The journey of the FTX cryptocurrency exchange in 2022 from a US$40 billion company with a superstar CEO to collapse and bankruptcy amid allegations of fraud and money laundering summed up for some all that’s wrong with centralized exchanges for a blockchain technology that prizes decentralization.
Following the FTX collapse in early November, around US$13 billion was pulled off centralized exchanges, according to blockchain forensics firm Chainalysis.
In tandem, decentralized exchanges (DEX) that allow users to trade peer-to-peer and retain direct ownership of their assets, saw trading volumes more than double to US$51 billion in the week of the FTX collapse from US$20 billion the week prior, data from blockchain aggregator DefiLlama showed.
This seemed to be the precursor to a major shift in trading patterns and sparked comments that centralized crypto exchanges – including Binance, the world’s biggest – are a sunset sector, set to be eclipsed by the emerging world of peer-to-peer decentralized trading.
Except that has not happened, at least not yet. DefiLlama’s aggregated total trade volume on DEXs now hovers around 10% of the total on centralized counterparts.
Bye bye beach
Some crypto commentators say that centralized platforms will remain the next safe haven for crypto investors, just not the ones operating like FTX out of the Bahamas, or Binance, which has been called a “ghost company” due to the difficulty defining exactly where it is based and legally accountable.
“We will see the decline of offshore centralized exchanges … which set up offices in lesser regulated territories such as the Bahamas,” Lee Jang-woo, adjunct professor of global entrepreneurship at Seoul-based Hanyang University, told Forkast. Lee said strictly regulated centralized platforms will expand and more will be run by traditional institutions.
Singapore’s DBS Digital Exchange would seem to be an example of what Lee is getting at, though for now the DBS platform, or DDEx, only handles business from institutional investors and high-net worth individuals.
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The exchange – a part of the DBS Group, one of Asia’s biggest banks – has taken a prudent and measured approach towards developing a digital asset platform since starting out in 2020, according to Lionel Lim, the chief executive officer of DDEx.
“We believe that the market has decisively shifted its focus towards trust and stability especially in the wake of multiple scandals that have rocked the industry,” Lim said in a Feb. 15 press release to announce that Bitcoin trading volumes on DDEx surged 80% year-on-year in 2022, while the number of Bitcoin held in its custody service doubled.
The release did not reveal what those percentage gains amounted to in actual Bitcoin, but that the number of customers registered on the exchange doubled last year to 1,200. It trades Bitcoin, Ether, Bitcoin Cash, XRP, and added Polkadot and Cardano tokens in October 2022.
Lim’s view is shared by Jez Mohideen, chief executive officer of Laser Digital, the digital assets arm of Japan’s financial services giant Nomura Holdings.
“What has happened over the last two or three months, particularly after FTX, there’s no question that [crypto investors] are looking for solutions,” Mohideen said in an interview. “You find very few [crypto] entities where there is a prospect of transparency, decent amount of due diligence and risk management.”
That need for transparency will encourage the next dominant trend in crypto trading, said Paik Hoon-jong, the chief operating officer of South Korea-based blockchain fintech firm DA:Ground. “State or Wall Street-led exchanges that are 100% reliable and 100% legally compliant will rise above,” Paik said.
In September last year, Wall Street stalwarts Citadel Securities, Sequoia Capital, Fidelity Digital Assets and others joined hands to set up EDX Markets (EDXM) – a cryptocurrency exchange serving institutional investors that aims to open to retail in the future.
EDXM says it differs from most current crypto exchanges that act as the market maker, trading platform, and custodian at the same time, a setup with clear conflicts of interest, as shown in the FTX implosion.
Many of the recent crypto failures resulted from not following some of the regulations that are required in traditional finance, said Mohideen. “I think the traditional players or more institutional players coming into [crypto] appreciate and extrapolate the best of the traditional practices into the crypto side.”
Beyond traditional banks and brokerages getting into cryptocurrency trading and custody services, countries and cities are also looking at the landscape of opportunities and managing risk.
Indonesia plans to open a “national” cryptocurrency exchange in June, according to the country’s Minister of Trade Zulkifli Hasan. The ministry is expected to oversee trading on the platform and custody of investor assets.
South Korea’s Busan city is also working to establish the country’s first city-backed digital asset exchange this year.
Tentatively named the Busan Digital Commodities Exchange, the platform will tokenize commodities such as gold and real estate on the blockchain, with plans to expand services into cryptocurrencies and other digital assets.
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China, having experimented extensively with the digital yuan, launched its first non-fungible token (NFT) exchange called China Digital Trading Platform (CDEX) last month.
Platforms that guarantee higher compliance and security will also be favored by institutional giants – “having institutional liquidity is definitely a game changer,” Paik said.
As nations and cities move into crypto, government-backed regulators are cracking the whip across the existing industry.
This month, U.S. financial regulators ordered Paxos Trust Company to stop issuance of the Binance USD stablecoin. Paxos was also told it may face investigation for issuing an unregistered security. That followed regulators ordering the shutdown of staking services on cryptocurrency exchange Kraken for failing to register the service.
Also in February, India, the current holder of the presidency of the G20 nations group, said it is working with the International Monetary Fund and the Financial Stability Board to develop international regulatory standards for cryptocurrencies. The group includes the world’s 20 biggest economies that account for around 90% of global GDP.
What about DeFi?
Nevertheless, blockchain specialists say the future is in decentralization.
“We can’t forget that blockchain is rooted in decentralization,” Dinesh Goel, co-founder of play-to-earn game One World Nation, said. “With institutional and state-run platforms, central authorities still hold the power, and that’s not what a lot of crypto natives believe in.”
But Paik at DA:Ground said decentralized platforms are still prone to security breaches. “We’re still seeing many hacks and exploits on DeFi or DEXes, and people will not feel safe trading on these platforms until this is resolved.”
According to Chainalysis, over 82% of the US$3.8 billion in hacked cryptocurrencies last year were stolen from decentralized platforms.
“Certainly there have been security issues, but much of the recent crisis is due to the lack of accountability and over-leverage,” said Julia Zhou, head of ventures and market-making at crypto trading firm Alphalab Capital.
Zhou remains bullish on the prospects of DEXes as they are relatively new and their auto-market making model – the algorithmic bots used in DEXes for transactions – has the opportunity to innovate.
“Many of the products may seem over-financialized in the beginning but eventually will become more user friendly,” she said.
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Security vulnerabilities in DEXes are mostly the result of programming flaws, and DEX aggregator 1inch Network says the primary countermeasure against hacks is regular audits. Frequent audits and disclosure of audit reports will help platforms discover flaws in their smart contracts before they are taken advantage of, 1inch wrote in a blog post.
Both Lee of Hanyang University and Mohideen of Laser Digital said some sort of balance will be struck between regulated and centralized trading platforms and decentralized exchanges.
Lee said centralized and decentralized platforms complement each other and need each other to develop.
“Centralized exchanges will not be able to list a variety of cryptocurrencies as they become more regulated and controlled, but on decentralized exchanges, you can trade virtually anything coded,” Lee said.
“But of course, you cannot trade fiat money on decentralized exchanges, and centralized exchanges will be the window for that — eventually they will grow hand-in-hand.”