Our Collective Crypto Insanity: A Look at CEXs, Asset Ownership and the Role of Regulation

This piece was written by William Heyn, the Co-founder of SOMA.finance.

In the early days of crypto, “Not your keys, not your crypto '' was the mantra of HODLers who learned firsthand from exchanges like Mt. Gox that when it comes to cryptocurrencies, if you don't hold it, you don’t own it. 

After the events of 2022 and the collapse of FTX, crypto holders are once again learning the benefits of the regulation that exists within the traditional financial structure and the need to bring some of that framework to the world of crypto. But there is still a lot of work to be done, as little has changed within the wider crypto ecosystem, which has developed its own level of insanity in the way that it has been functioning while expecting positive outcomes. 

With the ongoing implosion of many parts of the “crypto” world,  there are understandably many questions.  While I can’t answer everything in this brief format, I’ll answer one. Centralized crypto exchanges, as they currently operate, are utterly insane.

Like any completely new and disruptive technology or industry, the crypto ecosystem is a world unto itself. So much of our crypto day-to-day experience happens within our own echo chamber, a fact that I am occasionally reminded of when I try to explain some aspect of our industry to someone I know from the traditional finance world. Unfortunately, most of these conversations revolve around some mistake a crypto company made that would have been clear as day to an old-school financial professional. 

None of this is terribly surprising. First off, all monkey pictures and “future use cases” aside, crypto today is a financial system. While crypto is new, finance is not. Finance is old. Secondly, the crypto industry is dominated by technology people, not experienced financiers. If we had a few more gray hairs around, we might have realized in advance that some of the crypto norms we have come to accept as “the way” are utterly crazy. 

This brings me to our collective insanity.  

Certainly, at some point in your crypto life you have heard someone make the assertion that centralized exchanges are like the new version of traditional stock exchanges. The implication being that a centralized crypto exchange is basically a new version of, say, NASDAQ. It’s easy to see the parallels. Both provide a menu of trading options, order books, settlement between the parties and they both exist as a medium of (theoretically) fair exchange.  Most centralized exchanges strive to make their user interface look like stock exchanges, certainly slicker and more user-friendly, but there is always a ticker, an order book, a buy and sell option and so on.

The superficial aspects do appear the same. However, they are not the same. They function completely differently.  In order to purchase shares of a publicly listed stock on an exchange you have to take a few steps. First you need to find a broker to interact with an exchange on your behalf. You ask the broker to buy ABC stock and they place an order with the exchange. They do so, collect money from you and in T+2 days or less, you have shares of ABC stock in a brokerage account that is, in every legal and regulatory sense, owned by you. Critically, the account is custodied by the broker, not the exchange. 

On the other hand, if you want to buy a token on a centralized crypto exchange, you first open an account with the exchange.  You then give your money to that account, also on that exchange. You then ask that exchange to trade your money for XYZ crypto and (hopefully) they do so. You then have XYZ crypto sitting in a wallet, again, on that exchange. That wallet may or may not be owned by you in theory, read your terms of service carefully, but whether you legally own it or not, you do not have any control over it. If you don’t control it, you don’t own it. We DeFi folks have started to realize this with our “not your keys, not your tokens” battle cry. But we missed the point.

The point is, there is a very good reason that financial systems separate the role of broker from the role of exchange. A broker is required by law and regulation to do certain things. They are required to deal fairly with you, they are required to make certain disclosures and, most of all, they are absolutely required to keep your assets secure and segregated. Under no circumstance do your assets become their assets.  Most importantly, the exchange you trade on itself never owns your assets, it cannot act independently of your instruction and, as such, serves as a dispassionate medium of exchange. To do otherwise would be a complete conflict of interest.

When the role of broker and exchange are wrapped into one, like they are on centralized exchanges, you have no such protection and your tokens are only yours in an abstract sense.  Once you give them to the exchange, note, I use the word “give” intentionally, because that is in effect what you are doing, they are no longer yours.  The exchange can move them, they can transact in them and they can impair them with debt. Now, if a centralized exchange were to, on its own volition, act completely above board, keep your assets segregated and secure and only move or impair them with your consent, then there might not be a problem. Perhaps there are centralized exchanges that run this way. 

However, we have seen time and again, that this is not the case and history is not on the side of consensual compliance by most of these companies. This is absolutely not to say that most, if not all, of the people who found and run centralized crypto exchanges are necessarily bad or dishonest people. However, what we gray-hairs have learned over centuries of doing this is that rules and regulations are necessary. Money does crazy things to people, and in traditional finance if something is not against the rules it can be done, not should, but can. It may be unethical, it may be unkind, but it is not against the rules. But there are limits. Most decent humans would never consider selling illiquid penny stocks to widows and orphans, but some people would, so it is against the rules. 

First thinking that centralized crypto exchanges are like newer versions of stock exchanges. They are not. They are certainly not a safe place to entrust your assets. Without the segregation of your account and the exchange, these systems are standing conflicts of interest.  Without them adhering to proper custody rules, your assets are at risk and, in reality, cease to be “yours” the moment you deposit them.  Even worse, what happens if the exchange controls “your” tokens, controls the transactions of these tokens and might or might not itself be on the other side of your trades?

Second, thinking that somehow crypto is not, or should not, be regulated. Without rules, there are no safety guidelines on how your assets must be treated. Worst case, without regulations, you are effectively abrogating your system, and your assets, to the very worst, most dishonest, lowest common denominator human within said ecosystem. That is the ultimate insanity.

Where do we go from here? Brokers and stock exchanges are the old way, but tried and true for a reason.  Centralized crypto exchanges are, well, insane. One company cannot be allowed to control both the assets being traded and the system they are being traded on. For a crypto trading system to be effective, fair and accountable, the role of custodian and the role of exchange need to be separated. A crypto system based on that premise might actually start to look like a new version of NASDAQ. A system built on self-custody of your assets might look even better.