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3A Exchange (3Aex.com) CEO Column: Analyzing CEXes’ principle of neutrality and risk management from the decline of FTX

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3A Exchange (3Aex.com) CEO Column: Analyzing CEXes’ principle of neutrality and risk management from the decline of FTX

November 17
16:25 2022

The rapid decline of FTX proves a “law” in financial markets: traders can’t compete with exchanges on mitigating risks because a real exchange won’t expose itself to trading risks. Traders, however strong they are, always deal with risks.

The decline of FTX is not mainly due to FTX itself but to the closely integrated Alameda, which is also under the control of the same stakeholder SFB. Judging from the information disclosed so far, this closed loop of failure started from Alameda’s aggressive investment, along with poor liquidity of assets held, plus a bear market, and then the financial information was revealed, which triggered the market’s crisis of confidence in FTX and led to a run on a bank”.

The combination of FTX and Alameda once made SFB rise sharply: the exchange set the rules and traded in the market itself, so it naturally had the advantage. For FTX, however, the negative significance of this paradigm is strategic and can be said to be fatal too. Because the neutrality of an exchange is its fundamental principle, violating this is extremely unfair to other investors. Moreover, insider trading is inevitable, which can be a legal issue, and it has always been the focus of supervision, which determines that FTX is basically impossible to be whitewashed and recognized by supervision.

The profound lesson we learn from FTX is also reflected in the risk management at CEXes. The  crypto assets is characterized by the continuous emergence of technological and application innovations, which easily leads people to think that they are engaged in the technology industry, and most of the practitioners also have the technology background. However, it is essentially still finance. In particular, the exchange, as a core link on the industrial chain, has a systematic influence on the industry, exercising the functions of asset pricing and risk management. This is certain that we are still in the financial industry, so it is necessary to understand it from a financial perspective accordingly.

3A Exchange (3Aex.com) is also convinced that innovations such as blockchain, token and smart contract will create a “new world”. However, this new world does not represent the complete subversion of traditional finance, but its evolution and transformation. At the same time, it is also a gradual and dynamic process, and it needs to be coordinated and integrated with traditional finance at some levels.

Therefore, what people should do in CEXes’ risk management is actually to “embrace tradition” and learn from the risk management system and mode of traditional exchanges. After all, there are so many lessons we can learn the mistakes from the history that there is no need to repeat them again. For example, the LUNA model and project, in the view of the traditional financial market, was bound to be a Ponzi scheme as it provided more than double-digit fixed income. This is common sense, but it once had been hailed as a star project in the crypto asset industry.

3A Exchange (3Aex.com) sees what happened at FTX as an opportunity to send a warning that CEXes should establish a more transparent risk control system supervised by a third party in terms of risk management, so as to restore people’s confidence in CEXes. After all, the No.2 CEX collapsed overnight, and this industry does not have the assistance from the central bank or the government as traditional exchanges, so it can only rely on self-discipline of the exchanges and industry.

There are two kinds of measures that can solve the problems of transparency and trust: firstly is to solve the problem for the long-term. For example, the establishment of an independent clearing house across exchanges and even across industries is responsible for the margin and clearing of CEXes, which is completely independent in organizational structure, corporate governance and finance. In essence, it performs the functions of user margin custody, clearing risk management and external supervision of exchanges, etc. This is a systematic project, requiring industry consensus on collaboration and time, but it can fundamentally solve the trust issue.

At present, supervision is basically absent, and moving closer to supervision violates the fundamental demands of the indigenous people of blockchain for “freedom and autonomy”. It is the best choice to set up an industry-based autonomous organization. Moreover, DAO and other organizational models can be introduced into the governance of clearing houses.

Secondly, there are short-term solutions, such as external audit, insurance, cooperating with third-party organizations to realize the isolation and custody of user funds from exchange funds; At the level of exchange governance, a risk management committee (or risk management DAO) led by external independent directors and attended by user representatives should be introduced, which plays a role of checks and balances and supervision on founders and CEOs, etc.

Actually, the best choice of CZ and Binance is to unite with other top exchanges, make everything possible to acquire FTX, and ensure the repayment of users’ funds, so as to save the crisis of confidence for the industry and the pressure in regulation in the future, and to promote some measures of industry coordination and self-discipline, such as aforementioned, especially the clearing house.

CEXes’ business philosophy should be to operate the CEXes from the perspective of propelling the industry. If the industry is good, the CEXes will naturally be good. 

https://www.3aex.com/

by Ethan Tao (Founder & CEO of  3A Exchange)

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Website: http://www.3aex.com/