Satoshi Nakamoto created Bitcoin to decentralize payments, replacing banking intermediaries with a peer-to-peer network. But despite the industry's focus on decentralization, most crypto users hold their assets on centralized exchanges like Coinbase. In many cases, these exchanges have proven even more unreliable than banks.
For example, FTX's spectacular collapse has left thousands of users worldwide unable to withdraw their cryptocurrencies from the exchange. With bankruptcy filings showing $50 billion in liabilities, it's unclear whether these users will ever receive their deposits back. Unfortunately, these problems are inherent to many crypto exchanges.
Let's examine why holding crypto assets in centralized exchanges is dangerous and why you should consider non-custodial exchanges or self-custody wallets to protect your assets.
What's Wrong with Exchanges?
Exchanges make it easy to buy and sell assets. Rather than finding a stranger willing to sell, these platforms bring together many buyers and sellers in a trusted environment. Many exchanges also incentivize market makers to provide liquidity to illiquid assets, making it easy for everyone to buy and sell without exorbitant prices.
Stock exchanges and brokers must register with the Securities and Exchange Commission (SEC) and comply with various rules and regulations, from financial reporting to market manipulation. As a result, investors trust brokers with their assets and don't worry about counterparty risk on stock exchanges.
In fact, many of the regulations surrounding stock exchanges came in response to problems affecting crypto exchanges today. For example, liquidity problems exacerbated by unregulated side bets at "bucket shops" caused the Panic of 1907. These events have many parallels to today's cryptocurrency markets, where liquidity crises have become commonplace.
Why Crypto Exchanges Are Risky
Crypto exchanges aren't subject to the same rules and regulations as stock exchanges. While U.S. crypto exchanges, such as Coinbase, are subject to some requirements, most crypto exchanges operate from obscure jurisdictions where few laws exist. And not surprisingly, there's no shortage of fraud, theft, and market manipulation.
According to CoinJournal, 42% of failed crypto exchanges have disappeared without a trace since 2014. A further nine percent were outright frauds from the get-go, and five percent suffered a devastating hack. Only 36% of crypto exchanges cited rebranding or business reasons as a cause for going out of business.
Fortunately, some exchanges are taking steps to reduce these risks. For example, Binance and Kraken publish cryptographically verifiable proof of reserves, although it says nothing about their liabilities! Meanwhile, Coinbase promises 1-to-1 backing and adheres to the SEC's reporting requirements due to its status as a publicly-traded company.
How Self-Custody Mitigates Risk
Non-custodial crypto exchanges provide the benefits of an exchange (e.g., liquidity and ease of use) with the safety of a user-controlled crypto wallet. Since they don't hold a user's private keys (e.g., non-custodial), users don't have to worry about a failed exchange freezing or stealing their assets, cutting down on the potential for fraud.
Decentralized exchanges, or DEXs, are the most popular type of non-custodial exchange. By using smart contracts, these exchanges incentivize users to contribute to liquidity pools and then facilitate trades without taking any custody of crypto assets. Popular DEXs like Uniswap and dyDx handle more than $1 billion in daily trading volume.
While DEXs sidestep trust issues, they have a few disadvantages to keep in mind. They tend to process trades slower and cost more than centralized exchanges, which could be an issue for active traders. At the same time, they have a more significant learning curve and only process crypto-to-crypto transactions, making them less beginner-friendly.
It's also worth noting that fraud isn't the only cause of cryptocurrency losses. Non-custodial exchanges often require self-custody wallets, and it's easy to lose keys or seed phrases to these wallets or run a hardware wallet through the laundry. As a result, there's a trade-off in trusting yourself versus trusting a centralized exchange.
Getting the Best of Both Worlds
Many crypto users have accounts on centralized exchanges and self-custody wallets. That way, it's easy to buy and sell cryptocurrencies on centralized exchanges and store them in self-custody wallets. In addition, many others use non-custody exchanges to generate income by lending to liquidity pools in exchange for incentive tokens.
When choosing a centralized exchange, you can minimize risk by selecting exchanges in jurisdictions with strict rules and regulations. For example, U.S. authorities regulate Coinbase, and it reports its financial condition in SEC filings. Using multi-factor authentication can also help keep your account safe from hackers.
The most common risk of using self-custody wallets is losing your private keys. You can minimize these risks by using offline hardware wallets that are less susceptible to attack or loss. When using software wallets, keep your operating system, browser, and other software up-to-date and use multi-factor authentication to keep out attackers.
When using centralized exchanges and self-custody wallets, you must aggregate transactions to calculate your capital gains for tax purposes. For instance, if you buy Ethereum on Coinbase and sell it to a friend via Ledger Swap, Coinbase has no way of knowing. You must compute your cost basis and capital gain separately.
The Bottom Line
Non-custodial exchanges and self-custody wallets provide a valuable alternative to using centralized exchanges. By keeping crypto assets offline and in your control, you can avoid becoming a victim of centralized exchanges that disappear with customer deposits or experience catastrophic attacks. But there are other risks to keep in mind, too.
If you use a combination of centralized exchanges and self-custody wallets, ZenLedger can help you aggregate transactions, compute your capital gain or loss, and complete the tax forms you need. You can even identify opportunities to harvest tax losses to offset your capital gains and lower your year-end tax bill.