Written one year after Terra-Luna returned to zero: Trust is rebuilt, and centralized exchanges will continue to exist

This month marks the one-year anniversary of the Terra -Luna incident and the six-month anniversary of the FTX collapse. These events represented the beginning and culmination of a chain reaction of other crypto projects that severely shook people’s confidence in cryptocurrencies and arguably triggered the most dire existential crisis in the 15-year history of the crypto industry.

Despite a rebound this year, with Bitcoin up nearly 65% ​​so far this year, these historical events are still worth pondering and thinking about how the crypto industry can rebuild better.

First, we should acknowledge that these events were not failures of blockchain technology, but rather the result of poor risk management and corporate governance, with some of the failed companies engaging in fraudulent behavior. The market continues to recognize the integrity and innovative potential of blockchain, as evidenced by the massive influx of funds into decentralized exchanges after the FTX collapse, and the positive response to Ethereum ’s Proof of Stake (PoS) transition and Shapella upgrade.

However, despite these developments, centralized digital asset exchanges (CEXs) will continue to remain relevant and exert enormous influence as a key entry point into the asset class, especially as its maturity and institutional adoption increase. After all, they remain the dominant platform when it comes to digital asset trading.

According to DefiLlama , as of mid-May 2023, CEXs accounted for almost 90% of all transactions on centralized and decentralized exchanges. Despite the setback in investor confidence last year, the outlook for CEXs remains bright.

What the industry does need to address, however, are the many weaknesses that came with interdependencies and an early “move fast and break things” ethos. To survive this crisis of confidence , CEXs need to address the need for better investor protection, risk controls, and prudent governance structures.

CEXs are here to stay

Managing a portfolio of digital assets is operationally complex, and investors require a comprehensive set of capabilities, such as custody, trading, investment products, advisory, and efficient fiat on- and off-ramps. In this regard, many CEXs integrate these solutions into a single platform, greatly reducing the technical complexity of owning and managing native tokens on different blockchains. When considering alternatives, the value proposition is clear: investors manage multiple wallets and directly participate in multiple liquidity pools across different blockchains. While some investors have the ability to do so, the high learning threshold suggests that CEXs will remain the platform of choice for many.

Investors who actively manage their portfolios may also want to frequently rebalance their asset allocations between traditional and digital assets. Therefore, the fiat on-ramp and off-ramp infrastructure layer in CEXs is critical, especially during market volatility.

Safety and security are other advantages that CEXs can offer. While the mantra “not your keys, not your coins” has long been circulated in the industry, according to Chainalysis , 18% of all cryptocurrencies stolen by hackers in 2022 came from CEXs, and the remaining 82% were decentralized applications. While CEXs still have a lot of room for improvement in better protecting customers from cyber breaches, they are relatively safer. As the industry works to restore trust and enhance its cybersecurity systems, the security gap between CEXs and decentralized applications should continue to widen.

Finally, an often underestimated benefit of a CEX (especially those that cater to high net worth and institutional clients) is the peace of mind of having a “call center” if something goes wrong. This is especially true for investors who manage assets on behalf of clients, such as family offices and hedge funds. Horror stories of millions of dollars worth of Bitcoin locked away in wallets are common, and investors will see value in working with centralized exchanges (CEXes) that offer a dedicated hotline or account manager.

Rebuilding trust by isolating assets

While CEXs may continue to exist, one area such platforms must improve is the separation of customer and company assets. There is more scrutiny around this now than ever before. Policymakers such as U.S. Treasury Secretary Janet Yellen have identified asset segregation as a key area that needs to be addressed in future regulatory frameworks, in large part to prevent a recurrence of the case of FTX commingling customer funds, a practice that caused many retail investors to suffer significant losses when the exchange went bankrupt.

Before the FTX collapse, the Monetary Authority of Singapore ( MAS ) proposed new regulations in a consultation paper released in October 2022 requiring cryptocurrency platforms to separate their assets from those of their customers. MAS also sought industry feedback on whether cryptocurrency platforms should appoint independent custodians to protect customer funds.

Therefore, CEXs should rethink their “one-stop shop” narrative. While it makes sense to have a seamless front-end user interface between custody and trading, on the back end, investors’ assets should be held separately by an external and qualified custodian, such as a bank or registered broker-dealer. CEXs should seek and publish independent certifications from auditors to verify that assets are indeed segregated and that robust risk and governance requirements are in place.

Instilling trust in a trustless system

When Satoshi Nakamoto published the seminal Bitcoin white paper in 2008, they envisioned a monetary system that no longer had to rely on blind trust. Yet, the entry point for most investors to gain exposure to digital assets today — exchanges — still operate in a largely opaque manner.

The events of 2022 have demonstrated that for the industry to move forward, investor protection, transparency, robust governance structures, and providing value to customers must return to the forefront of how exchanges are built and operate. CEXs that embrace these values ​​will find themselves with a competitive advantage as investors increasingly rely on trusted centralized platforms to manage their digital asset portfolios.

As we continue to rebuild, the industry may return to its roots: an industry born out of a vision of a fairer, more transparent, and more efficient financial ecosystem.