Crypto Exchanges Are Broken, But the Hybrid Model Promises A Better Future

Cryptocurrency exchanges play a vital role in the blockchain industry, acting as gatekeepers to the world of digital assets. While there are other ways to acquire crypto, such as peer-to-peer protocols and trading with friends, the vast majority of newcomers will begin their journey on a crypto exchange, where they can sign up quickly and start exchanging their fiat for Bitcoin, Ethereum, and other tokens.

Despite their importance for the crypto industry, the fact is that exchanges as they are today are far from adequate. The reliance on these centralized custodians is contrary to the ethos of crypto in general, which is all about letting people take control of their finances, without intermediaries. There’s a good reason why Satoshi Nakamoto, the creator of Bitcoin, emphasized this “decentralization” of money, for the fact is that crypto’s gatekeepers have consistently proven themselves to be unreliable.

Such was the case way back in 2013 when the crypto world was first becoming public knowledge. It was back then that the once pre-eminent crypto exchange, Mt.Gox, had its main wallets hacked and drained of user’s funds. It tried to cover up the hack and continue operating, but word of the incident eventually got out, prompting mass withdrawals from users. Unable to keep coughing up, Mt.Gox halted user withdrawals and within a few weeks, it closed down its platform. Some users reportedly lost thousands of dollars worth of crypto, and to this day they haven’t recovered those losses.

History was to repeat itself in 2022, at a time when many hoped that crypto was finally about to go mainstream. The crypto bull run of 2021 saw digital assets like Bitcoin reach incredible all-time highs, and though the markets were in decline the following year, there was still a lot of optimism for the future.

That was until the crypto lending crisis hit, causing multiple DeFi lending protocols, such as BlockFi, Celsius Finance, and Genesis to collapse. The Terra Luna project also collapsed at that time, resulting in the infamous de-peg of the once-popular UST stablecoin asset, but even those disasters didn’t prepare us for the spectacular fall of FTX.

FTX was the second-largest crypto exchange by trading volume with billions of dollars of user assets under management, but the total lack of regulation in the crypto industry allowed its owner and founder Sam Bankman-Fried to misappropriate those funds. He transferred billions to FTX’s sister company Alameda Research which were then used on risky, highly speculative investments, and ultimately made some spectacular losses.

When word got out of what Alameda was doing, users rushed to withdraw their funds. FTX paid out more than $6 billion to panicked users but ultimately ran out of cash, forcing it to suspend withdrawals, still owing its customers billions.

Striving for Transparency

The collapse of FTX rocked the crypto industry, pushing it deep into one of the harshest declines it has ever endured. However, the incident prompted surviving crypto exchanges, such as Binance and Coinbase, to strive for more transparency to reassure users their funds are safe.

In November 2022, Binance announced it was publishing a “proof-of-reserves” audit that publicly reveals the underlying assets it holds, to prove it can meet its obligations if every customer decides to withdraw their funds. Following that move, many other exchanges, including Coinbase, Crypto.com, Kraken, Bybit, OKX, and Gate.io, did the same.

However, not even the proof-of-reserves is enough to truly reassure investors. FTX itself had performed numerous third-party audits of its finances using reputable firms, yet none uncovered the extensive fraud it was engaged. The failure of these audits underscores the challenge of identifying such misappropriation even with established compliance measures. As such, the fact most exchanges publish proof-of-reserves doesn’t mean an FTX-like incident won’t happen again.

Fortunately, the crypto world is evolving and there is a lot of optimism that the crypto exchange of the future will be much safer than the platforms we know today. There are those in the industry who are striving to right the wrongs of yesterday and ensure a safer and more reliable trading experience that eliminates the reliance on custodians once and for all.

Shoring Up Security

The most visible evidence of this change is the growth of decentralized exchange platforms, which have become more appealing among experienced crypto users. Their biggest advantage is that they provide better security and privacy than their centralized exchange counterparts, and users have more control over their trades, with no limitations placed on trading volumes. In addition, they also list many more digital assets than most CEX platforms.

With the ongoing evolution of DeFi and the growing desire for self-custodial options among users who want to retain control of their digital assets, the popularity of DEX platforms will likely continue to grow. Because clients have more control over their finances and trading activities, many see DEXs as a superior alternative to CEX platforms.

Crypto exchanges are also focused on improving the security of their platforms to reassure customers, and this is a trend that will accelerate over time. Already, we have seen some exchanges implement advanced security measures such as hardware security modules. These are specialized devices that securely store and manage the cryptographic keys for cryptocurrencies. They act like a private vault, protecting the security keys from hackers and unauthorized access. Examples of platforms integrating with HSMs include Thales, an Ethereum-based protocol that enables the creation of peer-to-peer trading markets anyone can join.

Other innovations seen in crypto exchanges include multi-signature wallets, which are wallets that require multiple individuals to sign them in order to transfer the funds within. By employing multisig wallets, crypto exchanges seek to reassure customers that it’s not possible for them to misappropriate funds in the same way as FTX did.

Exchanges are also doubling down on user security, introducing enhanced measures such as two-factor authentications and biometric security to help them protect their accounts from unauthorized access.

A New, Hybrid Model Emerges

A more recent trend in the crypto exchange industry that’s likely to surpass all of the above efforts is the rise of the hybrid exchange platform, which seeks to provide all of the advantages of CEXs and DEXs, with none of the disadvantages.

The issue is that although DEXs are undoubtedly safer due to their self-custodial nature, they’re also a lot less user-friendly. Hybrid exchanges aim for the middle ground, providing high availability of assets, ease of use, order matching, and legal compliance, together with self-custody of funds and full privacy. They also implement robust security measures and perform regular audits to further reassure users.

There’s a lot of anticipation around hybrid exchanges, which offer a solution to the counterparty risk that comes with utilizing a CEX, as well as the transparency of DEX platforms, plus the advanced features and efficiency of centralized platforms.

One promising platform is GRVT, a fully-custodial hybrid centralized exchange that utilizes zero-knowledge proofs to ensure full privacy for every user. It’s one of the first AppChains built on the zkSync blockchain, and attempts to systematically address all of the major concerns around exchange platforms.

GRVT achieves security by layering Web2 controls such as password-based logins and two-factor authentication with Web3 controls such as private wallet keys and smart contracts. It allows users to remain in full control, with self-custody of their funds and direct settlement of up to 600,000 trades per second in users’ wallets. In terms of risk management, it supports portfolio margin, cross-margin, and partial liquidations, while using ZKsync’s Validium technology to ensure transaction privacy.

Integration With DeFi

As hybrid exchanges become more prominent, their decentralized nature will allow them to evolve to incorporate more functionality, particularly around DeFi. Over time, we’ll see them offer more innovative services with DeFi capabilities such as yield farming, lending, borrowing, and staking directly integrated within their platforms, increasing accessibility.

Such platforms will grow with the expansion of digital assets. With the rise of tokenized commodities, hybrid exchanges will become vast, liquid marketplaces that enable the rapid exchange of real-world assets, bringing in a more diverse array of investors.

Another force we expect to see impact crypto exchanges in the future is artificial intelligence, which will become increasingly integrated with hybrid exchanges. Investors will be able to utilize AI technologies to analyze market trends, make predictions, alert users to risks, automate portfolio balancing, and many other applications. AI-powered chatbots are already becoming somewhat commonplace, providing users with extensive, real-time support.

A Safer Future Awaits

Innovative new models such as hybrid exchanges demonstrate that the crypto industry is learning from its mistakes and moving towards a more secure, inclusive, and technologically advanced ecosystem, which prioritizes user control, ease of use, greater accessibility, and less reliance on trust.

In the future, crypto exchanges will no longer be just transactional platforms. They’ll become integral elements of a global and decentralized financial ecosystem with no single party in control. It’s an evolution that’s already underway, and the advantages are so great that it’s unlikely to be stopped.

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