Intro

This past bear market gave participants in crypto markets an important lesson in counterparty risk. We saw the collapse of some of the biggest lenders, market makers and exchanges in the space during 2022, sucking a vast amount of liquidity from trading venues which affected every corner of the industry.

It was not only new participants to the space who were affected. Even those who had been through Mt Gox in 2014 and the Bitfinex hack in 2016 forgot through time the very real counterparty risk of leaving assets on exchange, with the FTX collapse as the nail in the coffin ending the last cycle.

The caution is warranted: history is littered with cryptocurrency exchanges playing fast and loose to gain share, by cutting corners with security, custody, and as was the case of FTX, outright fraud.

Unfortunately, exchanges playing by the rules are usually slower to innovate which costs them in a bull market, and their brands and trust are impacted by events such as FTX.

The industry has arguably never had less confidence in an exchange’s ability to custody their assets. The time for alternative custody solutions is now, and we believe “Off Exchange Settlement” (OES) could, and should, become the industry best practice when interacting with centralized exchange liquidity venues.

Ethena is aiming to be the first example of a protocol accessing centralized liquidity via these custody solutions, and we are excited to announce our integration with Copper’s Clearloop network.

What is Off Exchange Settlement?

At a high level, Off-exchange settlement (OES) entails a custody provider ensuring the collateral assets for positions are held off exchange, whilst still allowing the client to be able to access the liquidity to trade and settle on centralized venues.

The custodian mirrors the assets held onto the exchange and process trades as usual, with the only flows between the custody wallet and the exchange being the settlement of outstanding P&L, funding payments, and the movement of shortfalls in margin positions - in the case of Ethena’s perpetual futures positions this will be both P&L on the futures and the funding rate inflow or outflow.

The optimal OES flow requires 4 entities:

1. Exchange — mirrors assets in the custody account to use as margin on their own books.

2. Custodian — a regulated entity with best practices, SOC certifications, audited by the Big 4, with an on-chain proof of client assets, based in a strong jurisdiction

3. Client — in our case this will be Ethena, the entity looking to place trades.

4. Trusted Third Party — a regulated, reputable entity used to provide a dispute resolution mechanism.

How will Ethena use Copper and OES providers?

To access centralized exchange liquidity, Ethena must provide collateral to support the delta hedging derivative positions that act as the peg stability mechanism. Ethena will deposit all of our collateral with "Off-Exchange Settlement" providers like Copper. Copper both custodies deposited assets for institutions as well as enables Ethena to delegate/undelegate assets to/from centralized exchanges without ever transferring the assets to the exchanges.

"Off-Exchange Settlement" providers enable Ethena to settle the outstanding PnL of our derivatives positions frequently. This enables Ethena to mitigate any potential owed liability in the event of an exchange failure between settlement cycles.

Most importantly, Ethena depositing collateral assets with an "Off-Exchange Settlement" provider does not transfer beneficial title over the assets to the provider or our exchange partners. In the event of an agreed exchange failure, Ethena will be able to delegate funds to another exchange to support our hedging requirements.

Copper offers a custodian approach for institutions where funds are either segregated or held in a commingled omnibus wallet. In a segregated wallet, Ethena retains a key share along with Copper and a professional trusted third party and the funds are not exposed to any operational issues from Copper’s side. In the commingled omnibus wallet, the funds are held on behalf of Ethena by Copper in a bankruptcy-remote trust whereby the funds are accessible and not expected to form part of Copper's estate in the event of Copper entering administration or bankruptcy.

What are the Alternatives to OES?

1. Leave assets on an exchange - we’ve covered this in a bit of detail already, but it is worth noting that a lot of users just choose to leave assets on an exchange for simplicity. The safer approach is to only transfer money to an exchange when you need it and withdraw when you don’t but humans are lazy and will take the path of least resistance. Exchanges are where most of the liquidity and financial products in crypto reside, we just need a way to access those products and liquidity without actually leaving money on the exchange itself to minimize counterparty risk.

2. Leave assets in DeFi - one common rebuttal to counterparty risk on centralized exchanges is to move your assets to DeFi. Market participants thought the FTX collapse would drive a lot of users away from CeFi towards DeFi. A year later and that hasn’t been the case - CEX share of volumes remained broadly the same since 2022, with Binance gaining most of FTX’s share of volumes.

   The thought process behind DeFi getting more traction was that smart contracts are more transparent, trustless and immutable than the black box that is centralized exchanges. What this line of thinking ignores is that there is still an element of trust placed in depositing assets into a smart contract - not every investor vets every smart contract and for all they know it could have a vulnerability hiding in plain sight.

   Over the last year or two we have also seen some of DeFi’s biggest blue chip protocols suffering exploits. In total, there have been over $7bn worth of hacks in DeFi.

   The majority of DeFi users don’t have the skills or the time to vet every smart contract they interact with onchain.

   The problem arises when users blindly trust DeFi protocols because they view them as trustless and 100% secure, without realizing they are placing a level of trust in the contracts, their programmers and their auditors.

   Not only that, but trading costs are also a lot higher on decentralized exchanges vs their centralized counterparts. As far as Ethena is concerned, accessing centralized liquidity is a must for our product: centralized exchanges have over 96% of the open interest for perpetual futures. If we want to scale our product into the hundreds of millions, we need to have access to that perpetual future market.

A lot of users simply aren’t comfortable leaving large sums of money in DeFi contracts as it stands today, and with better liquidity offchain, investors would rather the security gain of a custodian while still being able to access better liquidity on centralized exchanges.

Our requirements will be mirrored by the vast majority of institutional capital seeking better execution and more liquidity for their trades - they all want to do this in a manner that minimized counterparty risk, and while DeFi offers a good alternative for that, minus the exploits, it has yet to be able to match the execution costs of CeFi.

Who Benefits from OES solutions?

We believe that OES provides a helpful middle ground between these two extremes. The introduction of a third party whose explicit mandate requires they custody assets securely and diligently, but importantly, where these entities do not have an explicit incentive to act maliciously by rehypothecating users assets, we are able to achieve a useful outcomes of secure transparent custody with minimized exposure to exchanges whilst still being able to benefit from their liquidity and product suite.

1. Exchanges:

   There are a couple of major benefits for exchanges when they integrate with an OES custodian partner like Copper:

   A. Less spend on security: exchanges likely don’t actually want to custody your assets, if they do it’s probably a sign that they have some other use for them i.e rehypothecation. The reason for this is that exchanges spend a significant amount of security of their assets and they were not built to be custodians. In the last bull market the industry grew so quickly without using custody solutions that exchanges had to adapt to custodying billions of assets - in doing so their security budgets would have swelled exorbitantly. Using OES custody solution will allow exchanges to cut back on their security spending from custody and focus on their actual business lines they were built to offer.

   B. More volume: exchanges that adopt OES solutions will likely be more attractive to that institutional capital we mentioned earlier that is wary of leaving assets on a centralized exchange. Offering up an alternative, while still allowing access to centralized liquidity, will open that exchange up to huge new pools of trading volume. Ethena is a perfect example of this, all exchanges that have integrated with custody solutions offering OES will be receiving our hedging flows on their perpetual futures contracts. Any exchanges that aren’t are not even an option for us to consider.

   This is healthier for the industry as a whole, giving more confidence to users regarding the safety of their assets, and limiting the risks exchanges can take with customer deposits, potentially eliminating the likelihood of another FTX type event.

2. Clients:

   The obvious benefit to the client, like Ethena, is accessing centralized liquidity in a manner that minimizes the counterparty risk associated with centralized exchanges. We would not feel comfortable building USDe if that meant leaving client assets on exchanges, which would have been the case pre-OES. OES also allows us to offer transparency of assets via onchain wallets so users can validate the existence and location of protocol collateral. Compare this to the opaque nature of the location of centralized exchange assets.

   The only obvious cost to the client is the fee charged by custody providers for their service. While this cost impacts the client's bottom line directly, it is the price to pay for peace of mind. A product like Ethena would not exist if it meant custodying assets with a centralized exchange. From a trading perspective, these costs would be partially offset by the better execution on centralized markets vs DEX’s. For institutions looking to enter the space for the first time, and do not feel comfortable auditing the security of smart contracts, a service cost to a custodian is a small price to pay for the combination of improved liquidity, broader customer reach and enhanced security.

3. Custodians:

   The benefits to the custodians are obvious - more revenue from the service charges discussed above. The costs can be significant and are the same as those flagged earlier that exchanges would be happy to avoid. This spend is entirely necessary for custodians however, as their whole business model is keeping your assets safe, unlike an exchange who offers multiple different business lines. That spend helps the custodians keep assets safe in the event of an exchange failure, which has happened in the past.

Copper: Coinflex Exchange Failure

Copper’s OES platform (ClearLoop) demonstrated how client funds remain protected in an actual bankruptcy, when one of the connected exchanges (Coinflex) defaulted in 2022. Client’s delegate funds were held securely within Copper’s infrastructure and none of Copper’s Coinflex clients suffered any losses originating from the bankruptcy.

Copper users’ funds were wholly available within days of Coinflex’s bankruptcy.

Traditional Finance and the Use of Custodians

Crypto exchanges have until now amalgamated custody, trading, execution and settlement. When DEX’s amalgamate these business functions, it is with the purpose of maintaining decentralization throughout the trading process. When a centralized exchange amalgamates these business functions it is to either a) rehypothecate customer assets or b) make the exchange a seamless trading experience.

Centralized exchanges are the closest thing crypto has to traditional finance, but exchanges in tradfi do not hold client assets and a different entity is responsible for the operation of each of the above business lines, and for the purpose of this piece, custody of assets.

Generally speaking, if a centralized exchange operates like a traditional finance entity, it should follow in the steps of the tradfi model of separating business lines and reducing costs and liability.

In traditional finance exchanges generally do not hold client assets Instead trading firms secure their derivative positions through:

i) Clearing agreements with FCMs,

ii) Via ISDA and Repo agreements with investment banks, and

iii) Bilateral agreements with prime brokers.

The prime broker model has not yet fully developed in crypto as they often need well-capitalized balance sheet parents as backstops. While disaggregation of these activities is likely, separating custody is the most important.

Risks of using Custodians

No one can claim that integrating with custodians is riskless or trustless. The point we are making in this piece is that it is likely the best alternative out there versus leaving assets on an exchange and that we believe it represents an attractive tradeoff. But it is important to be transparent about the risks of using custodians and how Ethena is attempting to manage these risks:

• Funds tied up on exchange: the period in between any P&L is settled between the exchange and custodian wallets is the exposure to an exchange failure for the custodian and therefore the client. The longer the period between settlements, the more risk there is. Thankfully, Copper clearloop can settle P&L with exchange positions every 4 hours, so an exchange failure would only result in a max of 4 hours of exposure on one exchange.

• Custodian hacks: unfortunately there have been instances of custodians being hacked and losing private keys. Copper has had no such record, but it is certainly a risk worth considering for clients. That risk can be solved by multi-part wallets where signatures are needed from two of three parties and prevents a single source of failure with regards to lost keys - institutional clients will likely only select custodians who have this set up, like Copper’s Clearloop.

Conclusion

Off Exchange Settlement looks to be the most logical next step to move the industry forward, mitigating counterparty risk to centralized exchanges while still allowing access to the execution benefits centralized liquidity offers. For a protocol like Ethena, partnering with a custody provider like Copper enables us to scale into the billions via centralized liquidity, while keeping our assets off centralized exchanges. Ethena and Copper are looking forward to setting a new standard for crypto-native money that can help drive the industry forward.

h/t to Nickel Digital Asset Management and their article below which inspired a lot of this piece.