liquidate positions in time, the custodian and a trusted third party can transfer assets from the multi-sig/MPC wallet to an exchange wallet. The multi-sig/MPC setup requires multiple signers to approve transactions, ensuring funds are secure even if a private key is lost or compromised. The trusted third party, who must be knowledgeable, independent, and regulated, provides additional assurance in protecting the institution’s funds during critical situations.
OES solutions enable clients to trade on centralized exchanges while ensuring their assets remain protected within a secure custody framework at all times.
Following the FTX meltdown and the emergence of numerous off-exchange settlement solutions, along with crypto exchanges adapting to meet the needs of their high-profile institutional clients and other risk-averse investors, OES solutions have swiftly become a cornerstone of crypto trading security architecture in under two years.
For example, DeFi protocol Ethena integrates OES into its operational framework to safeguard itself from exchange counterparty risks. This approach not only ensures Ethena’s security but also provides assurance to Ethena’s users that their assets are protected from such risks.
Copper provides two custodian approaches for Ethena: segregated wallets, where funds are held with Ethena, Copper, and a trusted third party, avoiding operational risks from Copper; and co-mingled omnibus wallets, where funds are held in a bankruptcy-remote trust, ensuring they are not part of Copper’s estate if Copper faces bankruptcy.
Fireblocks offers an OES solution similar to its traditional MPC wallet, allowing Ethena to store funds in an on-chain wallet controlled solely by Ethena and key holders across exchange partners. This setup ensures that if Fireblocks enters administration or bankruptcy, Ethena and its partners retain full access and control of the wallet.
Mitigation of exchange counterparties risks aside, off-exchange settlement offers additional substantial perks.
Additional Perks of Off-Exchange Settlement
Increased Capital Efficiency
As mentioned earlier, before the advent of OES, crypto trading often involved significant trading and operational costs.
Off-Exchange Settlement (OES) significantly enhances capital efficiency by optimizing crypto trading workflows. With settlements handled directly on the OES platform, assets avoid blockchain traversal, reducing network fees. Assets remain in a single collateral pool, avoiding deposit, transfer, and withdrawal fees and bypassing the need for cold storage solutions. This approach optimizes liquidity and minimizes operational costs for clients. Plus, there are no delays or extra costs associated with delegating or redelegating collateral to and from exchanges.
Efficient Trading
Off-Exchange Settlement (OES) providers enhance trading efficiency by connecting clients not only to centralized exchanges but also to decentralized exchanges and OTC markets. This broad access allows clients to diversify counterparty risk and hedge positions across various platforms. Additionally, OES improves capital efficiency by enabling assets to be deployed from a single collateral pool to multiple exchanges.
This simplification of the trading process maximizes asset utilization, enhances trading strategies, and reduces operational burdens.
Privacy and Anonymity
Large institutional players often prefer off-exchange settlements because they want to avoid public scrutiny or revealing their trading strategies, which could happen if they were to conduct large transactions on public exchanges.
Regulatory Compliance
Some institutional investors must comply with regulations that require more stringent measures of asset custody, record-keeping, and reporting than what public exchanges offer. Off-exchange settlements can offer tailored solutions to meet these requirements.
Off-exchange settlements seem to tick all the boxes for both convenience and security.
But doesn’t shifting from direct use of centralized crypto exchanges to intermediaries like Off-Exchange Settlements merely create new threat vectors?
OES: Creating New Risks
In the paragraph dedicated to how OES operates, we have detailed a certain number of measures that are preemptively taken by OES to avoid turning themselves into a threat to their client, but it doesn’t mean that OES is devoid of risks.
Counterparty & Custodial Risks
Off-exchange settlement solutions are designed to address counterparty risk by consolidating traders’ assets into custodial accounts, which are then reflected in an exchange account for trading. However, this method of using custodial accounts can transfer the counterparty risk from the exchange to the centralized clearing party responsible for managing these assets in some off-exchange settlement models.
Entrusting assets to a custodian or clearinghouse means users forfeit direct control over their funds. If the custodian encounters financial difficulties, operational failures, or breaches of trust, users might face delays or losses in accessing their assets.
This risk is compounded if the platform lacks adequate insurance or fails to properly segregate customer assets, as a compromised or insolvent custodian could lead to significant financial losses for users.
Additionally, off-exchange transactions often lack transparency, as they are private and not recorded on public ledgers until the final settlement. This reduced visibility can complicate the detection of fraudulent activities and make it harder for users to assess the platform’s true risk.
The reliance on third parties also introduces a potential reputational risk.
If a custodian experiences a security breach or legal issue, the resulting fallout could severely damage the platform’s reputation. This loss of confidence might lead to customer withdrawals and have a cascading effect on related entities, such as Ethena. A breach of trust involving a key component of their operational infrastructure, like off-exchange settlements (OES), could prompt users to disengage en masse.
Such events could significantly impact the stability of the platform and the safety of users’ investments.
Cybersecurity & Operational Risks
As off-exchange settlements handle increasingly mind-blowing large volumes of funds, they are fated to become prime targets for cybercriminals. Despite advanced security measures, platforms like Fireblocks and Copper are vulnerable to unauthorized access, data breaches, and hacking attacks due to the high value of the assets they manage. Successful cyberattacks could result in significant losses for users through theft or data compromise.
Operational risks also pose a threat to off-exchange settlement platforms. The blockchain technology supporting these systems is still relatively new and evolving, which means potential vulnerabilities could affect their security and reliability. Additionally, internal failures such as software bugs, human errors, or misconfigurations can lead to incorrect settlements, loss of funds, or unauthorized access.
To mitigate these risks, users of off-exchange settlement platforms must conduct thorough due diligence. This involves carefully evaluating the security measures, regulatory compliance, operational protocols, and overall trustworthiness of each provider before entrusting them with their assets. Additionally, employing multiple off-exchange settlement providers can further help to spread risk and enhance security, providing an added layer of protection against potential vulnerabilities.
Off-exchange settlements in crypto were created to address the needs of large-scale investors who require privacy, efficiency, and compliance in their trading activities.
While they offer benefits such as reduced market impact, enhanced security, and lower systemic risk, they also carry risks like counterparty risk, lack of transparency, and custodial risk.
Overall, when used correctly and with due diligence, off-exchange settlements can contribute positively to the security and stability of the cryptocurrency space. However, the associated risks must be carefully managed, especially as the regulatory landscape continues to evolve.
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