Resilience And Opportunity through a Multi-partner model
As a financial institution or financial technology company you must find a balance between mitigating risk and exploring new opportunities. Thankfully, by adopting a multi-partner model you achieve both.
A multi-partner model is where a company works with multiple partners (e.g. custodians / exchanges), by leveraging a combination of products across the various partners. This is in contrast to choosing only one partner and being limited to the products they support.
Financial institutions and fintechs should approach custodying and trading digital assets like their cloud infrastructure. If you asked your technology team to host all of your technology infrastructure with one cloud provider, they would explain at length why that is a bad idea. It’s best practice for companies to use multiple cloud providers (e.g. AWS, Azure, GCP) instead only relying on one.
The same is true for digital assets. A multi-custodian model spreads assets (and risk) across multiple custodians and banks, while a multi-exchange model uses multiple exchanges and liquidity providers to broaden trading options.
Multi-custody decreases risk
In a multi-custody model, an institution uses multiple crypto custodians and or banks to hold assets (fiat + digital assets). You might hold 50% of assets on Coinbase and 50% on Gemini. Or a third each on Coinbase, Gemini, and Anchorage.
The exact split will be down to customer preference and market incentives (such as insurance limits). This model helps companies and customers in three ways.
1. Risk Management
When you use a single custodian, you are completely reliant on that custodian. This is a fundamental issue with digital assets, all the way down to self-custody—if everything is in one cold wallet and you lose the private key or secret phrase to that wallet, you’re out of luck.
The same goes for using custodian services. If all your customers’ assets are with a single custodian, any problem with that custodian propagates down to you and your customers. In this rapidly changing crypto environment, we’ve seen this at least twice in recent months:
- Crypto banking firm Juno had custodian Wyre as its single custodial option. When Wyre started experiencing liquidity issues in late 2022, this led to Juno having to stop deposits and tell current customers to withdraw their funds.
- Crypto company FTX was acting as a custodian as well as an exchange. When FTX went bankrupt anyone with their assets custodied at FTX lost access to their funds. These people are now embroiled in a legal battle to recover their assets.
With multi-custody, these issues are mitigated. If one custody partner goes down, assets are still available via other custodians. If assets are locked in a legal tussle, other assets can still be called upon from other custody partners. Even with temporary technical failures, your customers can always access at least a portion of their assets.
2. Compliance with Regulations
Though the concept of country or continental borders doesn’t really work with blockchains, digital assets are still subject to different regulations in different countries. Two recent examples.
- The wider tech analogy here is with GDPR. With GDPR, EU regulators want to restrict the storing and processing of EU citizens’ data outside of the EU. This requires global companies to have servers, data centers, and teams within the EU specifically for EU customers’ data. They have a multi-cloud approach imposed on them.
- Likely, a similar issue will come to crypto where US or EU regulators want their citizens’ assets custodied in their domain. EU regulators will want EU customers’ assets custodied within Europe, and US regulators will want US customers’ assets in the US. If you are working with customers around the world, you’ll need custody partners in different jurisdictions to support these customers.
Complying with emerging regulation is going to mean that fintechs looking to operate in multiple jurisdictions will have to work with multiple partners.
3. Customer Protection
Using multiple partners to custody fiat assets (banks), means you can utilize the FDIC insurance of all banks to insure more of your customers’ money. The limit for FDIC insurance is $250k per depositor, per bank, for each type of asset. So a multi-bank (i.e. multi-custody) approach is used for fiat as well. You can spread your money across multiple banks, taking advantage of the insurance per bank. So if you invest $750k in one bank, only $250k is insured; if you split that $750k equally over three banks, all $750k is insured.
Though crypto insurance is nascent, you can take advantage of insurance across custodians with a multi-custody approach rather than being subject to a single insurance policy with just one custodian.
Multi-liquidity drives revenue and reduces cost
A multi-liquidity approach uses multiple exchanges and liquidity providers to expand trading options and services for end users. Multi liquidity does help mitigate risk—e.g. outages at one exchange will not stop your operations—but the main benefit of a multi-liquidity model is that customers have access to a more diverse selection of trading options, at the most competitive prices.
1. Reduce costs by ensuring you get the best prices
If you use only one exchange provider to execute trades, you are at the mercy of the prices they set and the fees they charge. By using many exchanges you can compare the prices across your partners and route trades in the most cost effective manner.
Exchange A may charge fees of 25 BPS (basis points/0.25%) for BTC-USD trades, and 15 BPS (0.15%) for USDC-USD trades. Whereas Exchange B may charge only 15 BPS for BTC-USD trades and 20 BPS on USDC-USD trades.
In this example, it makes sense for a company to route BTC-USD trades to Exchange B, and USDC-USD trades to Exchange A. A company can pass the cost savings onto customers for free or turn it into a revenue generating feature.
2. Offer a wider range of trading pairs
Different exchanges offer different trading pairs. If you are locked into one exchange, you are locked into only those trading pairs.
It also means you can’t offer more interesting and riskier trading pairs to those customers who want a higher return and will shoulder a higher risk. For example, if your exchange doesn’t support Solana, your customers can’t buy Solana. The same for niche or newer assets on the market—you cannot offer these assets to your customers until your exchange partner supports it.
3. Offer a wider range of trading products
Working with more exchange providers can give you access to different products.
- Limit orders – Exchange A may offer the ability to create limit orders as well as market order.
- Derivatives – Exchange B may have derivatives markets where customers can long and short assets.
- Leveraged Trading – Exchange C may allow customers trade with leverage, with different exchanges likely offering leverage limits.
By integrating with multiple providers, companies can provide all of these revenue generating products to their customers, whereas this would be impossible relying on only one.
4. Increased efficiency in executing trades
With a single exchange, you are locked into any problems with that exchange:
- High traffic: Cryptocurrency exchanges can experience high levels of traffic, especially during times of high market volatility. This can cause delays in processing trades and updating the order book.
- Technical issues: Technical issues such as system outages, software bugs, or network congestion can cause slowdowns on a cryptocurrency exchange.
- Poor infrastructure: Some exchanges may have poor infrastructure, such as slow servers or inadequate bandwidth, which can result in slow trading times.
If you are using multiple exchanges, you can a) split your trading volume to speed up the process from your side but also b) mitigate these problems by moving trades to better-performing platforms on demand.
This also helps during market volatility. In 2022, trading platform sFOX were able to reassure customers during a peak in volatility because they were using multiple liquidity providers. From a customer email at that time:
In addition, SFOX offers 50+ liquidity providers and during these times we are able to route customer orders to other venues.
Multiple partners mean more value for customers and more trust for you
At Layer2 Financial, we provide our clients the benefits of multi-custody, multi-exchange through one easy to use API.
By adopting these approaches you ensure a reliable and efficient fintech stack. Using multiple custodians to improve resilience, adhere to regulations, while using multiple exchange partners to drive revenue while limiting costs.
Layer2 Financial is a Crypto as a Service infrastructure that makes it easy for fintechs, banks, and neobanks to launch fully compliant crypto products, in a matter of days. Layer2 provides seamless access to compliant custody, trading, payments, fiat ramps, and yield; all through one user-friendly API. Click here to learn more.