Solving the Crypto Custody Problem
Cryptocurrencies threaten to revolutionize major sectors of the global economy. By replacing trusted intermediaries with blockchain technology, startups aim to disrupt banking, crowdfunding, supply chains, real estate, healthcare, and more.
To capitalize on this opportunity, cryptocurrency investors, traders, hedge funds, and enthusiasts have used centralized exchanges to create one of the most volatile and dynamic markets in financial history.
However, currently 100% of the top 50 exchanges by volume are centralized.
With Opportunity Comes Risk
Exchanges still remain vulnerable to unrelenting cyberattacks and fraud. Since 2011, over 60 major cryptocurrency hacks have occurred worldwide, with investors suffering $12.6 billion in losses.
Brief History of Crypto Hacks
The Pre Mt. Gox Era (2011–2014)
- Only bitcoin was stolen as altcoins were effectively non-existent.
- Over this time period, about 300,000 of the roughly 10 million bitcoin circulating were stolen (3% of total supply).
Mt. Gox: First Major Heist (February, 2014)
- Mt. Gox volume dominance was a historic anomaly, handling ~80% of all crypto volume. For comparison, no exchange today handles more than 10% of total volume.
- The Mt. Gox bankruptcy kicked off a +75% correction that took more than three years to recover from.
Post Mt. Gox: Ecosystem Growth (2014–2017)
- There were 36 major publicized hacks, equivalent to one every five weeks.
- In August of 2016, $72 million worth of bitcoin was stolen from Bitfinex, causing the price of BTC to decline 23%.
Current Landscape (2018–Present)
- 2018 has been the worst year on record for both the frequency of hacks and the amount stolen.
- The largest single hack in history occurred when Japanese exchange Coincheck was robbed of $530 million over the course of eight minutes.
Comparing the Pre and Post Mt. Gox Eras
Despite an increase in security procedures, the frequency and severity of hacks has only increased. Surprisingly, the rate at which centralized exchanges have been hacked has remained consistent at ~70% since 2011, even with a rise in other potential targets for hackers (ICOs, DAOs, stable coins, and private companies).
During the nine hacks that occurred before Mt. Gox, $7.6M was stolen, representing an average of $850k per hack.
During the 53 that have occurred since then, a total of $1.3B has been stolen, causing the average hack value to jump to $24M.
That is 28x jump in average hack value from the pre-Gox era.
What options do investors have?
Hack severity has dramatically increased and will continue to get worse as the ecosystem grows. If an exchange is compromised, the true cost of the hack is felt by depositors. This is because those who stored funds on the exchange are unable to recover that money.
The risk that an exchange is unable to give your money back is called credit risk.
Investors, traders, funds, and users currently have two main options when it comes to dealing with exchange credit risk.
Option 1: Store on Cryptocurrency Exchange
Investors that require liquidity to capitalize on profitable trading opportunities can choose to keep their money on centralized exchanges like Binance, Huobi, or Bitfinex.
Advantages
- Access to liquidity
- Simpler custody option compared to personal offline wallets
Disadvantages
- Open to exchange credit risk
- Obvious target for hackers
- Little transparency about the security of the exchange
This option is best for investors who demand immediate access to the markets, such as traders, market makers, and people who are not comfortable with self-storage options.
Option 2: Personal Cold Wallets
Investors can choose to keep their crypto in personal offline wallets, meaning they are not exposed to the risk of exchange hacks. By using paper wallets or hardware wallets, like Trezor or Ledger, investors eliminate the risk of a cyberattack by disconnecting from the internet. Note: hot wallets such as MyEtherWallet are still exposed to cyber attacks.
Advantages
- Zero exchange credit risk
Disadvantages
- No immediate access to liquidity, useless custody option for active traders
- High potential for user error
- Legal restrictions limit many institutions from self custody
This method is best for long term investors or “HODLers”, as they have no need to access the markets to trade on a regular basis. However, the investor must be comfortable storing their own private keys offline.
New Alternative: CDx
Investors have lacked a solution that protects their crypto assets from risk, while simultaneously maintaining access to the liquidity needed to profit from the fast moving world of crypto.
CDx is a smart contract protocol that aims to solve this problem.
Credit default swaps are effectively tradable insurance policies. The buyer pays the seller a premium upfront in return for protection from an exchange being hacked.
CDx: The Protocol for Tokenized Credit Default Swaps
CDx protects investors’ crypto assets by allowing them to hedge the risk of an exchange hack or scam through an entirely new asset class: tokenized credit default swaps. This protects investors’ crypto assets, allowing them to insure against exchange hacks and exit scams.
Advantages
- Zero exchange credit risk
- Access to liquidity
- Full transparency into each exchanges’ perceived risk
- Allows users to profit by selling insurance on exchanges
Disadvantages
- Must pay a premium in exchange for protection
CDx is valuable to anyone that currently stores their assets on an exchange, including both active investors and HODLers.
By eliminating credit risk, CDx allows investors to store their crypto assets on exchanges and trade with confidence.