Exchanges use a cold-storage/hot wallet combo to keep assets safe – but it’s slowing down their businesses and keeping them from growing.
In the crypto-native community, exchanges get a bad rap. Between a plethora of cryptocurrency exchange breaches since 2014 and high-profile insider theft cases, the smart investor usually chooses a custodial solution, not an exchange, to keep their vital funds.
Exchanges’ poor reputation is rooted in the pitfalls of a co-wallet system: the practice of keeping the majority (80-95%) of the exchange’s total assets in a hardware-based system (e.g. hardware security modules, or HSMs), then making small transfers to individual “hot” (software-based) wallets to enable liquidity.
In this article, we’ll outline four distinct disadvantages of the existing standard that prevent exchanges from achieving volume, growing their business, and offering more services.
Customer trust issues
With over $1.86B in crypto having been stolen from exchanges in the past 5 years, it’s no wonder the crypto-savvy consumer is skeptical about exchanges’ reliability.
Widespread public movements like the “Proof of Keys” annual event seeks to prove that most exchanges are not able to give customers autonomy over their own funds – a reality not due to greed, but due to the slow transaction time inherent in the co-wallet setup.
The lack of public trust in exchanges has a ripple effect beyond online chatter and a renegade move to pull keys out of exchanges on the same day.
The average crypto holder will spread his/her assets among several exchanges; from an exchange’s end, this means a significant drop in potential volume per existing customer – and a large loss in potential revenue.
On the macro scale, the loss of trust in exchanges has prevented players in the fiat community from working with existing exchange institutions to bridge the two sectors. In layman’s terms, customer trust is the key to the financial sector and the fintech sector unifying the playing field for the modern investor and/or trader.
Limited service offerings
Until now, token transactions have mostly been carried out manually. In many exchanges, assets primarily sit in cold wallets – on an HSM, for example – and a human approver must access the asset to manually carry out a transaction. This can take hours, days – even weeks, depending on the exact circumstances and on the exchange’s approval policies (for example, a large transaction can require several human approvals before being authorized).
Forward-thinking exchanges may have implemented multi-sig – but multi-sig transactions can create slower block transaction times, and create overall total cost of ownership (TCO) issues for service providers. The result: no matter what solution exchanges are using, most of them are facing significant hurdles in offering the same range of financial services as in fiat.
Inability to automate
The human-approver system prevents automation – and limits the number of transactions being conducted to the number of staff and the number of cold wallets available and accessible by those staff. A sudden upsurge in trading volume could force the exchange to scramble to keep up with the hardware support needed for so many assets – a costly endeavor that also takes significant time.
Another pitfall of the automation debacle? Being limited to operating hours. Even in the best of circumstances, humans deserve vacations – and that means a delay in transaction approval and clearance during weekends, holidays, and overnight.
New ledgers rise and fall all the time – due to the crypto market’s natural volatility, the prevalence of sudden hard forks (the ETC/ECH hard fork, for example – or BTC/BSV), and widespread security issues.
Cold storage systems usually rely on HSMs as a gold standard – and HSMs are limited in the number of cryptographic curves they are able to process. Tokens are based on specific curves; if a new token rises which does not fall within the set curve of the supporting HSM, the exchange is left without a fast means of offering it to their customers. It’s a kiss of death in a market which constantly pivots.
Hardware = Harmful (at least from a business growth perspective)
Exchanges rely on the ability to pivot – and to scale.
Hardware presents all the limitations of using a physical infrastructure for digital currency, and it’s keeping exchanges from producing the volume they need to increase revenue, the range of services to attract the semi-professional crypto-trading class, and the flexibility to move with the market.