This report offers a comprehensive overview of the current state of centralized exchanges and provides valuable insights into potential future developments and solutions to prevent incidents like the collapse of FTX. In the second part of this report, we will give you an exclusive preview of our latest comparative analysis of centralized exchanges that have their own native tokens, featured in our Baserank Premium research content. This analysis offers in-depth insights into the strengths and weaknesses of these exchanges and provides valuable information for crypto experts and the general public.

1. The Current State of Centralized Crypto Exchanges

The collapse of FTX has shaken the centralized exchange industry, highlighting the importance of trust and transparency. As with banks in traditional finance, centralized exchanges should prioritize the safekeeping of their customers' assets. The events such as FTX serve as a reminder of the need for self-custodial cold storage to protect crypto assets. Despite regulatory oversight from the SEC, SBF's ties to the Democratic Party, and audits by multiple companies, FTX still managed to lose 8 billion USD of customer funds. This incident highlights the challenges that centralized exchanges face and the need for solutions to ensure greater security and transparency in the crypto space.

2. Main problems of centralized exchanges

Centralized finance has long been criticized for its lack of transparency. Just as developers rely on open source, centralized finance should embrace open finance, allowing all stakeholders to see a company's assets and liabilities. The recent events at FTX highlight this need for transparency, as it was impossible for outsiders to predict the collapse. While some exchanges have implemented a proof of reserves, it is important to remember that reserves only represent one side of the balance sheet. Liabilities are equally important and must be considered in relation to reserves in order to have a full picture of a company's financial health.

Another major issue with centralized finance is the central point of trust. The original idea behind cryptocurrencies was to eliminate the need for trusting a central authority with one's money. However, centralized exchanges still represent that central point of trust, which can be problematic if the individuals running the exchange are irresponsible or greedy. The question then becomes how to prevent fraudulent activity by the central authority.

Finally, the reliability of auditors must also be called into question. The central point of trust applies here as well, as the events at FTX have shown that even reputable auditors can be unreliable. It is unclear whether the auditors missed crucial details or were compromised by those who hired them, but either way, it raises doubts about the trustworthiness of audits. These issues must be addressed in order to ensure greater security and confidence in the centralized finance industry.

3. Possible solutions

We´ve gathered three solutions that can be applied to fix the main problems of centralized exchanges. Note that all of the solutions have some advantages and disadvantages. Some people could argue that decentralized exchanges and self-custody are the only solutions.  Centralized exchanges can usually provide a better user interface, especially to newcomers, and features such as password recovery, on the other hand, the clients are not in charge of their funds. The decentralized exchanges provide full access to your funds but cannot help you in case the user makes some significant error. Then there are some hybrid options, which combine both worlds and can be seen in the following diagram.

1. Currently, most centralized exchanges fall into this category - operators of the exchange have to actively choose not to be evil and not steal customers' funds.

2. Exchanges that enhance audits, and regulation and rely on external control mechanisms similar to how the banking and traditional finance industry works.

3. Exchange that uses a combination of cryptography to prove the solvency of a centralized entity, while keeping users’ funds in the hands of the exchange and its operators.

4. Hybrid solution - Centralized exchange with DAO governance of fund reserves.

5. This category applies to decentralized exchanges (DEX) where users hold their own funds and the DEX does not have ways of stealing customer funds.

Option B - Regulation

One of the ways the exchanges can give a higher level of confidence to users is the route that was taken by Coinbase to comply with global regulatory obligations and eventually get listed as a publicly traded company. Exchanges that face the regulation rather than trying to avoid it by hiding in less strict jurisdictions are forced to provide balance sheets and other financial reports. The drawback of this solution is that it kills all innovation and it is certainly not a quick fix for most exchanges. It is difficult and expensive for crypto exchanges to comply with all the global regulatory obligations. It also goes against the idea of decentralization, as the authorities are highly relevant in the whole process. If crypto users choose to use only regulated exchanges and the regulations get tougher, more strict regulation could lead to a consolidation similar to what happened in the banking system. Exchanges will be forced to get a license and report to government-appointed organizations like the SEC.

Option C - Proof of Solvency

Another way to address the issues is to use cryptographic proof of solvency. The method, which can be used is a Merkle sum tree, where each column represents username hashes of individual customers together with their balance. All the balances have to be non-negative and the total sum should then equal to the assets that the exchange is holding in their reserves.

However, the problem here might be with the privacy of clients, as it would be possible to determine the balances on the branches of the tree in case of a potential attack. Another solution would be the usage of ZK-SNARKs, which can even protect the privacy of users. The most straightforward solution is then to assign all the deposits of users into a Merkle tree and implement the ZK-SNARK that would prove that the funds of users are non-negative (for cases of malicious accounts inserted by the exchange to the tree). On top of this can be another hashing layer for privacy so it is impossible to see the balances of other users. This solution is more broadly explained by Vitalik Buterin here.

Option D - Proof of reserves and deposits

BitMEX published a study on how proof of liabilities could be approached. The study mainly concerns the privacy of the depositors. Also, it relies on monthly deposit attestations provided by the exchange. The exchange still can steal users' funds, however, such misconduct would be exposed no later than in a month's time. We focus on how to increase the users’ funds’ protection. The proposal introduces a quasi-DAO over the reserves.

Clients receive tokens indicating their deposits. These deposit tokens’ transfers are documented on the blockchain, allowing for a public and verifiable record of liabilities at any moment. The overall value of reserves and deposits can be calculated in a decentralized way using a service like Chainlink to obtain exchange rates.

Additionally, deposit tokens act as a decentralized key to the reserves and are designed to prevent the misuse of exchange funds. The DAO, made up of token holders, elects a reserve manager and can limit the transfer of reserves out of designated wallets. In the event the reserve manager attempts to exceed these limits, a transaction delay and potential veto by token holders can prevent the unauthorized transfer of funds.

The third solution has been suggested by Jakub Jedlinsky from Altlift. The details are published in a separate article.

Comparative analysis of exchange tokens

In this report, we provide a comparative analysis of exchange tokens and evaluate which of them are undervalued and which are overvalued. Our analysis focuses on centralized exchanges that have their own native tokens.

Crypto exchanges are well-positioned to succeed in the current market environment. Similar to how sellers of mining equipment profited during the gold rush regardless of the success of individual gold miners, crypto exchanges are likely to continue to be profitable regardless of the performance of individual crypto assets. The demand for crypto trading drives the success of exchanges and their native tokens, making them independent of any specific blockchain platform or project.

In a gold rush, sell shovels.

In a crypto rush, invest in crypto exchanges.

However, a profitable exchange does not necessarily translate to the best outcome for the exchange's native token. That is why at Baserank we evaluate several important criteria when assessing the value of exchange tokens.

Centralized exchange tokens are among the few utility tokens that have a real utility value. Unlike many utility tokens that are purely speculative, centralized exchange tokens are more akin to investment-grade crypto assets. They offer a good risk-reward ratio compared to other, riskier crypto assets.

1. Methodology

Our methodology focuses on a comparative analysis of crypto segments, where we can apply the same set of metrics. We recognize that there are many factors to consider when evaluating a token and that different metrics may be relevant for different crypto asset classes. The following diagram illustrates some of the factors that may affect the value of a token.

Our comparative analysis of centralized exchanges focuses on the value-generation drivers and specific investment metrics. This allows us to evaluate the potential returns and risks associated with investing in these exchange tokens.

Our methodology has identified a number of problems with certain exchanges. These include fabricated trading volumes, insufficient liquidity of native tokens, and a lack of proof of reserves. As a result, we have applied penalties to these exchanges accordingly. The exchanges penalized for fake trading volumes are Coinsbit, Liquid, Bibox, and BTSE. We have also imposed penalties on exchanges with low liquidity of their native tokens, including EXMO, ZB, LATOKEN, AscendEX, Bitpanda, Coinsbit, Liquid, Bibox, Bankera, Coinmetro, BTSE, and Bitmart. The extent of the penalty varies based on the severity of the issue. Finally, we have also penalized exchanges that have not released proof of reserves by the beginning of December 2022, including Bitmart, BTSE, Coinmetro, Gate.io, Bankera, MXC, Bibox, WazirX, Liquid, Coinsbit, Bitpanda, AscendEX, LATOKEN, ZB, and EXMO.

2. Results

The following table shows the final ratings for centralized exchanges. The data were collected throughout December 2022 so we can offer you the most accurate results. It can be seen that Binance, Kucoin, Huobi, and Bybit are the top-rated assets. On the other hand  ZB, Bankera, Liquid, and Coinmetro ended up with a rating of 1.

3. Recommendations for Exchanges

1. Be more transparent.
1. Disclose your trading volumes properly, and distinguish between spot and derivatives trading.
2. Financial reporting would be very helpful - publish quarterly reports of trading volumes, users buying, holding, and using tokens, token buybacks, and burns. Ideally, incorporate
3. Help investors understand your token - explain in plain words its value drivers.
2. Increase the use cases for your token where it makes sense.
1. Offer higher discounts for trading fees, do not decrease discounts over time.
2. Users should hold native tokens to access some of your services.
3. Do not try to add vague features to the token that only adds complexity and no value.
3. Buyback and burn tokens
1. Keep buying back tokens continuously, the number of tokens bought back and burned should not be limited. You are essentially creating a deflationary currency and rewarding early buyers.
2. Distinguish between tokens that have been bought back and burned and tokens that were sitting in your wallet and burned - there is a big difference. Burning tokens, which were excluded from the circulating supply since the beginning, have almost no effect.

4. Recommendations for Investors

1. Consider adding the best-rated exchange tokens into your crypto portfolio.
2. Look for the real value of tokens, do not fall for exchanges that have issued useless tokens.
3. Be careful about exchanges reporting fabricated volumes - they should not be trusted.
4. Focus on the overall picture, do not rely on one single indicator, exchanges can fabricate some indicators. Choose tokens that perform well across multiple categories.
5. Request financial reports from the exchanges including the liabilities.
6. The market changes very quickly. Continue checking the exchanges’ current situation.

5. Past Editions Results

The following table shows the results of our past editions. As can be seen, our ratings are correlated with the return on investment (ROI) of the tokens, with the best-rated tokens having the highest ROI and the lowest-rated tokens having the worst ROI. This demonstrates the effectiveness of our methodology in identifying undervalued and overvalued exchange tokens. Even though all ROIs from the last edition of our research are negative due to the bear market, the best-rated exchanges have the lowest drop on average.

This is a guest post from CoinMarketCap with Baserank. The original article was published here.

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