Digital assets: Can one learn from others´mistakes?

The year 2023 started on a good note for digital assets, as rising prices restored hope. Returning risk appetite in financial markets amid expectations of less aggressive monetary tightening, a weaker US dollar, and sound asset-class-specific fundamentals have shaped a less dire outlook for cryptos. Yet the world’s largest centralised exchange still seems incapable of learning from others’ mistakes. Binance mistakenly stored a certain tranche of its reserves with customer funds, once more underpinning our assessment that more regulation will be required to restore lost trust. While cryptos have likely left the worst behind, we still believe the wounds of this crisis will take more time to heal.

Despite cryptos’ positive price action in the previous week, with Bitcoin rallying over 6%, the headlines have again been dominated by centralised exchanges (CEXs), specifically Binance. The FTX fiasco in November rightfully unleashed an avalanche of scepticism towards CEXs’ management of customer deposits and reserves. In reaction they transitioned into a proof-of-reserves conviction, listing some of their wallet addresses to provide transparency about the size and composition of their reserves. 

While we acknowledge the ambition to be more transparent, it is important to note that the proof-of-reserves was not audited – not least because the CEXs struggled to find an able and willing auditor. Despite this, Binance recently acknowledged that they had erroneously used their cold wallet, “Binance 8”, for the storage of customer funds from the exchange and for the collateral of several of the tokens they issue. As the FTX fiasco has shown, the segregation of assets is imperative, a standard that traditional financial institutions such as asset managers or banks have been following for decades already.

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 Why would Binance need collateral for its own tokens? Because when Binance wants to bring a non-native token, e.g. Ethereum, to their own blockchain (Binance Smart Chain), they need to issue a synthetic token of it whilst locking the original token in the Ethereum blockchain. While this a standard practice in the digital asset space, such reserve assets should always be kept independent of customer assets. 

Events like this showcase that the crypto ecosystem has plenty of room to grow in terms of compliance and legal practices, and that the recent gains should not be seen as the starting point of a rapid and longer-lasting recovery for the asset class. The stain that the FTX fiasco has left on CEXs has not vanished. 

We thus reiterate our assessment that more regulation will be required to restore lost trust in cryptos, eventually leading to a level playing field between the world of crypto and the world of finance. We still believe the wounds of the crisis will take more time to heal, even though cryptos have likely left the worst behind.