Why do trading platforms always experience bank runs?

As the crypto market as a whole enters a bear market, many institutions, especially trading platforms, have experienced bankruptcy and bank runs one after another. The dramatic collapse of FTX this month has once again sounded the alarm for people. People can't help but ask why famous trading platforms continue to close down in every cycle. Is this an inherent defect brought by cryptocurrency, or is it an overall problem of the industry?

Business model of trading platform

To answer this question, we need to first review the traditional financial asset exchanges that have a history of hundreds of years.

What is the business model of traditional trading platforms?

The main profit models of these traditional asset exchanges are actually similar. Whether you are a stock exchange (such as Nasdaq, Shanghai Stock Exchange) or a commodity futures exchange (Chicago Stock Exchange, Dalian Commodity Exchange), their main income actually comes from the transaction fees charged during the transaction.

The fees can come from spot trading or derivatives (perpetual contracts, futures, etc.), but the essence remains the same: the more customers trade on it and the higher the trading frequency, the higher the exchange's fee income. After deducting labor costs and various expenses incurred by asset custody from these incomes, the remaining is the profit of the trading platform.

We randomly searched the income structure of some traditional exchanges and found that their main sources of income are still traditional transaction fees and derived value-added services such as information services. The fee income of pure cryptocurrency trading platform Coinbase accounts for a higher proportion. Based on the full-year data of 21, Coinbase's fee income accounts for more than 90%.

Source: Company announcements, company websites, CICC Research Department

It can be seen that the asset trading platform under this model is not as sexy a business as people imagine. It may not be difficult to make a profit, but it is also difficult to make huge profits by opening an exchange.

Business Model of Crypto Trading Platforms

Let's go back to the crypto asset trading platforms we are familiar with. The reason why they always give people a feeling of being rich is that most of them do not follow the most basic exchange business model, and more or less misappropriate user assets for speculation or market manipulation. This is the most essential difference between these platforms and traditional compliant exchanges (such as Nasdaq, Hong Kong Stock Exchange, etc.).

So the next question is, how do these crypto asset trading platforms misappropriate customer funds?

Two forms of misappropriation of client funds

Depending on the specific methods, there are currently two main forms of misappropriation of customer funds by trading platforms. The first method is simple and crude, and is literally direct misappropriation, while the second is more covert.

The first type of misappropriation: direct transfer

For example, after the FTX crash, we found that its user custody assets, which should have been stored in cold wallets, were borrowed by Alameda, which is also controlled by SBF, for speculative trading or to make up for losses at the beginning of this year.

This misappropriation is equivalent to lending the client’s entrusted assets to external parties, so the client’s entrusted assets directly become Alameda’s IOUs. If Alameda can continue to make profits and repay the loan on time, it may be fine. However, once Alameda fails in investment and loses the ability to repay, the value of the IOU will directly return to zero, resulting in the user’s assets being unable to be redeemed.

Type II misappropriation: using customer assets for trading

The second type of misappropriation is more hidden than the first, because in theory these assets are still stored in the exchange's account or address. In addition, in many cases, the value of the total assets of the trading platform is greater than the value of the liabilities (that is, the value of the assets deposited by users), which is why many platforms repeatedly claim that they have sufficient reserves.

So if this is the case, why do we still call the use of customer assets for trading "misappropriation"?

Let's take a simple example. Suppose a trading platform only has a total of 10 million US dollars in customer custody assets, Bitcoin (this 10 million US dollars constitutes the platform's liabilities to customers, and customers can apply for withdrawal at any time). For speculative purposes, the platform exchanged 5 million US dollars for Shibs with greater appreciation potential.

In the bull market, the price of Shib purchased by the platform increased by 3 times to 15 million yuan. Assuming that the price of Bitcoin remained unchanged, the platform now has 15 million Shib + 5 million Bitcoin, a total of 20 million assets. At the same time, the debt owed to customers is still 10 million Bitcoin. Obviously, any audit report issued at this time will show that the assets of platform users are fully paid.

But if the market turns into a bear market, the price of Bitcoin drops by 50%, and Shib drops directly to 1% of its highest value. The platform's assets will become 2.5 million yuan (500*50%) of Bitcoin and 150,000 yuan (1500*1%) of Shib, a total of 2.65 million US dollars. However, the liability side still owes users (1000*50%) 5 million US dollars in Bitcoin. At this time, the platform's assets are obviously not enough to pay off the debt owed to users.

Note that at this time, the assets in the platform are still stored in the platform's address or account, and the first type of misappropriation does not occur, but the user's assets still suffer losses.

This is one of the reasons why the platform is more likely to go bankrupt after the market turns into a bear market: the assets it holds are inconsistent with the risk exposure of the assets deposited by customers due to the platform's own speculative trading. Even if the previous audit report shows that the platform has excess reserves and there is no misappropriation in the first case, as market prices change, the platform may still have problems with insolvency, which will eventually cause a run.

We can also see signs of the second type of misappropriation from the collapse of FTX. According to some rumors, FTX's assets were far higher than its liabilities to users at the beginning of this year, and its main positions were FTT, Sol and other FTX tokens. However, as the market went down, its asset side depreciated much faster than its liabilities, which eventually caused an irreparable deficit.

If these rumors are true, then the FTX incident involves both the first type of direct misappropriation and the second type of misappropriation. It can be said that the platform has completely ignored the most basic business logic and put users at unpredictable risks.

Is it normal business practice for trading platforms to misappropriate funds?

Some people believe that the platform's use of user assets to gain more profits is a helpless move in the highly competitive market environment, and the platform's only mistake is that it lost money in the transaction. If the platform can maintain profitability, then all the bad consequences will not happen in the end.

Indeed, this logic is basically the real situation of the current cryptocurrency trading platform under fierce competition. However, we still need to answer here whether this behavior of misappropriating funds should be recognized as normal business activities.

If we put aside the subject of this issue, that is, the trading platform itself, and only look at the specific business activities behind it, in fact, these two types of misappropriation are mature business models that have already existed.

The first type of misappropriation is actually very similar to the lending business of banks or small loan companies in traditional finance, while the second type of misappropriation corresponds to asset management businesses such as funds and VCs. In this case, can we say that the behavior of cryptocurrency trading platforms using user funds for lending or investment is also a kind of "innovation" to improve the efficiency of fund use?

Obviously not. Even if we completely ignore regulatory issues and only evaluate from the most basic business logic, this behavior is not in line with the most basic market transaction principles.

After all, if the platform makes money through misappropriation, the profit will belong to the platform, but if there is a loss, the loss will be borne by all users. The high "financial management" income that we occasionally see platforms provide is often used as a bait to borrow new money to repay old debts when the platform's deficit is too large to make up for it, and it is not a real dividend.

In comparison, the business models of banks and fund companies are completely different. Generally speaking, in order to compensate users for the credit risk they bear, banks need to pay fixed interest to depositors, and although fund investors need to share losses, they will also receive most of the profits through dividends when they make a profit.

Simply put, the risks and potential returns assumed by customers in these two models are equal, and users have the right to freely choose according to their preferences, so it is a fair market transaction behavior.

On the contrary, the misappropriation of funds by trading platforms is completely in a black box. The platform not only enjoys all the profits of the misappropriation, but also does not have to bear the risk of investment failure. If I make money, it is my money, and if I lose money, it is the users who bear the blame. It is also difficult to be regulated and sanctioned by major countries. Such unequal business opportunities will naturally continue to attract participants who lack moral bottom line.

Not to mention that this unfair transaction has never been disclosed to users when opening an account, so it is not an exaggeration if we directly define it as fraud.

How to solve the problem of misappropriation of user assets?

To be honest, the problem of misappropriation of user assets is not a new problem, and it has nothing to do with crypto assets themselves. Because there have been countless similar painful lessons in traditional finance, and many mature solutions have also been explored. These mature solutions are now collectively referred to as supervision.

1. Compliance supervision

Although the regulatory policies of each country are slightly different, the overall idea is basically the same. For example, the "third-party custody" that domestic A-share investors are more familiar with is to transfer the custody of assets and funds from the trading platform to third-party banks and securities registration institutions, completely eliminating the ability of brokers to embezzle user funds. In addition, there is an access system for practitioners, severe criminal penalties for misappropriation of funds, regular audit systems, etc.

These systems have greatly suppressed the ability of centralized trading platforms to do evil. Take domestic securities firms as an example. We should have rarely heard news about user assets being misappropriated, and we have basically never heard of bank runs.

2. Trustless decentralized trading platform

In addition to the centralized solution, another completely different approach is the "trustless" solution represented by decentralized trading platforms.

The fundamental purpose of decentralization is to reduce the trust cost of collaboration between social entities. Just like the example just given, the traditional regulatory thinking always uses a larger centralized organization to enhance the trust of a smaller centralized organization. But all of this still has to be based on the ultimate trust in a certain organization. But the facts tell us that even if this centralized organization is as powerful as the Federal Reserve, it is still not so reliable in the long run. (You can look back at the depreciation rate of the US dollar over the past 100 years. Compared with the zero-returning coin, it can only be said that its zero-returning speed is slower and more stable.)

Therefore, if we want to fundamentally solve this problem, we need a completely decentralized technology platform. Based on the trust in the public chain consensus mechanism and the smart contract code, we can build healthy business logic in an unregulated environment.

For example, Uniswap in spot trading does not need to custody user assets, so there is naturally no problem of misappropriation. All business logic is based on the on-chain code that cannot be tampered with and the public chain consensus mechanism with extremely high attack costs.

3. The middle ground

Of course, the vast majority of current crypto asset trading platforms are actually in the gray area between the first two solutions. They lack the corresponding supervision of centralized platforms, and do not have the transparent and verifiable attributes of decentralized platforms. Therefore, they have become a high-incidence area for misappropriation of user assets.

Strictly speaking, these centralized platforms cannot be considered as blockchain industries, but are just traditional centralized institutions that trade encrypted assets and evade regulation. Their operating philosophy and organizational methods are also far from the core spirit of cryptocurrency.

Of course, the industry has explored some solutions for this kind of centralized institution in a gray area, including the Merkle tree proof of funds, which has recently attracted renewed attention.

Due to space limitations, I will not discuss the Merkle tree proof logic in detail here, and it also has many unresolved issues. For example, this proof can only prove that the platform's assets are greater than its liabilities at a certain point in time, but it cannot determine whether the assets at this point in time are temporarily borrowed, nor can it prove that the platform does not have the second type of misappropriation.

Although some improved solutions have entered the theoretical design stage, including the method of using zero-knowledge proof to assist verification proposed in Vitalic's article, these theoretical ideas are still some distance away from actual implementation.

Finally, to sum up, for all kinds of trading platforms currently in the middle ground, the so-called Merkle tree asset proof can only be regarded as a very small subset of the traditional audit mechanism, and the role it can play is far from everyone's expectations. Therefore, the Merkle tree asset proof only creates certain obstacles for trading platforms to misappropriate user assets, but it cannot fundamentally solve the problem.

Some reflections from the FTX bankruptcy incident

At the end of the article, we once again summarize some lessons learned from this FTX crash incident.

1. The core of financial products is risk management, not user experience

The core value of any financial institution is the reasonable management of risks, rather than various superficial features such as convenience, experience, speed, etc. Various behaviors of putting the cart before the horse have repeatedly appeared in Internet finance, and then they were repeatedly repeated after the so-called "crypto-institutional bull market".

For ordinary investors, if they cannot use regulated and compliant centralized trading platforms and are not used to operating decentralized on-chain DeFi protocols, they may as well presume guilt when using various centralized platforms in the gray area. Once there is any sign of trouble, be aware of it first, and don't try to use your hard-earned money to bet against the personal morality of the project party.

2. Trust in individuals, organizations, and powerful forces is extremely unreliable

We often say "Don't trust, verify", but the fact is that people are still accustomed to superstitious belief in power.

The history of cryptocurrency development has repeatedly told us that superstition about any person or organization is extremely unreliable. The only thing we can trust is a sound game check and balance mechanism (such as the "invisible hand" of the free market, separation of powers, proof of work, etc.), rather than any powerful authority or individual who promises you a bright future (in addition to the collapsed FTX, of course, it also includes Sun Ge and CZ who are still calling the shots).

Facts have proven, and will continue to prove, that these unconstrained centralized entities will only exploit people’s trust to reap their wealth. The only difference may be the specific method and time of the harvest. Therefore, do not simply entrust your wealth to any unconstrained centralized organization. Learn to be a “sovereign individual” who can be responsible for yourself, rather than a giant baby who always needs to be taken care of by others.

BlockBeats reminds that according to the document "Risk Warning on Preventing Illegal Fund Raising in the Name of "Virtual Currency" and "Blockchain"" issued by the China Banking and Insurance Regulatory Commission and other five departments in August 2018, the general public is requested to look at blockchain rationally, not blindly believe in the exaggerated promises, establish correct monetary concepts and investment ideas, and effectively enhance risk awareness; any clues of illegal and criminal activities discovered can be actively reported to the relevant departments.