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Numerous custodial and non-custodial storage providers advocate for the adoption of Off-Exchange Settlement (OES) as the optimal strategy to mitigate counterparty risk for traders maintaining margin on an exchange.
An efficient off-exchange settlement OES framework involves four essential entities:
- Exchange: A lightly regulated trading venue.
- Custodian: A regulated entity adhering to best practices, holding SOC certifications, audited by the Big 4, with on-chain proof of client assets, situated in a robust jurisdiction.
- Trader: A client of both the Exchange and the Custodian.
- Trusted Third Party: A regulated and reputable entity utilized to provide a dispute resolution mechanism.
The off-exchange settlement OES workflow typically comprises three fundamental steps:
- The client entrusts assets to the Custodian.
- The Custodian “locks” the funds in a designated wallet based on the client’s instruction, favoring the Exchange.
- The Exchange “mirrors” these locked funds on its platform, enabling the client to engage in trading with the secured capital serving as margin.
In the subsequent sections of this document, we present our viewpoint on off-exchange settlement OES as a viable solution—a strategy we actively employ and have advocated for over the years as an essential implementation for exchanges and custodians. We believe this approach facilitates a structural overhaul of counterparty risk models within the digital assets space, drawing from the best practices of traditional finance models and augmenting them with crypto-native tools. This, in turn, lays the groundwork for increased participation of institutional capital.
Comprehending the Risks of Exchange Counterparty Vulnerabilities
Exchange counterparty risks manifest in various ways, such as cyber hacks, bankruptcy, commingled accounts, and the misappropriation of client funds, exemplified by incidents like the one at FTX. These risks arise due to the distinctive structure of the cryptocurrency trading market, where exchanges serve as both custodians and trading platforms. The significant counterparty risks associated with this setup have constrained the capital deployed by trading firms on exchanges and deterred traditional firms from venturing into the crypto market.
To mitigate these risks, operational teams have historically implemented time-consuming processes to monitor exposure and regularly sweep excess exchange margins to safeguard their businesses. However, these processes primarily manage exposure and fall short of fully mitigating the risk of funds being commingled at an exchange. Additionally, this trading model poses challenges for exchanges as institutions reduce capital to adhere to risk limits.
Achieving Optimal Off-Exchange Settlement (OES): The Role of Wallets
An effective off-exchange settlement OES solution hinges on the implementation of two distinct wallet types by the Custodian, each delineating a specific cryptographic control arrangement over the assets:
- Multi-Party Wallet: This wallet operates on a 2-out-of-3 signing mechanism, involving the Custodian, Client, and Trusted Third Party as signers. Specifically designed to secure the majority of the Client’s assets available for trading on the Exchange, the Multi-Party Wallet ensures a collaborative and secure approach to cryptographic control.
- Settlement Wallet: Under complete control of the Custodian, the Settlement Wallet serves a dual purpose: Holding Client Assets: This component of the wallet safeguards a portion of the Client’s assets earmarked for trading on the Exchange.
- Exchange Asset Management: Simultaneously, the Settlement Wallet also manages a portion of the Exchange’s assets.
The Custodian assumes the responsibility of settling profits and losses (PnL) stemming from trading operations. This settlement occurs periodically, at the discretion of either party, with options ranging from on-demand settlements to daily, hourly, and potentially even minute-by-minute or tick-by-tick settlements. The Custodian’s role in PnL settlements extends to both the Client and the Exchange, fostering a comprehensive and transparent approach to asset management within the OES framework. This dual-wallet structure optimally addresses the cryptographic intricacies associated with asset control, providing a secure foundation for Off Exchange Settlement operations.
Striving for Optimal Off Exchange Settlement (OES): A Custodian’s Perspective
To provide a comprehensive overview, it is essential to delve into the costs and benefits that custodians encounter when engaging in the establishment of OES across multiple exchanges for their clients. From a technological standpoint, these endeavors pose intricate challenges, necessitating an inherent understanding of the products offered by the exchange, margining mechanisms, and broader risk controls.
The paramount objective for custodians should revolve around maximizing assets under their custody. The implementation of off-exchange settlement OES, catering to both institutions and individuals, is poised to usher in a substantial influx of customer assets to custodians. For institutions, this encompasses assets currently residing in ETFs and other sub-optimally structured products. Embracing OES not only provides institutions with secure custody but also empowers them to manage their positions within a liquid market. Likewise, for individuals, off-exchange settlement OES represents an opportunity to transition assets from hardware wallets and the precarious realm of post-it notes with seed phrases tucked in desk drawers to a more secure and professionally managed custodial environment. The transformative potential of OES, while demanding a nuanced technological approach, aligns with the custodian’s overarching goal of enhancing and securing their assets under custody.
Off-Exchange Settlement (OES) emerges as a triumph for exchanges, traders, and custodians in unison. The advantages are manifold: Exchanges are relieved of the burden of safeguarding traders’ funds, traders find respite in mitigating counterparty credit risk associated with exchanges, and custodians stand to benefit by charging fees on assets under their custody.
The imperative for a secure trading solution on exchanges holds paramount significance for the overall success of the cryptocurrency industry. To attain genuine recognition within traditional finance, it is imperative that we establish a comprehensive and robust protective mechanism for investors’ assets through the implementation of OES. This safeguarding initiative not only fosters confidence in the crypto space but also positions it as a credible and serious contender in the eyes of traditional financial entities.