The FTX collapse demonstrated the wisdom of segregating market-making activities, on the one hand (Alameda), from those of running an exchange (FTX) and a custodian (FTX again), on the other. However, the question of whether to segregate the activities of operating an exchange and a custodian is more nuanced. Large banks typically run their trading businesses and their custody businesses in the same legal entity, using information walls to control conflicts of interest and ensuring that their own assets are separate from those of their clients. This article will use the experience of the American grain industry in the late 19th century to illustrate the importance of controlling risks between custodial and enforcement activities.
Custody of Cryptoassets
Cryptoasset custody is a complex task that involves, among other things, managing information security risk to protect private keys and keep transactions secure. Custodians also act as a form of payment service provider, receiving crypto assets and sending them according to their clients' instructions.
Many early cryptoasset exchanges combined custody with execution for their primarily retail customer base and some continue to do so. When they first launched, exchanges had to develop the ability to safeguard their own assets. Extending this capability for free to its primarily retail customer base created much tighter customer relationships and was an indirect way to monetize the sunk cost of its internal escrow arrangements.
Since the failure of FTX there have been efforts from both the public and private sectors to change this model. The private sector has seen wider adoption of 'off-exchange settlement' (OES) by large exchanges, often in response to demand from institutional clients. OES seeks to mitigate counterparty risks by eliminating the need for clients to hold their crypto assets on exchanges. By the way, this is how Zodia Markets was designed from the beginning. In the public sphere, there have been regulatory actions such as those by the SEC requiring investment advisors to use only qualified custodians for their clients' crypto assets. There have also been consultations such as that from HM Treasury in the UK, which signaled its support for segregating clients' assets from those of the exchanges those clients use.
Cryptoasset exchanges
Cryptoasset exchanges and traditional exchanges had similar origins in that most began as informal venues for retail customers. On the crypto asset side, Coinbase started as a private service for buying and selling bitcoin via bank transfer, while Mt. Gox started as a merchant service for card collectors. In the traditional world, the LSE began as a private association of merchants based at John's Coffee House in the City of London, while in medieval Belgium merchants met at the Huis ter Beurze, a tavern which gave its name to the term ” bag”. ', as in Deutsche Börse. From a broader perspective, exchanges are designed to serve five functions:
- Standardization, for example through weights and measures or consistently designed commercial contracts,
- Protection of property rights, for example through rule books,
- Enforcement of contractual agreements through sanctions against bad actors,
- Mitigation of information asymmetries through the dissemination of information, often through a transparent order book and
- Provide public goods by ensuring compliance with regulations.
This was followed by the judicial and legislative sanction of these norms by the State, and not the other way around.
Buses and Segregated: Elevators and Bags
The development of grain exchanges in the United States in the late 19th century, particularly the Chicago Board of Trade (CBOT), helps illustrate the tension between custodians, on the one hand, and exchanges, on the other. In the late 1840s and early 1850s, the amount of grain shipped to Chicago grew dramatically as the United States expanded westward. Warehouseman-operated storage elevators were large specialized warehouses where grain was stored in containers before shipping. In a sense, they are equivalent to general cryptoasset custodians where assets from multiple owners are mixed into a single wallet.
The CBOT began as a sleepy organization, and even had to encourage attendance at its meetings in the 1850s by providing free meals. The exchange grew to play a role in standardizing the grading, inspection and weighing of commodities, including grain, which is feature 1 on the list above. The warehousemen who operated the elevators were at odds with the grain merchants and shippers, who were more aligned with the exchange.
Storing cryptoassets involves, among other things, chain indexing and asset control. Blockchain indexing makes it easier to find information stored on the blockchain instead of analyzing data block by block. To do this, it analyzes and stores the data in a centralized database where it can later be consulted. Indexing is a way to confirm the on-chain ownership rights of the custodian client. This is feature 2. Clients can certainly do it themselves, but it's much easier to pay a custodian to do it on their behalf.
Detection and scoring is a financial crime monitoring measure that has no real equivalent in traditional finance as it is specific to blockchains. Private companies provide scoring services to assess the financial crime exposure of a particular asset or wallet. If an asset or wallet has recently interacted with an address known to be associated with criminal activity, the score is negatively affected. This means that the notion that cryptoassets are perfectly fungible is not strictly accurate. Different portfolios and assets have different scores. When custodians operate omnibus wallets, this affects the overall holdings score by mixing assets of different scores.
The same applies to grain, in the sense that it is not as fungible as one might imagine. There are different grades depending on the growing area, such as Russian rye wheat, Río de la Plata wheat, East Indian wheat, etc. Other classification criteria included, for example, moisture content, foreign matter and damaged grains.
The challenge in the United States was the scale and sophistication of the custody infrastructure that collected grain in elevators before being transported. This was different from countries like Argentina, where the infrastructure was less sophisticated and grain was packed into sacks for shipping.
Custodians operating separate wallets for each of their clients are analogous to grain sacks in Argentina. Omnibus grain elevators created economies of scale through quantity and scale. However, this had the trade-off of making quality monitoring more difficult compared to using bags of grain that could be labeled with a particular grade from the point of packaging to arrival at the end customer. In crypto assets, general wallets also create economies of scale, such as reducing on-chain transaction costs, but scoring individual sets of assets becomes more challenging, if not impossible.
Combination Risks and Custodians Trade on Their Own Account
Mixing grains allowed warehousemen to engage in unscrupulous practices. For example, they could receive a shipment of grade one grain and then mix it with grade two grain to the point that it was still within the acceptable range for a single grade. As a result, the warehouse was able to improve grain quality on its own to the detriment of others. Of course, this meant a loss of dead weight for those who had high-quality grain stored in the elevator. This discouraged farmers from ensuring their grain was of the highest quality. Further down the supply chain, shippers were mixing to get as close as possible to the threshold between grades, so that loss to warehousemen was minimized. In a sense, there is a Gresham's law at work, according to which poor quality grain displaces good quality grain. In short, standardization and property protection, functions 1 and 2, were flawed.
A key difference between cryptoassets and grain markets is that the classification and scoring of cryptoassets is carried out by external private sector companies, since the data is public and anyone can do it. However, omnibus wallets limit this ability, as a large amount of trading activity can take place off-chain and then be net settled in the omnibus wallet.
Another source of tension revolved around function 4. Storekeepers, who could trade on the exchange but also trade outside it in private transactions, had information about supply and demand, as well as the qualities of the stored grain, creating thus a conflict of interest. While this information was proprietary and the treatment of information as proprietary acts as an incentive for owners to produce and sell that information, there is a counterargument that mandatory disclosure can help prevent insider trading, abuse market and adverse selection.
The key is that when stockists were able to commingle their own assets with those of their clients and when they were able to trade on their own account, they were tempted to engage in abusive and illicit practices, which put them in conflict with the CBOT. Not surprisingly, responses to the HMT consultation calling for business and customer assets to be separated were overwhelming.
The CBOT had a long-running conflict with warehousemen as it struggled to apply the same standardization of weights, measures and grades it had in other assets such as lumber. In 1906, the CBOT implemented the buying rule that required that any private trade concluded outside the exchange must be made at the day's closing price. Storekeepers feared expulsion from the exchange more than the costs of adhering to this rule, so they complied with it. The norm also received judicial support in this important function of the market. This allowed the CBOT to manage the conflict of interest around stockists being able to trade on their own account, but, importantly, this was not done by prohibiting them from trading.
All of this meant that the elevators' economies of scale could be preserved, while conflicts of interest and other stressful issues could be managed. What is clear is that banning lifts or preventing warehousemen from trading was never a realistic option. technology and the economies of scale it provided were considered a fundamental asset. Yes, it introduced new risks, but over time the market and regulators were able to manage these new risks according to a model that has worked for over a hundred years. Hopefully the same attitude can be applied in the cryptoasset markets.
This is a guest post by Nick Philpott. The opinions expressed are entirely their own and do not necessarily reflect those of btc Inc or bitcoin Magazine.
