By Karan Ambwani
In 2022, the cryptocurrency industry experienced one of its most eventful years on record. One major event that occurred was the collapse of one of the largest centralised exchanges. The repercussions of this collapse continue to be felt as the industry assesses the extent of the damage caused. Additionally, there has been an increase in fear, uncertainty, and doubt (FUD) among retail investors regarding centralised custodians.
A noteworthy trend is that centralised exchanges (CEXs) have seen a net outflow of over $10 billion in assets since November 4, resulting in double-digit percent decreases in exchange stablecoin holdings. A study by Chainanalysis found that after the collapse of FTX, over 68 percent of assets flowed out from centralised exchanges to personal wallets by institutions with values of at least $100,000. This was comparable to the implosions of Celsius Network and TerraUSD in the middle of 2022, when outflows were at 69 percent and 77 percent, respectively.
These kinds of major industry shuffling events or macro-economic factors usually give rise to creation of an auxiliary industry segment which serves the same user base and market but addresses the challenges in a unique manner. For example, the COVID pandemic has led to a shift towards remote work and online education, which has fuelled the growth of companies that offer these types of services, such as Zoom, Slack, and Coursera. The 2008 recession that followed the financial crisis led companies to look for ways to cut costs and increase efficiency, leading to the growth of companies that offered cloud computing services, such as Amazon Web Services and Microsoft Azure.
Similarly, this movement of assets off CEXs have reminded users to directly control and access their assets by transferring them to a personal wallet – following the original principles. The paradigm shift that enables trading and investing activities, would move from personal wallets to decentralised finance (DeFi) protocols, where users can facilitate ongoing trading or participate in other activities such as lending without central intermediaries or custodians.
Transparency is the key
Another interesting trend to observe is that the centralised incumbents are adopting self-regulating mechanisms to ensure transparency and bring back trust within their solutions.
Exchanges are releasing what is known as Proof-of-Reserve to publicly show that they have enough assets to cover all customer deposits. This is to build trust with their customers and demonstrate that they are solvent. One common method to present proofs is for the exchange to conduct an independent audit, in which a third-party reviews the exchange’s accounts and verifies that it holds the appropriate amount of funds. Another method is for the exchange to share its transaction history or a merkle proof allowing users to see that it has received and spent the appropriate amount of funds.
It is important for users to be aware of an exchange’s proof of reserves policy, as it can help to ensure that their funds are safe and secure. Some exchanges may be more transparent about their proof of reserves than others, so it is always a good idea to do your due diligence before using any centralised product or service.
Along with PORs, another important piece of information to measure financial health of an exchange is their reserve-liability ratio. This is, in other words, the ratio of assets reserves vs. the liabilities of the company as proof of the assets alone does not mean much until we have an insight on the liability of the corporation. We are yet to see any standardisations on these critical pieces of information – though this could be one of the areas of focus in the coming years for the regulatory bodies.
More on using decentralised technologies
Most of the major DEXs like dYdX and others have seen an increase in user growth and transactions after the FTX debacle. Decentralised exchanges have inherent transparency with on-chain visibility of reserves, treasury and liquidity pools. The wallet interactions and transactions are stored on distributed networks, governed by smart contracts and the data can be easily queried on the blockchain.
The DeFi space is primed to rapidly grow, evolve and become the de facto infrastructure of the trading of digital assets in the future. The move towards self-custody and decentralised products is the need of the hour for any user and technologist in the web3 world. Users should invest more time on learning and understanding how self-custody of assets work, how to keep their funds and keys secure, and how to interact more safely with decentralised services like decentralised exchanges (DEXs).
The author is India lead, dYdX Foundation