To manage crypto assets and interact with exchanges, asset managers, institutions, and hedge funds have increasingly adopted the practice of transferring assets to hot omnibus wallets in recent years to simplify and speed up trading activities.
However, hot omnibus wallets carry significant risks, including substantial exchange counterparty risks, capital inefficiencies, and increased operational expenses.
Exchange Counterparty Risks — By consolidating assets in an omnibus wallet, users inherently take on the risk associated with the exchange’s financial health. Should the exchange face insolvency or other financial difficulties, the assets within the omnibus wallet could be compromised, leading to significant losses for the users.
Capital Inefficiency — Omnibus wallets often lead to capital inefficiency, primarily due to the network fees associated with asset transfers. Every movement of digital assets in and out of these wallets incurs a fee, which can accumulate substantial costs over time, particularly for high-frequency trading or large institutional investors.
Operational Cost— The management of omnibus wallets requires considerable operational resources. Exchanges must continuously monitor and secure these wallets, which are frequent targets for hackers due to the large volumes of assets they hold. Despite stringent security measures, the risks of operational errors or breaches remain.
Since the Mt. Gox debacle in 2014 to the FTX meltdown in 2022, and with DDM Bitcoin and Wazirx losing more than half a billion dollars to hacks this year, crypto exchanges have repeatedly proven that they cannot be trusted with significant amounts of funds.
The counterparty risks posed by crypto exchanges — often seen as the most efficient and convenient trading platforms for digital assets — are so high that they have significantly hindered institutional actors and asset managers from investing to their full potential in the crypto ecosystem.
Entities that manage funds on behalf of others cannot afford to gamble with the assets entrusted to them by taking undue risks. Instead, they are inherently risk-averse and tend to prioritize security above all else.
The FTX meltdown in 2022 was deeply traumatizing for the entire crypto community, but it was particularly devastating for institutional players.
It became clear that new methods were needed to access the convenience of centralized crypto exchanges without the associated counterparty risks.
This realization paved the way for the rise of off-exchange settlements, offering a safer alternative for trading digital assets.
How Off-Exchange Settlements Mitigate Counterparty Risks
While off-exchange settlements offer numerous benefits to their users, their primary purpose is to provide a security solution that eliminates counterparty risk when trading on centralized exchanges.
How Does it Work
Off-exchange settlements refer to transactions and transfers of cryptocurrency assets that occur outside of traditional centralized cryptocurrency exchanges.
These settlements typically happen between private parties or through over-the-counter (OTC) desks, decentralized exchanges (DEXs), or private custodians.
These off-exchange transactions are settled without the need to use a public exchange order book, and they usually involve large sums of cryptocurrencies being transferred from one party to another.
They allow traders to engage in transactions with virtual balances on exchanges while the actual settlement is handled through the off-exchange settlement network.
This ensures that traders’ token balances are secured by the Off-Exchange Settlement (OES) system rather than being stored directly on crypto exchanges.
In summary, off-exchange settlement offers the trading convenience of a crypto exchange without the assets ever being held on the exchange itself, thereby eliminating exchange counterparty risk.
On paper, it sounds like a dream come true for institutional investors eager to expand their crypto investments and secure greater returns.
So, how does it actually work? How do off-exchange settlements mitigate exchange counterparty risks?
Mitigating Exchange Counterparty Risks
Off-exchange settlements serve as an intermediary between an exchange and an institution. While offerings can vary, most off-exchange settlement systems are structured in a similar manner, as outlined below.
The institution that wishes to use the OES must maintain its assets with an institutional custodian. The custodian secures the majority of the institution’s funds, usually in a multi-signature or multi-party computation (MPC) wallet, which requires approval from two out of three signers to authorize transactions. The signers include representatives from the institution, the custodian, and a trusted third party.
Off-exchange settlements use a “settlement wallet” in conjunction with a multi-signature or multi-party computation wallet to manage and settle trades between an institution and an exchange.
The crypto exchange partners with these off-exchange settlement providers to reflect the institution’s funds on their platform, allowing trading based on the assets secured in the wallet.
