THE CENTRALIZATION PARADOX IN CRYPTOCURRENCY MARKETS.

• Author: Yadav, Yesha

TABLE OF CONTENTS I. DECENTRALIZATION, CENTRALIZATION, AND EXCHANGES A. Marketplace Without Intermediaries B. Crypto-Exchanges as Centralizing Intermediaries 1. What Crypto-Exchanges Do 2. Why Are Crypto-Exchanges So Centralized? II. THE PROBLEM OF HYPER-CENTRALIZATION IN CRYPTO MARKETS. A. Informational Failures B. The Governance Challenge CONCLUSIONS INTRODUCTION

The costly and highly public collapse of cryptocurrency exchange FTX has highlighted two key phenomena central to crypto-market design. (1) First, despite its originating claims to decentralization, crypto-markets are anchored by exchanges that operate in a profoundly centralizing manner. In other words, single organizations act as anchor intermediaries to perform a variety of critical functions: marketing, trading, risk management, lending, venture investing, infrastructure building, and so on. (2) A number of crypto-exchanges have grown rapidly into complex and significant financial enterprises, whose operations create externalities reaching far beyond the walls of their own firm. That is, the failure of these large and important firms imposes costs on third parties that can be high and unpredictable for many to bear. (3) FTX's Chapter 11 bankruptcy filing, for example, involved an estimated nine million creditors across 130+ entities. Major crypto firms, BlockFi and Genesis Global Capital, ended up in follow-on bankruptcies of their own. (4) In the wake of FTX's Chapter 11 filing, customers that traded on FTX found themselves unable to retrieve cash/crypto held by the exchange, forcing some into immediate financial distress. (5) FTX fell owing over $3 billion to its largest fifty creditors. Two creditors held claims where the amounts owed to each exceeded $200 million. (6) Galois Capital, a large crypto hedge fund, was forced to shut its doors after $40 million of its assets became stranded in FTX's bankruptcy. (7) It ended up selling its FTX bankruptcy claims for sixteen cents on the dollar. (8)

Secondly, regulation has failed to exercise control over the structural and governance architecture of cryptocurrency exchanges, such that their institutional design practices have evolved largely outside of federal oversight. (9) Whereas "traditional" securities and commodities exchanges are subject to an extensive rulebook, with dedicated federal overseers to monitor and punish breaches, the same cannot be said for cryptocurrency platforms. (10) This has meant relatively few historic hard constraints in setup, allowing venues to evolve in ways responsive to the peculiarities of cryptocurrency products, competitive pressure, and the firm's private preferences about how it wishes to conduct business. Functionally, this latitude has offered exchanges the ability to develop practices, where multiple business lines are routinely folded into single organizational structures." But limited regulatory oversight has resulted in a patchy understanding of crypto-exchange operations, risk management, and governance. In the wake of FTX's collapse, insights about the firm's broken, dysfunctional, and opaque operating practices have come to light gradually as bankruptcy and criminal proceedings unearth what went on. (12) Binance, the world's largest crypto-exchange by volume, has found itself under frequent scrutiny for its complex and obscure governance, where doubt lingers over even basic questions like the jurisdiction where the firm is based. (13) Given limited regulatory standards, vetting, and transparency, it follows that the riskiness of any number of exchanges and their organizational models cannot be credibly gauged, making it exceedingly difficult for the crypto-market and its stakeholders to privately protect themselves against the failure of highly central and centralizing firms.

This essay highlights why, paradoxically, the seemingly decentralized world of cryptocurrencies has come to depend heavily on trading firms that institutionalize a highly centralized organizational model. (14) Despite shunning the notion of centralized intermediation, cryptocurrency users can face costly practical hurdles when engaging with decentralized public blockchains, like those underpinning Bitcoin or Ether. The task can entail technical knowledge, search costs for counterparties, unpredictable fees, delays in execution, and the need for users to be capable of protecting their own interests. (15) These challenges can hamper popular uptake as well as limit the capacity of cryptocurrencies to develop as a viable asset class, capable of being traded/used rapidly, reliably, and with customers able to access a range of services (e.g., professionalized custody of crypto-assets).

Exchanges respond to such shortcomings by offering a highly intermediated trading environment where a user's real-time engagement with blockchains is generally fairly minimal. (16) Trades are matched, verified, and settled on an exchange's books. (17) Users can enjoy various conveniences like greater speed, liquidity, and certainty about fees. (18) To enable transactions to settle rapidly outside of blockchains, exchanges typically require customers to maintain wallets issued by an exchange (hosted wallets) and the exchange often also holds the password to these wallets. (19) In maintaining access to and extensive day-to-day control of a customer's crypto and cash, an exchange can settle trades by updating user accounts internally on its books, rather than having to send instructions for individual transactions to underlying blockchains. (20)

Where platforms convene large numbers of customers and hold their cryptocurrencies/fiat, they also end up becoming well-placed to offer a range of commercial products, where an exchange might use its access to customer assets to pool these funds, place them in investment vehicles, extend credit collateralized by a customer's crypto, or provide premium custody-related services for additional fees. (21) Successful venues--capable of earning regular revenue from trades as well as through the sales of subscriptions and services--can become powerful pools of capital and influence. This can motivate top trading venues to use their own money to engage in venture investing, lending to crypto-businesses, brand-building through lavish marketing, as well as investing in the development of their own blockchains. (22) FTX, for instance, left behind an estate with an investment portfolio valued at around $5 billion, comprising equity in an eclectic set of ventures such as crypto-start-ups, a traditional securities exchange, as well as a fertility clinic. (23) Venues might also mint their own crypto-tokens, entitling holders to use the exchange's services and products at a discount. These tokens might then acquire market cache linked to the reputation and utility of the venue. (24) As assets capable of being traded and generating value, such proprietary exchange coins have held out the possibility of being used as collateral to fund the issuer-venue's operations or constitute a portion of its balance sheet. In the case of FTX, its proprietary coin--the FTT token--was deployed by the exchange's organization as collateral to release credit for funding its operations. (25)

In its second contribution, this essay details some of the key risks that arise from this organizational design choice. In the absence of systematic oversight, a highly centralized crypto-exchange design raises a number of risks for an underprepared marketplace--where externalities arising from fallout are liable to force costs on actors that may not be well-placed to anticipate or bear them. While a comprehensive discussion of the risks is outside the scope of this essay, some stand out as especially salient. Importantly, limited regulatory levers heighten the information asymmetries attaching to a complex, sophisticated, and centralized intermediary. In providing a variety of functions and services as part of a single or closely connected organization, crypto-exchange firm design increases the cost of investigation and analysis. (26) Insight is needed not just to calibrate the risk attaching to single types of activities (e.g., trading), but to further assess how such risks might impact other related functions (e.g., custody or commercial customer products). In the case of FTX, for example, as the exchange failed, panicking demand by customers for a return of their assets eventually resulted in a trading halt and a pause on redemptions. (27) With FTX in bankruptcy, the legal ability of customers to extract their funds has come to depend on the terms of service governing products marketed to customers, and whether these might have caused customers to cede their ownership rights in crypto-assets to the exchange. (28) This mixing of functions means that understanding one or two operations is insufficient to calibrate the risk of a crypto venue. Rather a deeper and more complex understanding is needed to parse out the fuller costs created by the interconnected operations of the exchange alongside those raised by the particularities of the crypto-market where it operates.

Further, complicated organizational structures raise the risk that corporate governance and risk management arrangements are insufficiently robust to contend with the problems facing large and interconnected organizations. Mixing functions invariably raises worries about whether an exchange, or one of its arms, is conflicted, primed to act against the interests of its customers in order to benefit itself. Information leakage represents an ever-present threat to good governance, where proprietary insights gleaned from one part of the venue's operations are used by an exchange to benefit itself in another. (29) For example, by dint of having a perch from which to survey customer trading, the exchange (or an affiliate) might look to trade ahead of customers, raising the cost to the customer, while increasing the certainty of profits...