“Decentralized” — this was the initial idea of cryptocurrencies. But do we see the actual decentralization at the moment? No. As soon as your crypto leaves your wallet, you lose access to it. Not your keys, not your crypto. This is the foundational principle of Web3.

The fundamental mistake of Web3

What is the best way to hold your crypto assets? A lot of people say: “Crypto exchange.” Why?

Because that’s how a user feels more secure. We are used to relying on traditional Web2 security methods because the industry hasn’t switched to Web3 yet. Average new to crypto users think that just depositing funds to Binance or any other exchange is the safest way.

You can always check your balance on the exchange. You need to enter your email and phone number and use Google authentication to move your money. It all creates a sense of security. “Nobody will move my funds because my private phone number or email is linked to my profile.”

All security measures, attractive user interfaces, and other features are only the tip of the iceberg. The real business is run underwater. As soon as you have deposited your funds to any centralized exchange (CEX) or custody like a “crypto bank,” they are not yours anymore. You totally rely on the third party. CEXs is the only one but the most obvious example of custody.

Just imagine how many people use CEXs just for storing their funds. CEX was not created for storing. Its main purpose is to allow for making quick trades, building trading strategies, using algorithmic strategies, and more. It gives you access to liquidity, the most efficient trading instruments, derivatives, etc. But fundamentally, an exchange is not the place to store assets.

What’s wrong with exchanges?

Crypto exchanges are not regulated well. Most of them are registered in offshore jurisdictions. They are getting regulated only in places where they can’t work without regulations. That’s why Binance and Binance US, FTX and FTX US exist. Why not combine? Because exchanges won’t benefit from it. For the US entity, they need to disclose the information regarding only US customers. For the non-regulated geos, they are free to do whatever they want.

After depositing funds to exchange, your assets turn into numbers you see on your trading dashboard. The real crypto assets are now on the balance of the exchange.

What they do with them — it’s all behind the scenes. Are you losing your sense of security?

But even regulation can’t resolve the major issue regarding liabilities. We can find out how much crypto the exchange has on its balance. But we don’t know the exact amount of assets customers deposited as some of them were fiat. Since we can’t access data from actual customers’ accounts, we can hardly learn how much they really deposited. It’s possible only if the exchange provides this data to the 3rd party.

If you are not an active trader and don’t use algorithmic trading strategies, the exchange is not the best place for custody. There are a few reasons why:

Security: The exchange is always a target for many bad actors.
Your account can be suspended at any time for multiple reasons. The suspicious transaction, sanctions lists, and more. The exchange can always find a reason to block you if they need it.
Liquidity risks. If everyone would like to withdraw funds even from the most reputable exchange, I’m not sure they will make it.

In most cases, exchanges (especially, small ones) use customers’ assets for multiple reasons. These may include marketing expenditures to attract new customers, trading activities, investments, and others. It creates a liquidity risk: if all clients would like to withdraw their funds, the exchange will collapse like FTX.

The FTX crisis in a nutshell

FTX was reported to misuse its customer’s assets to lend them to Alameda Research, its affiliate firm. It used FTX clients’ assets — at least 1 billion — for trading.
Moreover, FTT, the exchange’s native token, was used as collateral. When this data was disclosed, it partially fueled the rapid collapse of FTX and the whole Sam Bankman-Fried’s empire. It was a snowball effect: FTT dropped pushing FTX toward inevitable bankruptcy.
As per Financial Times, FTX had 9x more in liabilities than in liquid assets.
Having no liquidity, the exchange offered to lend USD at a 25% funding rate.

If you are looking to chill out USD is lending at ~25% right nowhttps://t.co/8kFx0CyJlC pic.twitter.com/p6tu1qjbK9
— FTX (@FTX_Official) September 7, 2021

Have you ever seen any dollar deposit allowing you to earn more than 5%? How can an asset with a never changing price generate interest?

Seems, the Terra UST case hasn’t taught FTX anything. Terra’s Anchor protocol offered an almost 20% “stable” yield. Later, de-peg and epic “death spiral” followed.

Finally, FTX has filed for bankruptcy, Sam Bankman-Fried has resigned, and customers will hardly get their crypto back.

Other exchanges are no better

Binance, the largest CEX, holds 40% of its reserves in its own BUSB and BNB. What if it collapsed? Who would save it? The Secure Asset Fund for Users wouldn’t be enough.

Back to the beginnings. Self-custody is why crypto was created

Seed phrases and private keys are the words that people (especially those new to crypto) are afraid of the most. “If I lose my seed phrase, I will lose my funds!” And this is true. Your keys are the way to your assets. Correct management of private keys and seed phrases is essential for every crypto enthusiast.

The most critical parts of a puzzle to be resolved for the mass adoption of self-custodial crypto are the following:

1. Fear of using seed phrases

2. Poor UI/UX of wallets

3. Very early stages of decentralized exchanges development.

The first one is resolved by education and the right security tools, like password managers.

The second one is on the way. The self-custodial wallet is just an interface to work with your assets. You can use multiple wallets at once for different purposes. Wallets are not solving the issues with storing seed phrases and private keys, but they can give you a lot of decentralized tools to work with your assets like token swap, in-app token bridge, Web3 browser, and more.

The third one is a long-term perspective. To make decentralized exchanges as convenient as centralized ones, we need a lot of time and effort. Now DEXs cannot provide such a variety of trading tools and financial instruments. But the time for better-developed DEXs protocols, well-built decentralized derivatives exchanges, and more will come.

So, when all these three parts are resolved we will see the crypto space as originally conceived.

The fundamental mistake of Web3

What’s wrong with exchanges?

The FTX crisis in a nutshell

Other exchanges are no better

Back to the beginnings. Self-custody is why crypto was created

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Nazar K.