The prevailing narrative for the past several years around blockchain and digital assets has been that regulatory risk is the biggest threat to the industry, but that’s false.
If the past two years have taught us anything, it’s that regulators will work at their own pace to sort rules and regulations; and we must continue to educate and lobby about Web3 technology on a global front. However, as an industry we also need to address the elephant in the room: founder risk, and not accept this as par for the crypto course.
In what seems like the blink of an eye, the leading lights of our industry have gone from starlets to snake oil salesman — the list of implosions reads like a who’s who of whom mattered only two years ago — FTX, Voyager and looking farther back Mt. Gox and Quadriga, the list goes on seemingly forever; but how did these platforms fail, and how were they able to take billions of dollars in client capital down with them?
Are regulators to blame?
Our industry pounds the drum about the lack of clear regulation when enforcement regulators come after projects. And I agree that about 90% of the time this drumbeat is true. But exchange founders that lost or misused client assets in their custody can’t really claim a lack of regulatory clarity as a defense.
There is a single aspect of digital asset and Web3 market structure that differs from traditional markets, and this difference is what has led to most of the pain in our industry — no industry standards around asset custody.
Anyone who understands basic finance knows a simple truth: assets should be segregated from where they are traded. The platform where you trade should not also be where your assets are held. This is a clear conflict of interest that, until remedied, will lead to continued asset vaporization.
Most of the prominent people in crypto built their bonafides claiming they have traditional markets experience. From Sam Bankman-Fried’s time at Jane Street to Voyager CEO Steve Ehrlich’s time at ETrade, people tend to tout their Wall Street bone fides.
See also: Where Is Crypto Policy Heading in a Post-FTX World? | State of Crypto Week
In that world, exchanges and trading firms do not hold the assets that are traded on their order books. No one who wants to trade Apple (AAPL) stock hands their stock certificate to Nasdaq and says “hold my stock until the trade is settled” because most reasonable people understand that something could potentially go wrong during the time when the exchange has your funds.
That’s why assets typically sit with a third-party custodian such as Bank of NY Mellon or Fidelity, even if you have a broker in the middle such as Schwab or TD Ameritrade.
No transaction-based platform should act as a custodian, even if the founder claims that “banks aren’t your friends.”
The crypto conundrum
All centralized exchanges and brokers have roughly the same setup — which is custodying the asset that you trade with them. Given the amount of probes and criminal charges and trials currently publicly known, I simply don’t understand how this is still possible.
Think about this scenario for a second: you on-board to a centralized exchange and want to trade. You transfer your assets to the custody of the exchange and you then have an account ledger that reflects your balance and you can trade off that. But your assets actually sit in custody with the exchange, co-mingled with those of other traders. There are no segregated accounts and you have authorized the platform you are using to be able to move your assets at-will.
In fact, the terms of service of many of these platforms list you as an unsecured creditor in the event of a bankruptcy (which most people don’t know since who really reads the terms of service?). Even if the terms don’t, most jurisdictions will treat your assets as such. Basically, you are handing your hard earned investment funds over to a third-party who can do as they please with them, and you’ll be lucky in the event of an insolvency to receive pennies on the dollar.
Even worse — if the exchange can move your assets — they can abuse your trust. The truth is, you don’t know for sure where your assets really are and what an exchange might be doing with them. And, at this point, shame on you for falling for it again.
There is a solution
Many people call self-custody the answer — but there is honestly no such thing as self-custody because in order to be a custodian, you have to be a non-conflicted third-party who holds assets as your raison d’etre, you have to be Fidelity.
The segment of the industry obsessed over self-custody hasn’t yet grasped the obvious: most people do not have the technical knowledge, ability or desire to use self-custody wallets and manage seed phrases. This is how we end up with people on national news lamenting their loss of a quarter billion dollars.
You and I cannot be custodians, but we can meet in the middle, KYC’d/AML’d self-ownership with support for key recovery across a sharded database. I know this sounds complicated, but it isn’t.
In order to interact with a trading venue, you first pass KYC/AML compliance onboarding before putting your assets in a specially designated non-custodial wallet controlled by you that can interact seamlessly with the exchange. You face none of the risks stemming from omnibus accounts that are being used by every other centralized venue.
What this means is that your assets are physically unable to be mingled with others like what happened with FTX and Alameda Research — you are safe from any actions by a centralized party or individual.
By going through this process, you are ensuring that you are not a bad actor, not trading with other bad actors and your trading platform is showing that it adheres to regulatory requirements. You also are setting a baseline in the event you lose your seed phrase where it can potentially be recovered by going back through the KYC/AML process to prove your digital identity in the event of a seed phrase loss.
This is the path forward
Currently, the bulk of online users are on Web 2 platforms, and we want to get them onto Web3. The future is coming soon, but we have about a decade where we need to ease people into the idea of decentralized, autonomous ownership of assets. This transition will not be easy, but it will be among the most meaningful shifts in human history.
We have likely hit the max on people who will do self-custody, and we need to evolve towards a more nuanced solution that enables mass adoption while also protecting from internal and founder risk at exchanges.
Rome wasn’t built in a day, and the financial markets of tomorrow will not be built overnight; but all this hard work will be worth it, and we call on the industry to meet users in the middle rather than force innovation down their throats long before they are ready to embrace it.
This will preserve assets, and build the trust needed for the mass adoption that will enable Web3 platforms to survive.
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