In recent months, there’s been another example of the damage caused by the lack of transparency within the world of CeFi crypto companies.
The decline in crypto prices set off a domino effect of imploding crypto hedge funds, lending companies, and exchanges that played loose when it came to risk management and safeguarding customer funds.
The recent crash of FTX is by far the most egregious example of mismanagement of customer funds by a custodian that we have witnessed by a high-profile centralized exchange.
To give a quick summary of what happened: FTX skirted its fiduciary duty as a centralized custodian by lending customer deposits to its sister firm Alameda, a market-making & trading firm that was famous for providing liquidity to the crypto markets during DeFi Summer and infamous for allegedly using their close relationship with FTX to gain access to customers trading orders in order to trade against then.
When Luna crashed and 3 Arrows Capital imploded, Alameda suffered a major loss to the tune of a few billion dollars. This loss threatened to put the firm out of business.
Sam Bankman-Fried, the now former CEO of FTX, made the decision to plug the hole in Alameda’s balance sheet with deposits made by FTX users.
This action exposed FTX to risks of insolvency in the event of a bank run, which is exactly what occurred when rumors of both Alamada and FTX’s financial woes led Binance CEO CZ to liquidate their stake in FTX by selling the exchange’s token FTT.
This triggered a bank run on fears that FTT’s loss in value would lead to forced liquidation of FTX’s outstanding loans, creating further instability. The bank run naturally led to a pause on customer withdrawals, FTX bankruptcy filing, and all the revelations that have come to light since.
What’s clear for this incident and the Celsius, BlockFi, and 3AC incidents is that there is far too much opacity in how CeFi companies operate their business.
The simplest way to verify the solvency of a business is to look at its balance sheet, which should provide a clear breakdown of assets and liabilities.
As private companies or companies that operate in offshore markets with limited regulation, these CeFi companies have no legal requirements to publicly share their balance sheets.
This puts investors and especially users in the precarious position of having to trust that the company they are custodying their funds with, or the company who is borrowing their funds in order for them to generate yield on their crypto is solvent.
In the wake of the FTX crash, several exchanges have come forward to provide ‘proof of reserves’ as a way to rebuild trust with their customers. However, proof of reserves is simply a display of the number of assets that these exchanges have on their balance sheet, which is only half of the equation.
As we said before, verifying the solvency of a business requires looking at a breakdown of both assets and liabilities. Regarding liabilities, this can be more complicated, as it involves not just knowing how much money the exchange owes, but also who the counterparties are that are owed this money.
Using ADIs to Create a Verifiable Audit Trail of CeFi Creditors
This is a problem that is perfectly suited for decentralized digital identifiers (DIDs).
DIDs refer to a system for assigning unique digital identities to assets, individuals, or entities on the blockchain. Accumulate Digital Identifiers (ADIs) build on this technology by presenting human-readable addresses that are chosen by individuals or assigned by organizations to represent their presence on the Accumulate Network.
Accumulate Network can serve as the de facto audit and communication layer for the transmission and recording of all data relating to CeFi assets and liabilities.
Everything from the list of individual creditors and the loan transaction receipts to the cold wallet addresses of crypto assets representing user deposits could all be registered as an ADI.
The goal would be to make it possible for anyone to observe the ratio of exchange assets to outstanding liabilities in real-time, and determine how safe it is to deposit funds to the exchange or Cefi lender based on this ratio.
Let’s walk through some examples of what this could look like:
First, to briefly explain how CEXs and CeFi lenders manage user funds:
CEXs and CeFi lenders are custodial services, where users are issued public key addresses that are all tied to a set of private keys owned by the platform. This gives the platform control over the underlying assets while still giving customers the ability to send and receive (with the platform’s permission) using the public key address tied to their account.
On a centralized exchange, if a customer purchases 10 ETH with their credit card, I am required to purchase an equivalent amount of ETH and store it in a cold wallet to match the user’s holdings. Similarly, if the user deposits 10 ETH from their wallet, I must store that 10 ETH in my reserves so that I can deliver it back to the user if they choose to withdraw their funds.
Customers who use CeFi platforms are essentially trading IOUs that they trust are fully backed by the exchanges reserves. All users crypto deposits are supposed to be backed 1-to-1 on the CeFi platform. This means 10 ETH of users’ deposits must be matched with 10ETH of reserves.
Matching crypto deposits with cash reserves is highly risky because if crypto prices appreciate then it increases the mismatch between the value of IOU deposits and exchange reserves. The same mismatch can occur the other way around.
If there is a mismatch in the value of the assets held by the exchange and the total IOU value of user deposits, it means that the exchange will be unable to fulfill all withdrawal requests if all users wanted to withdraw their funds at the same time.
Now, even if the exchange has reserves that match or even exceed user deposits, one still needs to verify that only the users have claims on those reserves.
For example, if 10% of an exchange’s reserves are loans that can be recalled at any moment, then in reality the exchange does not own that portion of their reserves even though they reside in their cold wallets.
Similarly, if a CeFi Lenders promising to generate 8% APY with user deposits cannot provide a transparent audit trail to show who the counterparties are that borrowed user funds to provide that APY, then the user is taking much greater risk than they are aware of.
Therefore, there are 2 important questions to answer: 1) how do we verify who has claims on the exchanges reserves? 2) How do we verify who are the counterparties that CeFi lenders are lending user deposits to?
This is where the Accumulate Network can help CeFi platforms provide much greater transparency. Exchanges can onboard their lending counterparty to the Accumulate network and tokenize their loan agreements such that the size and terms of the loan are transparent for all users to see.
These counterparties would serve a critical role of confirming the details of the loan by registering the exchange’s liability as an equivalent asset on their balance sheet.
These details could be embedded into the subdomains of the exchange and creditors ADIs:
|Exchange ADI string||Creditor ADI string|
Similarly, CeFi lenders could onboard all off-chain counterparties to whom they lend user deposits in order to generate yields.
If these counterparties are transferring user funds to other counterparties, then this trail must be documented as well. The end goal should be for users of the CeFI lending platform to be able to locate the wallet address where their deposits are being held, regardless of how many counterparties it moves through.
This is where the Accumulate key management system could provide value. It allows entities to generate multiple wallet keys that are linked to a decentralized digital identifier or ADI. Entities have access to a set of key books which reference multiple keys within a Key Page. Keys can be arranged based on a set priority. For example, you can create high-priority keys that are placed in cold storage for use in case your other keys are lost or compromised.
In addition, each account or sub-identity on the Accumulate network can be designated a specific key page. You can have a key page consisting of keys for significant transactions such as moving funds on behalf of a DAO treasury of institutional clients and another key page for transactions of lower importance, such as testing newly deployed Defi smart contracts.
Lastly, Key Books can also allow ADIs to update their security settings to include multi-sig transactions (transactions that require 2 or more digital signatures), delegated transactions (transactions that can be initiated by an external authority based on 3rd party verification), managed transactions (transactions that include self-imposed limits on spending or frequency) or other conditions without having to touch high-priority keys, thereby maintaining the highest possible security standards and minimizing vulnerabilities.
These are just a few examples of how CeFi platforms can follow DeFi in offering a more transparent and auditable record of their balance sheet and activities.
Given all that has happened in the past 6 months, exchanges and CeFi lenders should be highly incentivized to onboard all counterparties unto a digital identity layer like Accumulate.
This will be an important first step towards restoring trust in their users and bolstering their reputation as entities that not only profit from but also believe in the power and ethos of blockchain technology.