Trading Platforms' Custody Issue: A Key Consideration in Crypto Markets

The way people evaluate trading platforms is often backwards, according to recent evidence from the crypto market. Typically, fees are considered first, followed by available markets and leverage. Custody, however, usually comes last as a vague reassurance about security rather than a specific answer.

This order may be flawed, especially given the sector's history of opaque operational and counterparty exposures. A report by the Bank of England highlights this issue, noting that the distinction between custodial and self-custodial platforms is not complicated once understood.

Custodial platforms record an entry in a private database for users' assets, making them unsecured creditors of the business. On the other hand, self-custodial platforms allow users to retain control over their assets through smart contracts or wallets.

Hybrid designs have emerged as a middle ground, addressing custody risk but not necessarily making the matching engine transparent or removing the operator's discretion. The three models, custodial CEX, hybrid, and fully on-chain, have different characteristics, such as order matching, custody, settlement, transparency, and main risks.

Regulators are now converging on this issue, recommending clear disclosure of custody arrangements and client asset segregation due to past damage from unclear arrangements.