Exchange risk

I think Binance clients can generally feel pretty comfortable with the custodial risk of the exchange. They have completed 12 consecutive PoRs, and recently moved to a ZK model in terms of proving liabilities. Their most recent PoR had 33 assets, by no means all the assets on the platform, but by my estimate this covers 95%+ of the platform assets, so I’m happy with the coverage there. They do publish a list of addresses but as far as I can tell (and I would welcome more clarity on this), they aren’t actually signing those addresses, so we don’t have cryptographic verification that they own the addresses. I don’t have a huge reason to doubt the veracity of their claim regarding on-chain assets held, but they could go further here. I feel pretty comfortable in saying that they actually do have the $65b+ in assets that they claim to have.

In terms of actually verifying the liabilities, they claim to have a third party auditor, but they don’t actually share the name of the firm or make the report available, so I’m discounting that entirely. We still don’t have strong confidence that they are faithfully reporting (i.e., not understating) liabilities. They need to improve here.

As far as legal and contractual protections go, it’s not clear from their ToS that client assets are held in FBO trust accounts (i.e., bankruptcy remote), and it’s also not clear what jurisdiction and legal system they are based on. These are vital pieces that are necessary for a fully specced out PoR in my view.

So the PoR is useful, but it could be much, much better. Specifically transparency around the liability reporting, on-chain verification of assets, incorporating a third party auditor (more obviously), and creating legal and contractual clarity are necessary for me to trust it.

However, returning to a more basic heuristic, Binance has historically been solid from a user custody perspective. They don’t have a track record of mishandling client funds. They have a strong new CEO with a regulatory background who has a very strong incentive to do things properly, and they will be supervised by the DoJ as part of their settlement.

Also, it’s worth noting that institutional Binance clients can trade on the exchange with third party custody using something like MirrorX (https://www.binance.com/en/blog/vip/keep-your-institutional-assets-in-thirdparty-custody-when-trading-on-binance-with-mirrorx-7578047330993855911) or one of the emerging prime brokers. So larger clients don’t necessarily need to trust them. I’d want to see more integrations with the likes of Copper’s clearloop for instance though.

Lastly, if they had been misappropriating funds, I believe the DoJ would have included that in their indictment.

The Future of Binance

I believe that Binance will gradually lose market share, as they have been doing (they’re at 44% of the ex-US exchanges according to the Block (https://www.theblock.co/data/crypto-markets/spot/no-usd-support-exchange-volume-market-share) versus 67% a year ago), but perhaps not as quickly as some expect (i.e. after Bitmex’ settlement they fell off quickly). The reason for this, is that post FTX and Binance, newer exchanges will have a reduced motive to quickly gain market share by starting with no or light KYC. Everyone knows now that if they have weak KYC, the US will find a way to get to them. That was historically the way that newer exchanges gained traction, but executives understand now that it’s not really workable. Binance has some very sticky qualities, which is 160m users onboarded on the platform, tons (100+) of relationships with market makers, and deep spot liquidity even for the long tail. So it will be very hard for other exchanges to create the same value proposition quickly. That said, I expect that OKX, Derebit, and Bybit likely gain market share at Binance’s expense.

It’s worth touching on the SEC indictment. It looks like they’re looking for a gotcha (https://cointelegraph.com/news/sec-looking-evidence-potential-fraud-binance-us-changpeng-zhao) with the Binance US entity. I think it’s unlikely they find a smoking gun there, and Binance US is virtually irrelevant today. And as we know, the SEC has a patchy record when it actually comes to winning cases in crypto, so I’m not that concerned about it. This seems more like a fishing expedition than something that could threaten the broader Binance apparatus.

The Broader Crypto Ecosystem

I firmly believe that the DoJ action against Binance was the “end of the beginning” of the era of rollicking offshore crypto exchanges. The end started with the Bitmex criminal case, and the end ‘ended’ with Binance. As I said, newer exchanges can’t compete any more by going no-KYC. Newer exchanges will focus on regulatory compliance (whether in a light-touch offshore jurisdiction, or by having full KYC from inception). This is an absolute necessity to operate today. Especially if CZ gets an 18 month prison sentence. No one wants to risk that. I’m sure CZ would trade most of his wealth for the chance to be totally in the clear here.

What this means is that the institutional flow of capital in the US and major developed markets has a much easier time getting comfortable with the industry. The ETF was held up partially because the SEC hated the fact that the BTC spot markets were 60%+ dominated by Binance, a largely unaccountable exchange. Onshore exchanges felt hard done by that they had to compete with Binance and FTX, and it’s my view that the onshore exchanges felt that they had to engage in riskier listing and product strategies to compete.

Now that the threat from offshore exchanges has been mitigated, onshore exchanges can behave a bit more responsibly without feeling that they are losing a ton of market share. This also exposes them to less liability. So you will see fewer cases against the likes of Coinbase and Kraken going forward in my view.

I think we will also continue to see a move towards the segregation of exchange and custody, which has already been happening. Larger firms are very attuned to counterparty risk. This accelerates that.

And optics-wise, this gives people the impression that the bad actors and criminality are being cleaned up in the industry, which I believe is an unlock for sidelined capital to come in. I have a more moderate view on Binance, but I can see why some would see this as a strong positive.

I think it’s also very good for Proof of Reserve. Binance’s PoR, as weak as it was, helped eliminate any kind of bank run following the DoJ indictment. I think that’s extremely positive, and will be seen by many other exchanges as an extremely nice feature, turning a PoR from a cost center to something with a clear benefit.

Tether I’m less worried about. They are verging on being a systemically large holder of US treasuries, they work actively with law enforcement, and they are very active in freezing suspected illicit accounts. They also settled with SDNY a while back and were supervised for a while. They also have known US counterparties as part of their structure (Cantor). So I am not that concerned about a future issue with USDT.