Better Exchange Due Diligence Could Help Define Crypto’s 2023

The CEO of Digital Asset Research, Doug Schwenk, thinks vetting crypto exchanges can open doors to more institutional investment.

AccessTimeIconFeb 2, 2023 at 2:44 p.m. UTC
Updated Apr 9, 2024 at 2:30 a.m. UTC
AccessTimeIconFeb 2, 2023 at 2:44 p.m. UTCUpdated Apr 9, 2024 at 2:30 a.m. UTC
AccessTimeIconFeb 2, 2023 at 2:44 p.m. UTCUpdated Apr 9, 2024 at 2:30 a.m. UTC

The crypto industry lost a lot in 2022, but there’s plenty of optimism it will rebound stronger and better in the years to come.

One reason for that optimism is more risk-conscious investing and better due diligence, according to Doug Schwenk, CEO of Digital Asset Research (DAR), a securities analyst operating within the digital assets space.

“When prices were always going up, it became pretty easy for people in general to kind of ignore risk management,” said Schwenk. “With the collapse of Terra/Luna, FTX, Three Arrows Capital, Celsius Network, BlockFi, we've seen a lot of refocus in the industry on risk management.”

You're reading Crypto for Advisors, a weekly look at digital assets and the future of finance for financial advisors. Subscribe here to receive the mailing every Thursday.

For most of the past five years, DAR has preached the need for advisors and investors to vet their counterparties within the digital assets space.

As a free service, DAR offers a monthly general vetting of exchanges. January’s Crypto Exchange Vetting evaluated over 450 exchanges, clearing 18 with a “Vetted” status: Binance.US, bitbank, Bitfinex, bitFlyer, Bitso, Bitstamp, Bittrex, BTC Markets, CEX.IO, Coinbase, Coincheck, CrossTower, Gemini, itBit, Kraken, LMAX, Okcoin and Zaif.

Ten exchanges were considered “watchlist exchanges” for potential future inclusion on the vetted exchanges list: Binance, Bitrue, CoinEx, CoinTiger, Crypto.com, Gate.io, Huobi, KuCoin, LATOKEN and Phemex.

Growing up

DAR’s big business is working with institutional investors to conduct detailed due diligence on opportunities within the digital assets space.

Today, more of those investors are buying exchange vetting and counterparty diligence services from DAR, according to Schwenk. Instead of vetting one or two counterparties at a time, they are often looking at lists of 10 or more, implying that more investors are considering diversifying around counterparty risk by using multiple exchanges.

“I think this is an opportunity to really raise the bar as an industry, because we’ve had a couple of challenges,” said Schwenk. “A big one is just the immaturity of many of these counterparties. As centralized exchanges grow up, many of them are stubbing their toes along the way. Things are not as buttoned up and put-together as we would like them to be.”

There are also plenty of bad actors in the digital assets industry, according to Schwenk. But differentiating immature actors from bad actors is often only possible in hindsight, after the money’s gone.

The path towards more maturity and trust in digital assets will be paved by transparency. After 2022’s failures, investor and consumer expectations for transparency are going up.

“We’re working on developing and defining what the expectations of transparency should be that are reasonable for the industry to meet at this stage of its maturity, and necessary for those who are taking risk,” Schwenk said. “We’re going to see a lot of solutions to some of these problems being worked out and built out, whether it’s the ability to trade on Binance while your assets are in custody in a separate entity and in theory segregated client funds, or net settlements solutions.”

About FTX

One of the biggest failed exchanges in 2022, FTX, was not on DAR’s vetted exchange list ahead of its collapse.

“FTX was not on our vetted list, but we definitely had some things that worked, and some things that we could have done better with or that we just missed,” said Schwenk. “We had some immediate fails in our diligence based on public information on FTX, one being the lack of robust [know your customer] and [anti-money laundering] controls – you could actually trade on FTX.com without providing proof of identity, and that opens up the opportunity for wash trading and market manipulation as well as money laundering concerns.”

The opaque relationship with crypto hedge fund Alameda Research was another red flag, according to Schwenk. Attempts to get FTX to clarify its relationship with Alameda were dismissed.

Eventually, Sam Bankman-Fried stepped down from Alameda Research to focus on FTX and the nature of his continued involvement in both firms was obfuscated.

“They were just not very forthcoming,” said Schwenk. “One of the things we got right was in recognizing that there was no clarity into how they were managing those conflicts. You could jump to conclusions and suspect that there was a possibility Alameda was front-running clients or has fast-track access to the exchange – we didn’t know exactly what it meant, of course, but without a policy governing or for managing those conflicts, the suspicions were warranted. You need to have questions about why they weren’t offering to address the issue.”

Other concerns included the likelihood that FTX’s native FTT token was actually a security, and that FTX was potentially running afoul of securities laws.

DAR was engaged by a large hedge fund to conduct institutional due diligence on FTX – and when the analysts requested more transparency from the doomed exchange, they were met with resistance.

“We came in with a request for more transparency around the number of what would be deemed confidential materials,” said Schwenk. “This is something we’ve done successfully with CoinBase, Genesis, Hidden Road, Falcon X and a number of more mature centralized counterparties. The response of FTX was that ‘we are not willing to engage in diligence at all, especially given the questions we think you are going to ask.’”

So Schwenk and DAR tried to leverage personal relationships they had with people behind the scenes at FTX, but were “boxed out” of any amount of diligence they tried to conduct.

To see a digital assets exchange interested in courting large clients but unwilling to participate in modest due diligence “screamed red flags,” according to Schwenk.

“When you make those kinds of overtures, the tone and manner of the response, there’s valuable information in that,” Schwenk said. “It lets you know that they’re either immature, or that bad things are happening – and it turns out that it was both at FTX, based on the information we have now.

“I lived through the financial crisis as COO of a $1 billion hedge fund, we did diligence on Morgan Stanley, Goldman Sachs, BNY Mellon, Lehman Brothers, and we stayed out of Lehman because of the inherent risks and didn’t get caught in the bankruptcy,” he said. “Crypto people need to apply the same thinking in times of stress.”


Learn more about Consensus 2024, CoinDesk's longest-running and most influential event that brings together all sides of crypto, blockchain and Web3. Head to consensus.coindesk.com to register and buy your pass now.


Disclosure

Please note that our privacy policy, terms of use, cookies, and do not sell my personal information has been updated.

CoinDesk is an award-winning media outlet that covers the cryptocurrency industry. Its journalists abide by a strict set of editorial policies. In November 2023, CoinDesk was acquired by the Bullish group, owner of Bullish, a regulated, digital assets exchange. The Bullish group is majority-owned by Block.one; both companies have interests in a variety of blockchain and digital asset businesses and significant holdings of digital assets, including bitcoin. CoinDesk operates as an independent subsidiary with an editorial committee to protect journalistic independence. CoinDesk employees, including journalists, may receive options in the Bullish group as part of their compensation.

Christopher Robbins

Christopher Robbins is a nationally recognized journalist who has been featured as a speaker and panelist on topics including investing, personal finance and wealth management. He is a contributing writer for CoinDesk’s Crypto for Advisors newsletter.