Centralized cryptocurrency exchanges are the most popular kind. Therefore, it’s not surprising that there are over 300 of these platforms which serve as trading grounds, but also double as a storing platform for traders.
This is due to their native wallets, which makes it easy for anyone to use. These centralized exchanges can pose quite the problem. For those who don’t know, custodian central exchanges are those that holds your crypto assets’ private keys.
This means that they have complete control over your assets. Any entity that controls your private keys, essentially have access to your assets and can do whatever they want with it.
The dangers of this includes, their ability to withdraw your tokens/funds, as well as increased vulnerability to hack attacks. So, in the event of a loss, you may never be able to recover lost or stolen tokens.
More importantly it would imply that you’re willing to trust strangers just because they offer a platform for you to trade on. You wouldn’t trust a stranger with your wallet in the real world, would you?
So, you see why this is not exactly a smart thing to do. With the increasing number of custodian service providers, there are many options available for crypto traders and investors to explore.
These custodians usually have and run military grade encryption services that prevents them or anyone else apart from you, from accessing your wallets that are domiciled with them.
Centralized exchanges are really prone to a large number of issues because of a major flaw in their design: the person in charge of the private key, basically owns the assets therein.
Thus, if you have a wallet full of cryptos that’s resident on the exchange, that wallet and those cryptos aren’t really yours. Worse, those funds that are domiciled on the exchanges can be used by the companies to manipulate the market.
In fact, popular exchanges such as Huobi, OKEx and Binance have been known to do so. These exchange based custodian services are similar to the tiger guarding the sheep –the tiger will always eat the sheep.
Miko Matsumora, cofounder of Evercoin exchange says that this can create a large number of problems:
“The problem is that once crypto exchanges take custody, everything they do is hidden from view. Recently, Huobi used user EOS tokens to get payments to vote for their own block producers. This was visible on the blockchain. Who knows what other abuses are taking place behind closed doors,”.
Centralized Exchanges Aren’t Subject to Regulations
These exchanges can do almost anything they want with your funds because they aren’t regulated. This lack of regulations makes storing your funds on these exchanges problematic.
“Like a bank, a custodial exchange is empowered by their onerous user agreement to use user funds for whatever purpose they see fit. Like a bank they can lend out user funds, but unlike a bank they are largely unregulated and they do not provide interest payments,” Matsumura said.
So, even though their custodian services operate like banks, they don’t have the one thing that banks have: insurance. Banks in the US are insured by the Federal Deposit Insurance Corporation (FDIC). So, if the bank loses your money, you are insured and will get back your money.
But, if you lose your tokens on these exchanges, there’s no one to fight for you and get your tokens replaced, because they are uninsured. Where the FDIC protects against the loss of all insured deposits, many centralized crypto exchange custodian services don’t.
Hence, you’ll most likely be left high and dry in the event of their failure. The good news though, is that some of these exchanges are beginning to take proactive steps towards securing insurance coverage for all crypto assets within their purview.
Notable among them is Gemini, the exchange whose parent company is The Gemini Trust Company. The company whose cofounders include Facebook’s Winklevoss twins –Tyler and Cameron- stated this in a press release.
Gemini’s insurance coverage is provided by a group of insurance firms that were arranged by Aon. This, combined with the FDIC insurance they have on dollar deposits makes them an excellent exchange to legitimately run custodian services.
However, this may still not be enough. Alex Mashinsky, CEO of Celsius Networks, a VOIP company says,
“A lot of what the crypto community is seeing in traditional crypto markets is just a rebirth of bad ideas from the 1800s, all being used to take advantage of the fact that regulations don’t cover loopholes.”
“We are seeing a lot of conflict of interest concentrated most with exchanges where people don’t understand that these entities don’t act in their best interest. Due to the lack of transparency and regulations, there is a lot of stuff happening that would be illegal if it happened on the NYSE, for instance.
The idea of separating custodian share trading and so on all derived from the fact that if you look at the collapse of the Lehman Brothers, all of this goes back to why the federal reserve bank was created. Simply put, you can’t let the cat guard the milk,”
What are the Best Options Available?
It is well known in the cryptocurrency space that centralized exchanges do a piss poor job of keeping your tokens and crypto assets in their custody. But, there are viable alternatives that work just as well, if not better.
One of these is the separation of exchange services from custodial services. An example of a service that’s done this well is BitGo. According to Matsumura,
“This could be separated at the regulatory layer, or simply that users can become more sophisticated about how their funds are being abused and migrate to better solutions themselves,”
An even better option is to combine a user-controlled multisig key with the certified custodial service, for a more potent result. According to Paul Puey, cofounder and CEO of Edge Wallet,
“Partial custodial solutions, where companies hold only one of several keys needed to spend crypto, will be the future of custodial solutions. This will prevent any leveraging of assets, will require fundamentally different business models for custodians, and will help provide the benefits of security against loss and theft.”
An even better option –although not as popular at the moment- is the widespread adoption of decentralized exchanges. According to AirSwap Strategist, Sam Tabar,
“Centralized exchanges in crypto act like old world stock markets exchanges. These are old world solutions placed on new worlds. We don’t need old style centralized solutions to make a trade. The risk of having these centralized exchanges take custody of your money is not only high, but unnecessary. One of the reasons why exchanges make terrible custodians is because it’s unclear if they are fiduciaries towards those who park their money.”
“Custody should be a segregated function in my opinion. Most exchanges are not even insured. So you lose your crypto if the exchange gets hacked. Frankly, the trading world should be aware that they can make trades using non-custodial decentralized exchanges. There is no need to rely on centralized exchanges to make trades. Once the world is more familiar with this, there will be what I call ‘the great liquidity migration’ away from centralized exchanges”.