Three Basic Approaches to Solve the Problem of Centralized Exchanges Misappropriating Customer Assets

Written by: malatang.eth

The FTX incident has sent shockwaves through the crypto world. It turns out that even with the title of the world's second-largest centralized exchange, it can collapse overnight.

FTX, Alameda, and SBF have trampled on the most basic red line of the business world: do not misappropriate customer assets. Misappropriating customer assets is essentially a form of theft, and since the dawn of commercial activity in human history, this has been a fundamental moral red line. Whether in traditional business or in Web2 or Web3, if the industry culture allows for the casual breach of this bottom line, the industry will inevitably vanish.

Therefore, the greatest lesson from the FTX incident is that the BUIDL of Web3 must start from basic business rules and reflect on the self-regulation within the industry.

Currently, there are three basic approaches to solving the issue of exchanges misappropriating customer assets:

First, decentralized exchanges (DEX). There is a wealth of discussion on this topic. However, centralized exchanges have efficiency advantages that DEX cannot replace and can serve as a regulatory tool for the government. In the foreseeable future, centralized exchanges and DEX will coexist for a long time.

Second, the recently popular proof of reserves using Merkle trees. However, this method can only be used to verify data at a specific point in time; dishonest exchanges can maintain sufficient balances during audits and transfer assets after the audit point. Additionally, the front-end pages provided by exchanges can be faked, and third-party auditing firms may also be bribed. More critically, Merkle trees only address the issue of information disclosure and do not fundamentally solve the problem of customer asset misappropriation.

Third, the separation of trading, clearing, and custody, especially starting with "third-party custody" of customer assets. This is the practice in the traditional securities and futures industry.

According to the practice of third-party custody in the securities and futures industry, the trading and settlement funds of securities and futures clients are uniformly entrusted to a third-party custody institution. Here, the third-party custody institution refers to commercial banks qualified for third-party custody. Under the third-party custody model, brokers and exchanges do not provide clients with trading and settlement fund deposit and withdrawal services; instead, the custody bank is responsible for managing client settlement fund accounts and summary accounts, providing clients with trading and settlement fund deposit and withdrawal services, and supporting brokers in completing the legal fund settlement with securities registration and settlement companies and off-exchange collection entities. The bank is responsible for completing the transfer of clearing funds between the investor's dedicated deposit account and the broker's bank settlement account, transferring the broker's clearing settlement procedures to the bank, which completes them on behalf of the broker. This maximizes the avoidance of the possibility of brokers misappropriating client funds.

In the current structure of Web3 exchanges, centralized exchanges monopolize the functions of account opening, trading, settlement, and custody, and there are no intermediary institutions like brokers in this industry, with all power resting with the centralized exchanges. In this industry that advocates the spirit of decentralization, asset trading is extremely centralized, which is quite ironic.

The direction of evolution for centralized exchanges may be the separation of customer asset custody, that is, entrusting the deposit and settlement of exchange customer assets to credible and neutral third-party institutions. This third-party institution could be a custody company established with joint funding from major exchanges, resembling an industry professional association, or it could be specific smart contracts, protocols, or DAO organizations on the blockchain (if technically feasible). From a technical perspective, third-party custody companies currently appear to be the most realistic solution. They could be jointly initiated by several top-ranking exchanges, with equal shareholding proportions and equal rights and obligations in corporate governance, avoiding any single exchange from controlling the custody company or exerting additional influence.

When the market develops to an appropriate stage, the clearing function can then be separated from the exchange and entrusted to the custody company or a clearing/settlement company established along similar lines. In the securities industry, securities clearing refers to the delivery of the quantity and price of securities traded by clients, offsetting them against each other, and then delivering the net difference in securities and prices through a securities settlement institution, which reduces the quantity and frequency of securities and price deliveries, making securities trading more economical and convenient. In modern securities trading, both parties cannot settle securities on their own; only the securities registration and settlement institution is responsible for the clearing and delivery of client securities transactions. In Web3's centralized exchanges, the clearing and delivery of customer assets are controlled solely by the exchange, which still presents a moral risk of cheating. When the clearing function is independent, this possibility will be avoided.