13Feb 2023

Can Crypto Survive Without CEXs?

by Marc Woodward

For the average user, Centralised Exchanges (CEXs) like Binance, Coinbase, and Kraken provide a familiar user-friendly web and app interface, generally strong security and reliability, deep buy/sell liquidy for many tokens, numerous trading, leverage, and staking features, along with educational resources, and a help desk. Most importantly, CEXs offer direct and vital access to the fiat banking system with on and off ramps for capital. 

A mixture of failed business models, spectacular collapses, and new regulatory action has called into question the long term viability of Centralised Exchanges and platforms in an industry that was created with a vision of establishing a new decentralised and permissionless financial system, accessible to billions of people without the need for third party intermediaries. 

After a stunning run-up in 2021, 2022 proved to be an unprecedentedly challenging year for the crypto industry with negative macro events including rising interest rates, rampant inflation, fears of a recession, and the war in Ukraine, turning growth investors suddenly bearish, and marking the top of the Bull Market. This was followed by the collapse of the Terra (LUNA) ecosystem and its in hindsight, experimental algorithmic stablecoin, US Terra (UST), triggering a downward spiral in asset prices. 

One of the top performing and most influential crypto hedge funds, Three Arrows (3AC), which had popularised the idea of a “Super Cycle” of mass crypto adoption, plunged into bankruptcy, sending shockwaves throughout the industry, dragging many investors down with it. In addition, retail-oriented centralised crypto platforms like Celcius, BlockFi, Gemini Earn, and Voyager all failed, trapping or liquidating huge amounts of users’ deposits and destroying investor confidence as a result. 

Genesis, one the largest institutional crypto lending services, defaulted and subsequently went into bankruptcy. Popular retail crypto investment vehicles, the Grayscale BTC and ETH Trusts from its parent company, Digital Capital Group (DCG), traded at significant discounts to their underlying Net Asset Value, impacting retail investors, leveraged traders, and hedge funds. The sudden collapse and bankruptcy of high-profile Centralised Exchange, FTX, was a crushing final blow to a dismal year.

In December, an attempted ‘bank run’ on Binance, which with over US$60 billion in assets has three times the crypto holdings of the next 11 international exchanges combined, was thankfully unsuccessful, but added to investor nervousness, given the exchange’s huge balance sheet of assets, somewhat opaque reserve status, and lack of an auditor. 

These cascading “Black Swan” events have caused one of the most severe and lengthy crypto Bear Markets. The casual industry observer could not be blamed for thinking centralised organisations and perhaps the crypto industry in general were dead.

Last week, just after a very promising January, US securities regulators undertook a surprising, coordinated action against several centralised crypto organisations. Major US CEX, Kraken, announced that it had settled charges from the SEC for securities violations over its token staking program, agreed to shut down the service, and pay a US$30 million fine. The enforcement action was due to “registration issues” and “inadequate risk disclosures” to investors. In response, Coinbase, the largest US CEX, whose stock has dropped 20% on the news, said that its staking program would be not affected by the SEC’s move against Kraken, and has vowed to fight for “economic freedom” for all Americans. 

The New York Department of Financial Services, a financial regulator, has launched an investigation into Paxos, the NYC-based issuer of the US$16 billion Binance-USD (BUSD) stablecoin. The SEC plans to sue Paxos for listing BUSD, alleging it is an unregistered security, according to the Wall Street Journal, and Paxos will halt issuing, but still redeem, the token.There are rumours that Circle Financial, the issuer of the #2 and institutional-favourite stablecoin, USDC, which has a US$41 billion market cap, will be next. 

PayPal, which allows crypto purchases and holds in excess of US$600M of crypto, has paused its development of a new stablecoin for use on its platform. Citing volatility and counterparty risk, the U.S. Federal Reserve updated its rule book to prohibit member banks from holding crypto assets as principal, while still allowing them to provide custodial services. Binance recently lost access to US$ banking services, but mentioned this affects only a very small number of users (less than 1%). The Department of Justice is apparently investigating crypto-friendly banks, Signature and Silvergate.

Where there’s smoke, there’s fire? Unfortunately, these are likely signs of things to come under the current administration and SEC Chair, Gary Gensler. In fact, Mr. Gensler has indicated that the crypto industry is now “on notice” to get into compliance with existing Securities Regulations in the United States. 

Despite long standing requests from the industry and many in Congress for updated and clear forward-looking crypto regulations, the SEC and other agencies have instead decided to take a “regulation by enforcement” approach, and are now forcing the innovative crypto industry to adhere to antiquated securities laws. As SEC Commissioner Hester Peirce, who dissented in the Kraken action, explained, “Using enforcement actions to tell people what the law is in an emerging industry is not an efficient or fair way of regulating.

With a market cap of US$140 billion, stablecoins have been one of the key innovations and use cases for crypto, providing a common medium of exchange and non-volatile trading pairs for hundreds of tokens. Punishing enforcement action on US dollar-backed stablecoins would have a negative impact on the crypto industry. This would be incredibly shortsighted and damaging to innovation and financial inclusion. 

Stablecoins are the financial lingua franca of crypto, and extend the US dollar’s hegemony as the global exchange currency. Increasing regulation and the potential removal of fiat currency on/off-ramps to major centralised exchanges are a real risk, threaten to choke off the flow of funds from the largest capital market, and further impact the industry, especially retail adoption.

It’s important to emphasise that the major Decentralised Finance (DeFi) lending, borrowing, staking, and trading platforms like AAVE, Uniswap, Lido, dYdX, GMX, Curve, and many others, operated normally and were unscathed despite the carnage in 2022. DeFi Maximalists people that believe crypto platforms should all be web3, decentralised, and crypto native have emphasised this point and even cheered the demise of centralised platforms. 

“Not your keys; not your crypto” is a common response to serious mishaps with centralised exchanges and platforms. This often oversimplifies the complexities of holding crypto in your personal wallets, and ignores the risks of loss of assets from hacking or phishing for the average user, relative to centralised exchanges, which have strong security and often large treasuries to repay any theft.

Some rationalise that heavy-handed enforcement may actually accelerate user adoption of web3 and DeFi while pushing more capital offshore. This is somewhat wishful thinking, and it would be preferable that responsible, regulated CEXs remain a useful avenue for millions of people to participate in the crypto economy while acting as a gateway to a new decentralised world. The vast majority of trading volume and assets remain on CEXs versus DeFi. 

Although we at Apollo Crypto are huge proponents of DeFi and web3, investors in numerous early stage projects, and advisors to several teams, the centralised platforms and exchanges will continue to have an important role in the mass adoption of crypto. 

DeFi adoption and web3 innovation will continue, capital will find new paths to access crypto, and the proliferation of crypto into every corner of global finance will march on. Funds management behemoth Fidelity Investments with US$4.5 trillion of assets and 40 million US customers has recently enabled spot BTC and ETH purchases. Startup services like MoonPay and Metamask allow for direct crypto purchases into web3, and traditional apps like Robinhood, PayPal, and Square Cash are increasingly adopting crypto.

Much of the excess leverage, flawed business models, and many of the bad actors have now been flushed from the system, setting a likely bottom for the crypto markets, which came roaring back in January. Superior technology always finds a way, and capital will flow to the most efficient and profitable solutions. We at Apollo Crypto believe 2023 will be a positive year for the industry, despite the regulatory headwinds. 


Marc Woodward

Marc is Apollo Crypto's Investment Partner. He has 25 years of experience as a software entrepreneur and technology venture capitalist and has directed successful investments for top-tier funds in Silicon Valley and Australia. Marc adds significant value to our early-stage investing across our fundamental/directional funds through his expertise in venture capital investing and global network.