Exchanges Are Out; Where Should You Keep Your Crypto?

The implosion of one of the world's largest and most trusted cryptocurrency exchanges didn't just damage the industry's reputation; it left a long trail of creditors with burned fingers and mounting regret.

Parties affected by the crash include over a million investors who stored cryptocurrency on the FTX exchange, as well as tech startups backed by the embattled company's venture capital firm, Alameda Research. And then there are the entities that made investments in FTX itself, perhaps bedazzled by CEO Sam Bankman-Fried and his apparent Midas touch. Japanese conglomerate SoftBank, to give just one example, poured $100 million into the broker earlier this year.

One outcome of this mesmerizing money loss is a massive exodus of crypto holders out of exchanges. Meaning, retail investors are withdrawing their funds out of exchanges and into standalone wallets. ZenGo, for instance, reported a 230% increase in new users of their non-custodial wallet in the week following the FTX collapse.

Do wallets stand to replace exchanges as the go-to mechanism for retail investors to keep their cryptocurrencies? Crypto wallets also come with their own mix bag, shifting the responsibility to the users themselves.

Trusting Exchanges Is, Apparently, Asking for Trouble

Used by millions around the world, FTX had carved out a reputation as a highly trustworthy platform, bolstered by a seal of approval from Singapore's state-owned investment firm Temasek, which conducted eight months of due diligence on the firm in 2021 and found no red flags — as did blockchain forensics giant Chainalysis, which had access to FTX's internal ledger and on-chain data, having handled its KYC/AML processes, and failed to flag the immense fraud perpetrated. The ironic punchline is that Chainalysis has been named as a creditor.

There are undoubtedly many lessons to be learned from the FTX fiasco, but perhaps the most important is a familiar refrain: "Not your keys, not your coins." It is a famous saying in the cryptoverse, which suggests that the only way to be certain of your funds is to hold them in a private wallet.

Centralized exchanges, no matter how stable they appear to be, simply cannot be trusted with your money. Leaving wealth in an exchange wallet is asking for trouble, as many users can testify. And not just because an exchange could crumble at any minute or be forced to freeze assets by law enforcement, but because they can block withdrawals during turbulent periods. A long list of digital asset exchanges has also fallen victim to major hacks, during which customer funds have been swiped.

With that said, it is easy to see why some users prefer storing their crypto on an exchange. Taking one's crypto into self-custody can be a daunting move, as you will have to be responsible for securing your own private keys. There is no recourse or account recovery if you misplace this all-important seed phrase, as James Howells knows only too well. The Welsh Bitcoiner famously discarded a USB drive containing his private keys during an office clear-out in 2013, and his 7,500 BTC stack is as inaccessible to him as the gold in Fort Knox. And there are plenty of others just like him.

Taking Back Control

With self-custody, crypto users can immunize themselves from the manifold risks that come from keeping assets in an exchange. But self-custody has its very own inherent risks: you might misplace your seed phrase like James Howells; a fire or flood could destroy your only paper copy, an online record of the keys could be stolen or a head injury could make you forget its location. Private key mismanagement has reportedly resulted in over $100 billion in Bitcoin being lost.

So which is it — keeping your funds in an exchange and risking another FTX-style fiasco or holding them in a private wallet and betting on the fact that it won't happen to you — that you would not lose your key?

While we wait for exchanges to be regulated, it seems that a technological solution that builds additional layers of security and protection for self-custody is more feasible. It's called multi-party computation (MPC). This cryptographic technique allows multiple parties to evaluate a computation without revealing their own private data. Thus, the private key is broken up into "secret shares" encrypted and distributed among two or more parties, removing a single point of failure. Private key theft is not possible since there is no one private key to steal; same goes for losing — you can't lose what you don't have.

MPC is increasingly being recognized as the possible savior for wallet management. Crypto custody firm Fireblocks leads the way on the enterprise front, having achieved an $8 billion valuation earlier this year. The company helps shard private keys for a long list of clients including traditional financial companies, exchanges, hedge funds, neobanks and payment providers — in other words, clients who must ensure they don't lose millions of dollars of customer funds due to subpar key management.

A technological solution that is adopted by the enterprise, after a prolonged and in-depth due diligence, is surely good enough for private individuals, as long as the use of the technology can be simplified enough for the "average" user.

Publicly-traded exchange Coinbase is perhaps the best example of a crypto heavyweight leaning on MPC technology. Earlier this year, the company announced that its mobile wallet would be powered by multi-party computation, enabling users to "have a dedicated on-chain wallet that Coinbase helps you keep secured." You still tie your wallet to an exchange, and a centralized one, it must be noted. It's on Coinbase to convince and provide evidence of the complete separation of exchange and wallet.

The logical solution begs for a standalone wallet, MPC-secured, that lets you hold your funds without the risk of being "removed" from your funds, either by the all-too-familiar "halt withdrawals" or by losing access. One can assume that there's a flurry of activity among DeFi developers right now to replicate what ZenGo, the first web3 wallet to support multi-party computation for consumers, has released to the market. In this case, shares are split between the ZenGo server and the user's smartphone. And if you lose or upgrade your device, you can easily restore your wallet by scanning your face.

The advantage of MPC is that, unlike exchanges, the other party cannot lay a finger on your assets, since the user holds an essential part of the puzzle: shares are divided and encrypted, with no entity having full access to the traditional private key. Perhaps the best part is that regaining access to a lost wallet is incredibly simple. The same cannot be said for those who lose their private keys.

The downfall of FTX is destined to be a cautionary tale for many, the crypto industry's Enron. But the silver lining might be a newfound appreciation for sophisticated cryptographic methods such as MPC, which represents a welcome balance between financial self-sovereignty, wallet security and digital asset recoverability. The adage "Not your keys, not your coins," it seems, is one that never goes out of fashion.

(Nikolai Kuznetsov is a financial analyst and professional trader.)