FTX crisis catalyzed integration with off-exchange settlements in crypto to reduce fraud and bankruptcy risks

According to a recent analysis by Nickel, a staggering 63% of the largest crypto exchanges by volume have now integrated with off-exchange settlements (OES) solutions, marking a transformative shift from the pre-ftx era when only 5% of exchanges had adopted such solutions.

London-based Nickel Digital Asset Management (Nickel), Europe’s leading regulated digital assets hedge fund manager founded by Bankers Trust, Goldman Sachs and JPMorgan alumni, is calling for more crypto exchanges to integrate with Off Exchange Settlement (OES) solutions, which it says will dramatically reduce the counterparty risk, protecting investor capital against FTX-like events.

New analysis* by Nickel reveals that of the 20 largest crypto exchanges, 7 entities representing 63% of daily trading volume, have integrated with an OES solution. The 8th exchange is in the process of integration, which once completed, will boost share of OES-compliant exchanges to nearly 70% of daily trading volume. Another 11% are processed by well-established exchanges, such as Coinbase, Kraken and Bitstamp, which have not integrated with OES but are regulated in the US and Europe.

Nickel’s analysis reveals that of the four latest exchanges to have OES, the integration was either triggered or sped up by FTX debacle.
Nickel says optimal OES flow requires four entities:
⦁ Exchange – a lightly regulated trading venue
⦁ Custodian – a heavily regulated entity with best practices, SOC certifications, audited by one of the Big Four firms, with an on-chain proof of client assets, and based in a strong jurisdiction
⦁ Trusted Third Party – a regulated, reputable entity used to provide a dispute resolution mechanism
⦁ Trader – a client of the Exchange and the Custodian

The OES workflow usually follows these basic steps:
⦁ Client deposits assets with the Custodian
⦁ Upon the Client’s instruction, Custodian ‘locks’ the funds in favour of the Exchange
⦁ Exchange ‘mirrors’ those funds on its platform, allowing the Client to trade using the locked capital as margin
⦁ Any emerging P&L is settled on hourly basis, or potentially minute-by-minute, if need be
⦁ A failure of exchange does not affect client capital, as it is kept outside the exchange at all times.

Nickel says OES is a win for exchanges, custodians and investors alike: exchanges no longer have to custody clients funds, investors eliminate counterparty credit risk of exchanges, while custodians are rewarded through the applicable custody fees on assets under custody.

Anatoly Crachilov, CEO and Founding Partner at Nickel Digital, said:

“We believe OES is the best path forward to mitigate counterparty risks in the crypto ecosystem, eliminating the need for investors to keep their capital at trading venues.
The off-exchange-settlement allows for a structural change of counterparty risk models in the digital asset space, adopting the best practices from traditional finance while enhancing them with the crypto-native tools, such as real time on-chain visibility and 24/7 trading pattern, thus paving the way for increased participation of institutional capital.
A safe solution for trading on exchanges is vital to the success of the crypto industry. If crypto is to attract meaningful allocations from traditional investors, the sector must deliver comprehensive and robust protection of investors’ assets – OES solution is part of this new infrastructure.„

Nickel highlights the empirical evidence of OES protecting capital in case of bankruptcy: UK-based Coinflex went into receivership in late 2022, however thanks to the integration with Clearloop, Copper’s version of OES, as far as it is aware none of Copper’s clients suffered any losses originating from this incident.