What are off-exchange settlement?

| December 22, 2023

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Introduction

In the aftermath of the recent fraud and bankruptcy case involving FTX, once a major cryptocurrency exchange, the crypto industry must earnestly reflect: Why is crypto industry encountering such situations repeatedly? Is it truly necessary for traders to bear the counterparty risk of an exchange when dealing with digital assets? While the collapse of FTX caught many off guard, crypto-investors witnessed similar incidents before. Can this be prevented from happening again?

Key Takeaways:

  • Off-exchange settlement solution enables institutional investors to maintain their collateral, used for leveraged positions, away from the exchange platform.
  • Off Exchange Settlement (OES) as the most effective approach to mitigate counterparty risk for traders who must maintain margin on an exchange.

Why do we need off exchange settlement?

In the early days of the cryptocurrency space, several well-established, regulated exchanges resisted the obligation to safeguard their clients’ assets. 

Custodianship came with regulatory and legal complexities, substantial security and IT expenditures (as they inevitably became prime targets for theft), and, all too frequently, security breaches resulting in losses (sometimes affecting customers, but usually impacting exchange stakeholders). However, they had to take the responsibility to manage risk for thousands of retail clients within the volatile, emerging crypto markets. These losses were seen as a cost of conducting business, as there were no sensible infrastructure alternatives to relieve them of this burden.

 Over time, some exchanges found ways to transform the cost center of “client asset custody” into an innovative business segment, often more lucrative than running the exchange itself: rehypothecation of customer assets. This could be achieved through various means, ranging from less risky to more perilous:

Option No. 1:

If you’re a regulated exchange with strong banking relationships and positive nominal interest rates, sell all the stablecoins deposited by your clients, purchase short-term government debt, and accumulate the earned interest.

Option No. 2:

Develop lending and borrowing markets for customers to lend and borrow their assets to and from each other, provide matching algorithms, margining, and risk management systems, and charge trading fees. This is not far from what an exchange should be doing.

Option No. 3:

Offer interest on assets held at the exchange to customers, while also providing a borrowing facility for margin traders. Implement margining and risk systems, and charge a profit-maximizing spread between the two. This is akin to the previous option but involves less market activity, fewer arbitrageurs, and more optimized spreads. It’s no longer purely an ‘exchange’ but more of an ‘internal’ lending desk, as you can ensure that all assets remain within the platform.

Option No. 4:

Provide higher yields on assets held at the exchange and utilize those assets for market-neutral investments outside of the exchange’s ecosystem. This clearly deviates from the exchange’s core mandate, as customers effectively lend money, at a fixed interest rate, to a market-neutral trading entity masquerading as an exchange.

Option No. 5:

Offer higher yields (albeit not unreasonably high to avoid suspicion) and use these assets for highly speculative directional investments. Similar to option no. 4 but significantly riskier for depositors.

The legality of each approach is subject to debate and hinges on factors such as the Terms of Service presented to customers and the legal framework and jurisdiction in which the exchange operates (as well as how it markets its services). Much of it exists in a legal gray area, but the fundamental rule of acting ethically has always been: Would you feel comfortable explaining this to your clients? If not, it’s likely that you are not acting appropriately. Interestingly, we have yet to see an exchange openly acknowledge practices akin to options 4 and 5, except during bankruptcy proceedings and in courtrooms.

Upsides of off exchange settlement transactions: 

There are five major advantages of exchange settlement transactions:

Minimize Counterparty risk

Off exchange settlement platforms enable two parties to finalize a trade and settle off the order book. In pre-arranged transactions, off exchange settlement platforms function as a validating third party, supporting prompt settlement and reducing counterparty risk.

Prioritizing Compliance

Off exchange settlement platform’s KYC onboarding and AML requirements apply to both parties involved in a transaction, guaranteeing legitimacy and security for all sides of the transaction.

Confidential Settlement

Only the counterparties possess knowledge of transaction information. Trade details remain undisclosed within the off exchange settlement platform’s market data feed.

Competitive Pricing

Off-exchange settlement platforms impose no minimum trade size and are accessible at a market-competitive price. For clients seeking enhanced service and control, Off exchange settlement platforms also provide a white-glove solution.

Engineered for Speed and Security

Off exchange settlement platforms enable near-instantaneous execution of bitcoin and other cryptocurrency trades (or within an approved Settlement window). Both parties must have their accounts fully funded for the asset transfers to be processed.

Off exchange settlement procedure

An ideal Off exchange settlement process involves four key entities:

Exchange: A trading venue subject to standard regulation.

Custodian: A regulated entity that adheres to best practices, holds SOC certifications, undergoes audits by the Big 4, provides on-chain proof of client assets, and operates from a robust jurisdiction.

Trader: A client of both the Exchange and the Custodian.

Trusted Third Party: A regulated and reputable entity used to facilitate dispute resolution.

Off exchange settlement workflow

A Off exchange settlement workflow typically comprises three fundamental steps:

Step 1: The client entrusts assets to the Custodian.

Step 2: The Custodian ‘locks’ the funds in one of the client’s wallets in favor of the Exchange, as per the client’s instructions.

Step 3: The Exchange replicates these funds on its platform, enabling the client to use the locked capital as margin for trading.

Role of Wallets in an Off-exchange settlement process:

An ideal Off Exchange Settlement (OES) solution necessitates the provision of two primary wallet types by the Custodian, each reflecting distinct control over the assets:

Multi-Party Wallet: 

This wallet enables transaction signing by 2 out of 3 designated signers—namely, the Custodian, Client, and Trusted Third Party. It is designed to house the majority of the Client’s assets available for trading on the crypto-exchange.

Settlement Wallet: 

This wallet is under the exclusive control of the Custodian and serves the following purposes: holding a portion of the Client’s assets available for trading on the Exchange and holding some of the Exchange’s assets.

The Custodian bears the responsibility of settling profits and losses (PnL) resulting from trading operations on a periodic basis (as required by either party, daily, hourly, or potentially even on a minute-by-minute or tick-by-tick basis) for both the Client and the Exchange.

Role of required balance in an Off-exchange settlement process: 

Client 

The client is accountable for maintaining sufficient margin across the Multi-Party and Settlement Wallets to cover their positions on the Exchange. Failure to do so will result in position liquidation, similar to the current practice of posting collateral to the Exchange.

Furthermore, the client must uphold an ample balance in the Off exchange settlement Wallet, subject to a margin call and a defined remediation period. Failure to inject additional margin into the Settlement Wallet during this period will also lead to the liquidation of positions.

Exchange

The exchange bears the responsibility of maintaining an adequate capital reserve in the off exchange settlement wallet. Any deficiency in this regard should trigger an alert from the Custodian to the Client. At this point, the Client may opt to close out positions on the exchange and retrieve the collateral held in the Settlement Wallets.

Role of settlements in an Off-exchange settlement process: 

Frequent off exchange settlements play a crucial role in preventing the accumulation of counterparty risk and facilitating efficient collateral management across venues, especially in volatile markets. Consequently, off-exchange settlements and risk assessments of required balances should occur at regular intervals (e.g., every minute).

Off exchange settlements within the Settlement Wallet are automatically executed by the Custodian through a dedicated ledger. As previously mentioned:

  1. If the Client’s balances fall below the required thresholds in the Settlement Wallet, the Custodian issues a margin call to the Client.
  2. Should the Exchange’s balances dip below the adequate levels, the Custodian notifies all Clients engaged in trading on that specific exchange.

Under normal operational circumstances, the Client and the Custodian would jointly transfer funds from the Multi-Party Wallet to the Settlement Wallet following a margin call. Similarly, the Custodian would return surplus collateral from the Settlement Wallet to the Multi-Party Wallet when it accumulates, such as in cases of positive PnL, and when the Client requests such a return.

Current Off-exchange settlement Solutions

As of September 2023, the following represent some of the most prominent competing solutions in the market, each offering distinct variations of Off-exchange settlement:

Fireblocks 

Ceffu (previously Binance Custody) 

Fidelity

Liminal

Conclusion

Off-exchange settlement is a success for exchanges, traders, and custodians alike. Exchanges are relieved from the burden of custodial responsibilities, traders reduce their exposure to counterparty credit risk from exchanges, and custodians can charge fees for safeguarding assets.

A secure trading solution on exchanges is imperative for the crypto industry’s prosperity. To earn the confidence of traditional finance, comprehensive and resilient protection of investors’ assets through off-exchange settlement is essential.

More on Crypto

As we continue constructing a fully regulated digital asset custody platform, ensuring secure storage for both crypto and fiat assets remains a critical priority. 

To facilitate the last checkpoint of enabling institutions to convert their digital asset treasury into fiat currency, we’re expanding beyond pure wallet infrastructure and integrating seamless fiat off-ramp capabilities for our partners.

We’re thrilled to announce our partnership with Encryptus, licensed and compliant off-ramp solutions tailored for institutional clients. This collaboration elevates Liminal’s service offerings by empowering our partners to convert their digital asset treasuries into fiat currencies efficiently.

Integrating A Seamless Off-Ramp Solution

The digital asset ecosystem historically faced friction points when transitioning between fiat and cryptocurrencies. Off-ramp solutions address this pain point by enabling efficient and streamlined conversion between asset classes, minimising value loss and simplifying compliance processes.

Here’s how off-ramp changes the game:

  • Reduced Friction: Frictionless conversion minimises delays and operational complexities associated with traditional fiat-crypto exchange methods.
  • Enhanced Efficiency: Streamlined workflows expedite asset conversion, increasing speed and cost-effectiveness for institutional and individual users.
  • Optimised Value Preservation: Advanced off-ramp solutions prioritise minimising price slippage and value loss during conversion, protecting user portfolios.
  • Simplified Compliance: Integrated compliance features navigate regulatory complexities, ensuring adherence to relevant financial regulations.

With our partnership with Encryptus, we have embedded their institutional-grade APIs, connecting their off-ramp solution within Liminal’s wallet and custody platform. 

This integration simplifies our clients’ liquidation requirements while keeping their assets secure and more:

  • Effortless Digital Asset to Fiat Conversion: Our partners will be able to access treasury management and facilitate business payments in 54 countries and individual payments in an extensive network of 80+ countries.
  • Streamlined Compliance and Regulation: Our partners will be able to leverage Encryptus’s rigorous licensing and compliance framework, ensuring adherence to stringent financial regulations.
  • Enhanced Platform Value: We will be able to expand the functionality of the Liminal custody solution, attracting institutional users seeking comprehensive digital asset management capabilities.

Moving Towards A Robust Off-Ramp Partnership With Encryptus

The partnership between Liminal and Encryptus earmarks a significant step forward in secure digital asset custody, representing a shared commitment to pushing compliant practices while supplying institutions with easy access to convert their digital assets to fiat. 

For Encryptus, the opportunity to integrate with Liminal’s established platform presents a chance to reach a wider audience and scale their innovative off-ramp solutions to new heights. By streamlining fiat conversion within Liminal’s secure custody infrastructure, Encryptus gains access to a trusted network of institutional users seeking seamless and compliant treasury management.

For Liminal, this collaboration reinforces our dedication to partnering with companies that demonstrably prioritise clear governance and robust policy frameworks. By aligning with Encryptus’s stringent compliance standards, we reaffirm our commitment to building a secure and sustainable future for digital assets, where trust and regulatory certainty go hand-in-hand.

January 22, 2024

Hello world, it’s that time of the month when we share the biggest security breaches in the world of Web3 through our Security and Regulatory Newsletter. 

Liminal believes in optimizing security and custody practices globally across the Web3 industry. Through our Newsletter, we highlight security, regulations, and compliance incidents that have happened in the past month and how one can follow better Security practices to safeguard their digital assets. 

We will also highlight regulatory changes that might have happened globally, which were significant to the overall ecosystem.

Dive in and get a detailed analysis of everything security and regulation in the domain of web3 with Liminal’s Monthly Security and Regulatory Newsletter.

Web3 Security Compromises in January

Abracadabra exploited for almost $6.5 million, Magic Internet Money stablecoin depegs

The Magic Internet Money ($MIM) stablecoin has lost its dollar peg again, dipping all the way below $0.77 in a flash crash before returning to around $0.95.

The depeg appears to be related to an exploit of the Abracadabra lending protocol, which allows people to borrow $MIM. An attacker exploited an apparent flaw in the platform’s smart contracts to drain around $6.5 million.

Goledo Finance hacked for $1.7 million

Goledo Finance, an Aave-based lending protocol, was exploited through a flash loan attack. The attacker stole assets estimated by CertiK to be around $1.7 million.

Goledo Finance contacted the attacker to offer a 10% “bounty” for the return of the remaining assets. In a message on January 29, the attacker wrote: “I hacked Goledo and want to negotiate.”

Socket service and its Bungee bridge suffer $3.3 million theft

The Socket cross-chain infrastructure protocol was hacked for around $3.3 million in an attack that exploited its Bungee bridge. The thieves were able to exploit a bug that allowed them to take assets from those who had approved a portion of the system called SocketGateway.

A little over 700 victims were affected, and the highest loss from a single wallet was around $657,000. 121 wallets lost assets priced at more than $10,000.

On January 23, the protocol announced they had recovered 1,032 ETH (~$2.23 million) of the stolen funds.

Web3 Regulatory Practices for January

The EU Imposes Stricter Due Diligence Rules for Crypto Firms

On Jan. 17, the European Council and the Parliament came to a provisional agreement on parts of the Anti-Money Laundering Regulation (AMLR) that now extends to the crypto sector.

Under the new rules, cryptocurrency firms will be required to run due diligence on their customers involving a transaction amounting to €1,000 ($1,090) or more. 

However, the agreement isn’t final yet as it has to be first officially adopted by the Council and Parliament before the rules can be applied.

So, after the EU passed its landmark MiCA regulation last year, which clarified rules about cryptocurrencies, regulators are now targeting the space with tighter controls. 

While these regulations bolster security and trust in the crypto market, potentially attracting more cautious investors and combating financial crimes, they also present challenges. 

The US State of Virginia Introduces Digital Assets Mining Rights

Recently, the Virginia State Senate introduced Bill No. 339, which outlines regulations for the transactions and mining of digital assets and their treatment under tax laws. 

The legislation exempts individuals and businesses engaged in crypto mining activities from obtaining money transmitter licenses. Additionally, it protects miners from any discrimination. 

Issuers and sellers of crypto are also exempted from securities registration requirements if certain conditions are met. Moreover, those offering mining or staking services are not to be classified as “financial investment” but must file a notice to qualify for the exemption.

The bill further incentivizes crypto’s use for everyday transactions by offering tax benefits. Under this, up to $200 per transaction can be excluded from an individual’s net capital gains or gains derived from using crypto to purchase goods or services, starting from Jan. 1, 2024.

Key Takeaways:

  • Hackers continue to exploit vulnerabilities in DeFi protocols and cross-chain bridges, highlighting the need for robust security measures.
  • Regulatory frameworks are evolving rapidly, with stricter AML rules and supportive legislation for emerging technologies like crypto mining.
  • Staying informed about these developments is crucial for navigating the digital assets market safely and responsibly.

Stay #LiminalSecure

These events highlight the constant evolution of Web3 security and regulation. You can confidently navigate this dynamic landscape by staying informed and prioritizing security best practices. 

At Liminal, we’re committed to empowering institutions to unlock the full potential of digital assets without compromising security or compliance norms with our robust custody and wallet infrastructure solutions. Join us on this journey towards a safer, more accessible future for digital assets.

January 15, 2024

Buckle up as we’re about to take a trip down memory lane. 

The year 2023 was a wild ride that showed signs of a plummeting market, groundbreaking innovation and regulatory hurdles. 

Contrastingly, in the same year, we saw no market-shattering crashes. Financial institutions extending an olive branch, key jurisdictions unlocking the doors to blockchain technology. 

Simultaneously, at Liminal, we experienced significant breakthroughs, re-engineering our positioning and becoming a pioneer in digital asset security with bank-grade custody. 

We took major strides this year, right from building comprehensive products to becoming a qualified custodian, from revamping our brand design to expanding our offices in newer locations, from partnering with hyper-local communities to onboarding a diverse set of clients,  we did it all. 

So, let us take you through everything we accomplished in 2023 and what the future holds.  

Liminal Became A Qualified Custodian

One of the prominent moves we made this year was to change our positioning as a regulated custodian from being a wallet infrastructure platform. 

We got two licenses in key jurisdictions to operate as a regulated custodian. 

The first one came from Hong Kong, where we acquired the TCSP license issued by the SFC, which oversees and regulates financial activities to ensure compliance with legal and regulatory obligations. 

Our next license came in the MENA region, where we got In-Principle Approval for the FSP license granted by the FSRA, a governing body in ADGM, to establish a progressive financial services environment. 

Both these licenses paved the way for Liminal to push its wallet infrastructure and offer bank-grade custody to institutions looking to operate in these particular regions. 

Liminal Introduced A Suite of Products & Features

Continuing our building spree, we launched new products and integrations to broaden the existing infrastructure and added more parameters of security, scalability and sustainability. 

Staking-as-a-Service

Liminal launched staking for institutions to eliminate the risks involved in running staking nodes and the vulnerabilities in hot wallet transfer. 

Hence, we introduced an industry-first mechanism of cold wallet staking to ease staking for institutions and secure assets explicitly.  

Whitelabel Solution

Accelerating the go-to-market time for organisations looking to build a secure and customisable application, Liminal launched its whitelabel solutions

Targeted to help organisations meet security standards, manage assets with maximum control, and add their custom branding to give it a personal touch. Our whitelabel solution is a first-in-class custodian-developed solution for institutional grade custody.

Smart Consolidation

We are building not just secure custody but also automation-based features to eliminate manual errors, increase the throughput of transactions and scale institutional wallets. 

Taking this ahead, we launched the Smart Consolidation feature to automatically calculate all the active addresses and consolidate them into a single address. With this level of automation, managing multiple addresses becomes uber easy for wallet teams. 

Travel Rule 

To limit the use of cryptocurrencies for activities like money laundering and terror financing by regulatory bodies, travel rule was mandated for institutions to follow. 

Continuing the latest compliance integration policy, Liminal partnered with Notabene to introduce Travel Rule, enabling institutions to manage counter-party risk and extend the process of due diligence right from the Vaults dashboard.   

Liminal Accured List Of Security Certifications

Following our ISO certification for data privacy and risk management, we added two new security certifications to fortify our systems and build trust for our clients. 

Liminal Achieves Crypto’s Highest Security Mark: CCSS Level-3 Certified

Cryptocurrency security lacked a gold standard, creating a vulnerable ecosystem. Enter the CryptoCurrency Security Standard (CCSS), setting the bar for auditing and certifying custodian infrastructure and establishing levels of trust and confidence for investors. 

Liminal became only the second wallet infra platform and the first regulated custodian to be accredited with Level-3 certification, deeming wallets, transfer environments, workflows and engines safe and secure. 

Liminal Reciueved SOC 2 Type II Certification

To tackle threats in institutional-grade security, organisations’ SOC has been identified as the primitive compliance standard for service organisations to handle customer data.

Liminal successfully attained SOC 2 Type II certification, validating its setup of security controls & compliance processes to be industry standard. 

Liminal Level Up

Liminal unveiled its most significant platform upgrade ever, revolutionising the future design standard of a qualified custodian. This level-up activity included revamping our website and product UI, giving a completely new look and feel to not “Liminal” but “Liminal Custody”. 

The Liminal level-up activity was a strategic step and the biggest one for us this year to create an intuitive, inviting and tailored experience for our clients. 

Liminal Reached New Borders

We spread out our operations this year, reaching new borders and onboarding a new wave of institutions across gaming, DeFi, HNI wealth, treasuries, and exchanges! From Indonesia and Africa to India, UAE, and Korea, we are setting up custody operations worldwide. 

This isn’t just a roster of clients; it’s a network ready to spark connections, collaborations, and shared success to further the definition of secure assets. 

Liminal Collaborated With Law Enforcement Agencies

The best and the proudest moment of Liminal for this year was when we collaborated with CBI & Himachal Prashesh police department to aid them in seizing digital assets. 

This partnership put us on the map, as we became the first point of contact for LEAs in India, and we standardised the process of secure seizure of digital assets. Leveraging our expertise, we enabled a safe space for officers to learn the basics of custody, contributing to a safer digital landscape.

Team Liminal Grew Bigger

Building such a massive infrastructure, prioritising security and compliance over everything else, we had to grow the team to build at pace and expand at an even higher level. Not only did we grow in team numbers, but we also elongated our footprint to new destinations. 

Team Liminal went from 32 to 70 with 5 new offices in Mumbai, Ahmedabad, Hong Kong, Singapore and ADGM, setting up our custody operations steadfastly. 

What’s To Look Out For In 2024

We are excited to announce that our commitment to integrating the most secure digital asset wallets with a cutting-edge custody platform is swiftly becoming a reality. 

The upcoming year, 2024, will serve as a testament to this transformative journey. Moving beyond self-custody, we are constructing a comprehensive infrastructure encompassing both custodial and non-custodial wallets. Exciting products are set to launch starting from the first week of January, some of which are: 

  • Official Custody Platform Launch
  • Liminal’s Off-Exchange Settlement Hub
  • Secure Custody of Real-World ‘Tokenised’ Asset

The Web3 space has evolved explicitly this year, pushing the narrative of secure digital asset custody and security, introducing new regulations and compliance standards, licensing VASP providers and standardising the use of custodians as a trusted third party. 

At Liminal, we took major strides this year, from building comprehensive products to becoming a regulated custodian, from revamping our brand design to building the full infrastructure of custodial and non-custodial wallets.

January 5, 2024

Find Out How You Can Benefit From A Fully Self-Custodial Wallet Architecture