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CCData's recent Market Spotlight blog discusses the changing landscape of Centralised Exchanges (CEXs), highlighting the increasing importance of risk assessment and transparency. Following the FTX collapse, CCData has removed FTX from its Exchange Benchmark and pricing indices. The blog stresses the necessity for transparent financial disclosures and the implementation of Proof of Reserves and Liabilities in CEXs.
Alongside the growth of the digital asset industry, the challenges faced by Centralised Exchanges (CEXs) have also developed and changed over time. In 2019, the main concern revolved around fictitious volumes caused by wash trading, volume manipulation, and trading incentives. CCData identified this as a hurdle for the industry and the Exchange Benchmark was launched as a result — providing a framework for assessing the risk of operating on different digital asset exchanges. This includes the risk of non-regulatory adherence, KYC policies, data availability and market structure, insufficient security processes, and more.
Over the last three years, the methodology behind the Benchmark has expanded alongside the industry, to encompass more specific risk areas for exchanges, this includes:
The addition of the above data points is one of many updates CCData has taken to ensure the accuracy and reliability of the benchmark. This will be assessed on a continuous basis going forward and expanded over time.
In light of the recent market events, CCData has made the decision to remove FTX and FTX.US from its Exchange Benchmark rankings and CCCAGG pricing. Utilising our best-in-class data surveillance and monitoring tools, we are actively investigating ongoing developments in this still-unfolding situation.
FTX’s decline has been unprecedented and will continue to have a ripple effect on market participants. It has become clear that only a handful of high-level executives at FTX were aware of the underlying structural deficiencies within the exchange, but these events have proven that the accurate assessment of CEX risk is now more relevant than ever, with FTX’s insolvency shedding light on the hidden risks within these exchanges.
The purpose of this blog is to take another look at the CEX landscape, to describe and acknowledge the entity structure of CEXs, and to provide clarity on how this will be taken into consideration in future iterations of the Exchange Benchmark and ensure CCData's commitment to providing a transparent and holistic assessment of the digital asset exchange landscape.
The collapse of FTX has drawn many parallels to the collapse of Bear Stearns and Lehman Brothers during the 2008 financial crisis. During this time, banks were using customer deposits to fund highly risky, speculative business activities. This is akin to the strategies which are thought to have been incorporated by FTX and its sister firm, Alameda Research.
In all its simplicity, cryptocurrency exchanges ultimately act as unregulated banks, where customer deposits are treated as liabilities. If so inclined, exchanges are able to use these deposits to run their operations — partially due to a lack of regulation within the industry. Traditional banks operate similarly — they use customer deposits to carry out other business transactions (provide business loans, create structured products, etc…), many times using leverage to prop up potential profits.
However, there are some key differences between exchanges and banks which revolve around regulatory clarity:
2. Bank deposits are subject to government insurance, such as the Federal Deposit Insurance Corporation (FDIC) in the United States.
3. Bank divisions are subject to strict ‘Chinese Walls’ which prohibit sensitive information from moving between departments, for example between Retail Banking and Proprietary Trading.
Digital asset exchanges are not held to the same regulatory standard as above, if any. All the above are important points and would’ve been fundamental in avoiding the fraud that occurred in FTX:
Furthermore, terms and conditions documents from CEXs typically include limited liability provisions. Included below is a snippet of FTX’s Limitation of Liability terms and conditions which infers that FTX is not liable for any loss of funds:
Thus, the issue around FTX (and other centralised exchanges) is both the lack of liability and the lack of disclosure requirements relating to the use of customer funds and the use of leverage.
It must be noted that it has become increasingly clear from online discussions that only a handful of high-level executives at FTX were aware of the use of customer deposits for Alameda Research’s leveraged activities, implying an unprecedented level of fraud around last week’s events. However, the lack of transparency and regulation around CEXs means it is entirely possible, and even probable, that other exchanges may have also mingled with user deposits and will soon come out as insolvent due to the contagion caused by FTX’s demise.
While it might be seen as too little, too late, many exchanges have recently announced their willingness to release audited Proof of Reserves (PoR) to provide transparency about exchange holdings and liquidity, including Binance and Crypto.com. We hope and expect other exchanges to follow suit, although it must be stated that PoR is not sufficient to prove solvency and no misuse of customer funds. PoR needs to be accompanied by Proof of Liabilities (PoL) that demonstrates the amount owed to depositors.
There are two other important issues with the above:
First, PoR may be gamed if just taken as a snapshot — as funds may be borrowed prior to the snapshot, and returned to their rightful owner after this. PoR must be fully audited and must involve the constant monitoring of blockchain addresses. This is easily addressable by requiring minimum standards (such as audits) for PoR across the industry, or taking snapshots simultaneously [i.e. at the same timestamp] for all exchanges
Second, PoL are important to quantify total customer deposits, however, they do not highlight any off-chain or off-balance sheet liabilities, which may be hidden by exchanges to curtail any strange use of customer money. As this is more difficult to address, the auditing of CEXs by financial auditors and government agencies may be the only way to resolve this issue. As mentioned, CEXs act as financial intermediaries — and should be treated as such, rather than convoluting CEXs with decentralised finance.
Recently, Changpeng Zhao (CZ), the CEO of Binance, announced that Vitalik Buterin was also working on a proof of reserves protocol in which Binance would be a guinea pig. “He’s quite excited about it, and we are connecting our teams to do that,” said Zhao. “Roughly, we can expect a timeline of about a couple of weeks, and this is the reason why we published all our cold wallet addresses so that people can see them directly”. Although details have yet to be confirmed, this is a solution CCData will continue to monitor.
CCData acknowledged the importance of proof of reserves by incorporating it as a security metric on our latest Exchange Benchmark, released in October 2022. Based on our data, only 6 out of 133 exchanges have carried out a PoR in the last 4 years — Bitfinex, Kraken, Luno, Gate.io, Vaultoro, and Bitbuy.
Looking forward to the next iteration of the Benchmark to be released in April 2023, there will be two primary objectives:
First, to expand the scope of metrics that relate to transparency and proof of funds. This will include:
Second, to increase the coverage of the Benchmark by including new or unaccounted-for exchanges.
As a final note, we believe it is imperative to differentiate between CEXs and the rest of the digital asset ecosystem. Centralised exchanges are structured as legacy institutions that should be used for on-ramping into what is the real innovation and value proposition of digital assets — the use of self-custody and on-chain protocols that are truly decentralised and transparent. In fact, the debacle of FTX and accompanying fraud leads us to believe that there will be a significant transition of trading activity from CEXs to decentralised exchanges over the next five years, as market participants become more aware of the ‘not your keys not your coins’ mantra and switch to decentralised, self-custodial alternatives. Our expectation of this trend is a primary reason why we recently released a DEX Benchmark alongside our Exchange Benchmark report in October.
Unfortunately, after the recent events, trust in cryptocurrencies and its unique value propositions will wane, even though these events clearly exemplify crypto’s value proposition — that you should not hold your wealth on a centralised entity, but rather, via self-custodial methods where you are not at risk from centralised counterparty risks and moral hazard.
Indeed, the cryptocurrency projects that represent these value propositions — Uniswap, AAVE, and MakerDAO, among others — have been unaffected by the severe stress tests of this year, and are operating as usual with no hint of fraudulent activities. Of course, it must be stated that these face challenges of their own — with smart contract exploits and other DeFi hacks being a regular occurrence this year.
CCData holds its belief that digital assets and blockchain technology will continue to revolutionise the financial services industry in the long term. We will continue working towards making that goal a reality via our industry-leading methodologies, aggregate pricing, benchmarking and overarching digital asset data offering.
If you have any questions about the above changes or general inquiries about CCDatas market-leading digital asset data, please do reach out to us at research@ccdata.io
Disclaimer: Please note that the content of this blog post was created prior to our company's rebranding from CryptoCompare to CCData.
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