The recent collapse of FTX has sparked a debate on the segregation of activities in the crypto market, particularly between market making and running an exchange and custodian services. The question of whether to segregate exchange and custodian activities is a nuanced one, with examples from the US grain industry in the late nineteenth century shedding light on the importance of controlling risks in these areas.
Cryptoasset custody involves managing information security risks, protecting private keys, and facilitating transactions for clients. Many early crypto exchanges bundled custody with execution to build client relationships and monetize their in-house custody capabilities. However, since FTX’s failure, there have been efforts to change this model, with the adoption of Off Exchange Settlement (OES) and regulatory measures calling for the use of Qualified Custodians for client assets.
The development of grain exchanges in the late nineteenth century US, like the Chicago Board of Trade (CBOT), illustrates the tension between custodians and exchanges. The commingling of grain in elevators allowed for unscrupulous practices by warehousemen, leading to conflicts of interest and quality issues. The importance of segregating client assets from those of exchanges is highlighted to prevent such abuses.
The article also discusses the risks of commingling assets and custodians trading on their own account, drawing parallels between the grain and crypto markets. The conflict of interest and information asymmetries faced by warehousemen in the grain industry mirror challenges in the crypto market. The importance of managing these risks while retaining economies of scale is emphasized, with historical examples providing insights for the cryptoasset industry.
Overall, the article calls for a balanced approach to managing risks in the crypto market, drawing on lessons from traditional exchanges and industries like the US grain market. By addressing conflicts of interest, ensuring transparency, and segregating client assets, the crypto market can evolve in a sustainable and secure manner.
