The growing interest in cryptocurrency in the 2010s quickly created a demand for currency exchanges. Even though cryptocurrency is supposed to leverage the benefits of a distributed ledger, the technical challenges in scaling purely decentralized models led exchange founders to look at centralized models instead.
In some ways, the custodial model is a traditional finance (TradFi) model overlaid with cryptocurrency. Centralized exchanges (CEX) buy and sell crypto assets off-chain between their own users and run periodic transactions to balance the books. The exchange also acts as a custodian for the user’s funds and holds the private keys to the user’s account.
The centralized model (usually) works for TradFi. Governments have figured out Tradfi custodian regulation over time through a process of trial and error, boom and bust, that looks very familiar to today’s cryptocurrency market performance.
With crypto exchanges and alt currency in general, governments are still in the process of developing regulations.
A centralized structure also increases hacking risk. Peer-to-peer decentralized exchanges (DEX) are more congruent with cryptocurrency’s ethos and backend tech, yet they are harder to create, maintain and use. DEXs also provide anonymity that users appreciate and governments do not. You can read more about DEXs in our DEX 101 post.
Despite the risks, demand for cryptocurrency exchanges has taken off. The chart below shows the user growth in cryptocurrency exchanges through 2018. The familiar hockey stick, or exponential growth, began to take shape in early 2018.
Below we see that even during the current “crypto winter”, the number of crypto owners increased globally during 2022.
Its helpful for US and first world investors to remember that much of the volatility in cryptocurrency markets is driven by investors using crypto as a speculative investment.
In all markets, but especially developing countries, millions do not have access to, or do not trust, traditional financial systems. Grandview Research predicts that growth in crypto will accelerate as people continue to adopt crypto for its intended use – a way to access capital and facilitate peer to peer transactions.
All of the above trends translate into growth for cryptocurrency exchanges.
Today, the top 5 CEX by volume are Binance, Coinbase Exchange, Kraken, Kukoin, and Bitstamp. Since this post takes a closer look at Binance, it is worth mentioning that Binance.US, a separate entity for US customers, ranks 11th.
High-profile flameouts like FTX highlight the risks of widespread public adoption of unregulated financial assets. Binance had a controversial role in the demise of FTX. We’ll dissect the conflict briefly, but first, let’s review Binance’s trajectory.
In July 2017, brokerage software developer Changpeng Zhao, referred to in media as “CZ,” founded Binance, a centralized cryptocurrency exchange to allow users to buy, sell and trade various digital currencies.
Binance raised eyebrows from the beginning among crypto observers, embracing centralization as 50% of its ICO tokens were allocated to insiders and venture capitalists.
Binance’s focus on a user-friendly interface, low fees, fast trades, and customer service spurred rapid growth in its first year. Despite market volatility, Binance is still the world’s leading cryptocurrency exchange.
Like many CEXs, the platform stores customer funds in secure “cold wallets” stored offline. Even though the company uses multiple layers of encryption technology and 2-factor authorization to protect customers’ accounts from unauthorized access, Binance has suffered some high-profile hacks.
In July 2017, Binance launched its coin, BNB, as an Ethereum token. In September 2020, Binance launched the Binance Smart Chain (BSC). The company eventually merged BSC with the older Binance Chain and rebranded as the BNB chain.
Binance’s Sees Rapid Uptick in User Base – and Security Breaches
By January 2018, Binance’s market cap was $1.3 billion, making it the largest cryptocurrency exchange. Binance continued to grow, expanding its user base and participating in a $32 M fund to launch the ill-fated Terra (USDT) stablecoin.
On May 7, 2019, Binance announced a “large-scale security breach” during which hackers stole 7,000 bitcoin worth around $40 million. The hackers identified vulnerabilities in Binance’s hot wallet, which contained about 2% of the exchange’s total bitcoin holdings. (A hot wallet is a wallet with an online connection to the internet.)
Binance halted deposits and withdrawals for a week. The company covered the loss because it had previously set up a Secure Asset Fund for Users (SAFU fund) to cover hacking or other losses. The fund comprises 10 percent of all trading fees the exchange absorbs. Notably, Binance stores the SAFU fund in its own cold wallet.
BNB Chain operates using “Proof of Staked Authority,” a combination of proof of stake and proof of authority. This consensus mechanism gives Binance more control over the validator network because Binance has only 21 approved validators. That number is low even among other centralized chains. Solana, for example, has 1900 validators.
Binance gets even more top-down than that. Eleven validators of the Binance Chain, a blockchain independent of the Binance Smart Chain that BSC uses to increase its speed, choose the 21 BNB validators.
While crypto purists don’t like the centralization of validators, markets do. Why? Because the centralization of power gives exchanges more flex in damage control during potential or actual hacks.
Case in point: In October 2022, Binance announced another hack to the tune of $570 million. Because of their influence over a relatively small number of validators, they could move quickly and ask validators to pause transactions on the chain – i.e., shut down the blockchain. Which, in theory, should not be easy to do.
As CZ tweeted on October 6: An exploit on a cross-chain bridge, BSC Token Hub, resulted in extra BNB. We have asked all validators to temporarily suspend BSC. The issue is contained now. Your funds are safe. We apologize for the inconvenience and will provide further updates accordingly.
In 2019, Binance established Binance.US as a separate entity in response to the regulatory environment in the United States, specifically those imposed by the Financial Crimes Enforcement Network (FinCEN) and the Securities and Exchange Commission (SEC). These regulations aimed to prevent illegal activities such as money laundering and the financing of terrorism through cryptocurrency transactions.
Binance has hired several former regulators for the parent company and Binance.US. In April 2022, Binance.US closed on over $200 million in funding at a pre-money valuation of $4.5 billion.
Today, Binance faces multiple lawsuits in the US, with more likely on the horizon as some observers predict the SEC may also step into the fray in 2023.
Binance and the Collapse of FTX
In 2019, Binance invested as a shareholder in FTX, a rival exchange. Over time, FTX founder Sam Bankman-Fried (SBF) and CZ developed a contentious relationship. Crypto observers noted that CZ felt that SBF spent more time marketing FTX than building a solid exchange. CZ also disagreed with SBF’s conciliatory stance regarding crypto regulation. The two founders often spar on Twitter.
Even so, SBF reached out to CZ in November 2022, and they agreed for Binance to acquire FTX. In what seems like a poor job of managing expectations, on November 8, both men announced the deal on Twitter before any due diligence:
CZ: “This afternoon, FTX asked for our help. There is a significant liquidity crunch. To protect users, we signed a non-binding [letter of intent], intending to fully acquire FTX.com.
SBF: “Things have come full circle, and FTX.com’s first, and last, investors are the same: we have come to an agreement on a strategic transaction with Binance for FTX.com (pending DD etc).”
Raising expectations only worsened the market reaction when CZ tweeted 48 hours later that Binance was pulling out of the deal and would liquidate its holdings in FTX tokens.
Some Crypto Twitter and media influencers accuse Binance and CZ of orchestrating the downfall of FTX in a bid to monopolize the exchange space. Binance could have considered this, but the honest answer probably lies in CZ and SBF’s personal conversations before their tweeting.
FTX reached out to Binance for a bailout deal, and SBF tweeted about a finalized agreement before Binance’s due diligence process. SBF’s apparent belief that the books would stand up to scrutiny from Binance makes you wonder if he really understood what was under the hood at FTX at the time.
Not surprisingly, the collapse of FTX raised the clamor for more transparency from exchanges. In response, Binance issued a December 2022 report detailing its proof of reserves based on a snapshot review by international audit, tax, and advisory firm Mazars.
While the report provided a snapshot of Binance’s accounts, it did not include all the same information as a proper financial statement audit. The report showed that, in November 2022, Binance controlled assets equaling more than 100% of the platform’s liabilities. Mazars provided verification that Binance’s assets were controlled by the company, recorded on chain, and collateralized.
Fast forward to January 2023. As this in-depth report from Forbes shows, Binance is still struggling with its current situation. Forbes has a complicated history with Binance that isn’t consistently disclosed, and one should take their reporting about the exchange with a grain of salt.
In the wake of the FTX collapse, several other exchanges remain in competition with Binance. Competitors include US-based Coinbase, Kraken, and Gemini, with Bitstamp in Luxembourg and CEX.io’s home base in London.
As an early leader now dominating the cryptocurrency exchange market, Binance’s experience is a microcosm reflecting the volatility in cryptocurrency. When cryptocurrency markets struggle, Binance and other exchanges will lose assets as investors exit the platform.
The financial media focuses on clickbait headlines peppered with eye-popping investor losses. Investors and observers interested in crypto’s macro-story should keep an eye on cryptocurrency’s grassroots adoption in emerging markets. The overall number of crypto owners worldwide grew by 39% from 306 million to 425 million during the year, with Africa leading the adoption rate.
In many developing countries, a traditional financial system does not serve the masses. People are turning to cryptocurrency, not as a speculative investment but as an alternative currency to provide liquidity for small businesses and their financial lives.
Even as Binance and competing exchanges work to establish legitimacy in the US and other leading economies, global cryptocurrency adoption also represents tremendous opportunities to scale.
Whether you are new to cryptocurrency or an active trader of crypto assets, ZenLedger can help you aggregate transactions across exchanges, compute your capital gain or loss, and auto-fill the IRS forms you need each year. You can even use our tax loss harvesting tool to identify ways to save throughout the year.
The above is for general information purposes only and should not be interpreted as professional advice. Please seek independent legal, financial, tax, or other advice specific to your particular situation.