Creating an Audit Trail for Centralized Finance (CeFi)

Written by TJ

On July 7, 2022

The past 3 months have been a revelation for crypto market participants about the consequences of lack of transparency in a complex financial system.

The crash of Luna in March set off a domino effect of financial calamities that have since brought down highly regarded crypto entities that many would have never expected were in a fragile financial position.  These include Celsius, 3 Arrows Capital, BlockFi, and Voyager

What these entities had in common is that they made a name for themselves and generated enormous amounts of wealth by speculating in the crypto markets or offering a bridge to DeFi services, while embracing almost none of the principles of transparency and decentralization that makes this industry valuable.

The result was a cascade of liquidations, margin calls, and insolvencies precipitated by trusted custodial providers not practicing basic risk management and taking on extreme amounts of leverage often with customers’ funds.

In a world of open, transparent, and decentralized protocols, the actions taken by participants in these companies would have been exposed much sooner. However, as traditional centralized companies, these entities were free to operate as opaquely as any other bank or hedge fund, except without the legal protections such as FDIC insurance or regulatory frameworks such as Dodd-Frank that have become standard post the 2008 financial crisis.

Moving forward,  companies wishing to operate in the crypto space and serve as a front end for DeFi protocols must abide by the same standards of openness and transparency that Dapps like Uniswap, Aave, and Compound do in order to reclaim the trust of end-users. 

The Accumulate Network, through its ADI-enabled universal identity layer, offers a convenient solution for Centralized Finance (CeFi) companies to achieve this goal and transform the way this sector of our industry operates. 

A Universal Identity and Communication Layer for CeFi crypto companies 

Accumulate establishes a communication and audit layer for all individuals, entities, and blockchains to transact with each other using Accumulate Digital Identifiers or ADIs – human-readable addresses similar to website URLs that are chosen by individuals or assigned by organizations to represent their presence on the blockchain.

In addition, Accumulate’s key management system makes it possible for entities to create a single signature or multiple-signature authorization schemes. These are rules for determining the number of digital signatures required to validate transactions from an account and can be useful for funds that custody billions of dollars worth of digital assets on-chain where there is a  need to establish a hierarchy of permissions for how to securely manage those assets. 

Under this framework, Accumulate can enable CeFi entities to represent themselves and their affiliates as ADIs, with each ADI operating a set of keys for managing funds that are transferred to and form Defi protocols or other centralized counterparties.

These firms would be able to keep track of the flow of funds within and between various chains while enabling customers and the general public to view an audit trail of current holdings, outstanding loans, and debts (all classified under different sets of accounts). 

This audit trail could be created so that it conceals counterparties’ specific identities while only displaying essential data points to show proof of solvency.

Over time, as more entities join the network and as data accumulates, reputation systems can be established that rank entities based on their level of transparency. DeFi protocols could leverage this data to provide economic advantages to the most transparent entities, such as greater access to under-collateralized loans, or more willingness to collaborate with the CeFi company to serve as a front-end for non-crypto-native retail and institutional customers.

Aggregate On-Chain & Off-Chain CeFi data

One of the issues that the 3AC incident highlighted was the lack of communication between lenders who were not aware of who else had lent money to the hedge fund and who else may have had a claim on the collateral used to issue new loans to the firm. 

A similar lack of transparency between Credit Suisse, Morgan Stanley, and other banks is what ultimately caused the Archegos debacle in early 2021, where Bill Hwang’s firm Archegos had managed to exceed their trading margin limits by borrowing from multiple banks using the same collateral (a process known as rehypothecation).  

When the fund eventually blew up from bad trades and excessive risk-taking (similar to 3AC today) many lenders were caught by surprise regarding the level of risk exposure they and other firms had to the firm and were subsequently forced to eat the $20 billion loss.  

The solution to this problem is to consolidate data from on-chain and off-chain sources related to lenders, borrowers, wallets, etc to create a trustless and transparent database that can help counterparties and end-users determine the risk profile of CeFi companies like BlockFi, Celsius, 3 Arrows, Voyager, etc. 

Under an ADI-based system, these links could be formed in a seamless manner by creating a string of accounts, transactions, and wallets connected to a single ADI representing an entity. 

As mentioned previously on the topic of auditing assets, the task of consolidating all of this data could become a significant opportunity for traditional auditing firms like PWC, Deloitte, and KPMG that have yet to find a strong business case for blockchain technology. 

These firms could essentially operate as validator nodes tasked with verifying the accuracy of off-chain lending and asset data submitted by CeFi firms, ensuring that what ends up on the Accumulate Network is both accurate and up to date.  

Conclusion 

The past few months have exposed how many of the most trusted entities in the crypto markets have essentially been operating as unregulated banks and repeating many of the same mistakes that led to the 2008 financial crisis.  

While regulations are a potential solution to mitigate the worst of these incidents, self-regulation through distributed and trustless technology is the only way to truly prevent firms like 3AC or Celsius from wreaking havoc on the market due to undisclosed use of leverage and excessive risk-taking.  

Accumulate is designed to serve as a bridge between the traditional financial system and the web3 ecosystem, which makes our technology the ideal solution to enable CeFi companies to operate with the same standards of transparency that we expect of DeFi protocols like Aave, Compound and Uniswap. 

If we are to expect DeFi to one day overtake CeFi as the primary engine for global financial markets, then we need to improve the way in which centralized parties engage in lending and borrowing of assets. First, by onboarding, all counterparties to a single decentralized network, assigning identities and roles to each party, and then leveraging this identity infrastructure to facilitate clear and transparent communication of information that is vital for creditors, investors, and end-users to know when engaging with these platforms. 

This is how crypto will ultimately mature beyond the reliance of traditional regulatory authorities to become a truly self-regulated and sovereign industry.  

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