Since the collapse of the crypto exchange FTX, centralized exchanges (CEXs) have been getting a lot of negative press. Many commentators have been urging people to self-custody their funds in hardware wallets and trade on decentralized exchanges (DEXs), which as it turns out, many people have been doing. In the month following the FTX debacle, trading on DEXs rose by 68% to $97.2B, per DefiLlama data.
The implosion of former FTX CEO Sam Bankman-Fried’s empire came as such a devastating surprise to so many people that many have been tempted to write off the concept of CEXs as a whole.
Not so fast, says JPMorgan (JPM) in its Global Market Strategies report. According to the bank’s analysts, while there are massive problems with CEXs, it’s also true that DEXs are nowhere near ready for prime time – and this is especially true when it comes to institutional investors. The most likely course of events, JPM says, is that CEXs will remain dominant for the foreseeable future.
Let’s break down the bank’s bullish stance on CEXs and some of the other conclusions in the report.
CEXs v. DEXs
While many have taken the uptick in DEX trading as a vindication of the view that further decentralization is the trendline for crypto exchanges, JPMorgan thinks the recent increase is just a blip.
“While there has been some increase in the share of DEX in overall crypto trading activity in recent weeks,” according to the banking giant, “this is more likely to reflect the collapse in crypto prices and the deleveraging/automatic liquidations that followed the FTX collapse.”
The report’s authors go on to enumerate their reasoning:
- DEXs rely on smart contracts, which are vulnerable to hacks and exploits.
- If collateral drops too far, margin calls and automated liquidations pose systemic challenges to DEXs.
- Price discovery on DEXs often comes from oracles that rely on CEX data.
- It’s difficult to audit DEXs and decentralized finance (DeFi) protocols without compromising security.
- Liquidity pooling on DEXs may be a source of discomfort for institutions.
- The current lack of stop-loss and limit-order features on DEXs alters risk management.
- DeFi’s need for over-collateralization is a weakness compared to traditional finance (TradFi).
Crypto derivatives may migrate to regulated spaces
At present, CEXs are where most of the more exotic crypto trading features can be found, such as derivatives trading. In the United States, TradFi derivatives are regulated by the Commodities and Futures Trading Commission (CTFC).
JPM thinks that when it comes to crypto, we are likely to see institutions preferring to operate under the CTFC umbrella, as multiple hedge funds lost substantial institutional capital in the FTX implosion. The report picks out the Chicago Mercantile Exchange (CME) as a likely destination for some of this shift.
Separation of crypto services
FTX and other exchanges provide just about every mainstream service that a crypto trader might need. Effectively, they are one-stop shops. In practice, this appears to set up conflicts of interest and opens the door for market manipulation. JPMorgan predicts this common setup is likely to fall under increased regulatory scrutiny, with the chance the industry may be nudged into separating brokerage, trading, lending, clearing, and custodial services.
While the calls for crypto regulation grow by the day, the majority of the world still hasn’t managed to implement too much of it. Take the Financial Action Task Force’s (FATF) Crypto Travel Rule, for example, which regulates disclosures around crypto transactions. Despite being promulgated by the intergovernmental agency in 2019, the Crypto Travel Rule has so far only been taken up by about a quarter of FATF’s member jurisdictions.
JPMorgan’s analysts believe this is about to change, even to the extent that nearly finalized regulatory packages already scheduled for rollouts may arrive even sooner, such as the EU’s Markets in Crypto Assets (MiCA) framework.
The report says that investors should expect to see a heavier regulatory emphasis on asset protection and custodial arrangements as well as transparency and audits.
JPMorgan CEO Jamie Dimon was previously famously a vocal critic of crypto, saying in 2017 that if any of his employees traded crypto they would be “fired in two seconds.” While it remains unclear to what extent his personal views have actually shifted, the financial institution he oversees has gotten deeper into crypto than many of its peers.
The bank has experimented with a series of permissioned blockchains internally. Meanwhile, in November 2022, it registered a trademark for its own crypto wallet and also executed its first DeFi trade on a public blockchain, the Polygon Network.
Now, with this remarkably upbeat assessment of the future of the centralized exchange market, the bank appears to be signaling it thinks crypto is headed for an eventual rebound – most likely as a regulated asset class moving ever closer to the TradFi sector.