Thursday, November 16, 2023

Kraken v Kraken, or how to protect the public from crypto exchange failures

It's been a full year since FTX International and FTX-US collapsed, and the shocking thing is  there is still no regulated crypto venue in the U.S.! You'd think some lessons would have been learnt.

To best protect the public from the Sam Bankman-Frieds of the world, what the U.S. requires is securities-level oversight of crypto exchanges. Exchanges like Coinbase and Kraken are offering the sorts of investment services to the public that the U.S.'s main securities regulator, the SEC, is ideally positioned to regulate, such as trading, margin, custody, and market making. But one year after FTX's collapse, there doesn't appear to be a single SEC-regulated exchange.

The exchanges blame this on the SEC's lack of clarity. The SEC blames this on exchanges refusing to come in and register. God knows who's telling the truth.

Whatever the case, this intransigence only increases the odds that there'll be another U.S. crypto exchange collapse in the next few years, one that appropriate regulation could have otherwise prevented, or at least sheltered investors from the fallout.

What sort of protections am I talking about? After Canada suffered through the collapse of QuadrigaCX a few years back, and a bunch of Canadians like myself lost money, crypto exchanges were brought under the auspices of our existing securities regulatory framework, with a few nips and tucks to the rules to make them fit. This has led to a lot of changes that make Canadian crypto customers safer. I'm going to share the best example in this blog post.

Kraken is a well-known crypto exchange that serves both American and Canadian customers. However, if you're an American customers who uses Kraken, you possess a very different sort of asset than Canadian customers do.

Let's look at the fine print of the U.S. platform:

Source: Kraken's terms of service for U.S. customers

So in the U.S., asset are held "by us for you." That is, Kraken itself is doing the holding, safekeeping, or providing custody of crypto for its customers.

A key observation I want to make here is how fundamentally different this is from how standard regulated marketplaces function like the NASDAQ or the Toronto Stock Exchange. Traditional marketplaces offer a venue to trade assets, but they don't offer custody. If they tried to introduce this, their regulator would very quickly say no. I'll explain why below.

But first, let's head over to Kraken Canada. Once again, here's the fine-print:

Source: Kraken's terms of service for Canadian customers

What the underlined wording says is that if you're a Canadian, Kraken does not hold your crypto for you. That's very different from the U.S. Instead, Kraken says that customer crypto is deemed to be "custodial assets" and delegates your crypto to a "designated trust account at a Crypto Custodian." Bingo. There's the separation of trading from custody that I was talking about earlier, which aligns with standard practices for marketplaces.

Scan further through the fine print and you learn who that crypto custodian is: Anchorage Digital Bank:

Source: Kraken's terms of service for Canadian customers

Who is Anchorage? Anchorage is a federally-charted trust that is overseen by the Office of the Comptroller of the Currency, one of the key U.S. federal banking regulators. So if you hold some coins on Kraken, and you are an American, you own what is essentially a Kraken IOU, and you have to trust Kraken, but if you are a Canadian, you're effectively putting most of your trust in a federally charted financial institution. That's pretty stern stuff. 

Canadian securities regulators require all crypto exchanges operating in Canada to delegate at least 80% of customer crypto to a third-party custodian. (The other 20% can be held in a hot wallet for liquidity purposes.) Kraken doesn't appear to be doing this for its American customers, and that's because there's no U.S. regulator prompting it to do so. On top of requiring this separation, Canadian regulators stipulate that third-party custodians must be qualified. That is, they can't just walk in off the street. The custodian has to meet the regulator's standards, which requires having a Systems and Organization Controls (SOC) designation, and a bunch of other stuff too.

You can probably see by now that if you're a customer of Kraken, it's better to be Canadian than American, for the following reasons:

Anchorage is a federally-regulated financial institution and subject to strict oversight. Kraken U.S. is for the most part unregulated. No one is peering over its shoulder to check whether it is doing a good job safekeeping your coins.
Kraken has its fingers in a lot of different businesses, but Anchorage specializes on custody, and so it's probably better at the task.
Anchorage is independent from Kraken. This separation mitigates the risk of loss, theft, or misuse of assets by Kraken management. This is particularly salient in Kraken's case because it engages in many other business activities, such as trading or market-making, and these pose potential conflicts of interest.

In the future, one hopes that Kraken's U.S. exchange provides the same level of customer protection as Kraken's Canadian platform. But that's only go to happen if and when the SEC dictates a fundamental separation of crypto trading from custody, and whether U.S. crypto exchanges actually listen to the SEC.

Addendum (Nov 21): Talk about good timing. The SEC just announced that it is suing Kraken's U.S. entity for, among many other things, failing to segregate customer crypto assets and dollar balances. Segregation is different than third party custody. It basically means that customer property is kept separate from corporate property. This helps to prevent double-dipping. An exchange can make use of a third party custodian, for instance, but not segregate those funds into corporate and customer buckets. The combination of segregation and third-party custody is optimal.

By contrast, Canadian securities law clearly specifies that Kraken and any other Canadian exchange must already be segregating customers crypto and funds from corporate funds. In the regulators' own words, exchanges must keep customer property "separate and apart from its own property." This is in addition to the requirement that they use a third party custodian to store customer crypto and fiat. We can verify by reading Kraken's undertaking with Canadian regulators, in which it promises that it will be keeping customer crypto "separate and apart from its own assets."

Segregation is just one other low-hanging bit of customer protection that U.S. crypto exchanges should already have implemented, but probably won't until prodded by the government.

The next section is for pedants only, of which I'm embarrassed to be, which is why I'm putting this in very small print:

Kraken owns a U.S. bank. How does this fit into the story? Here are the details: In the U.S., the Kraken crypto exchange is really just the trade name for Payward Ventures. Payward Ventures is in turn a subsidiary of Payward, Inc. Payward, Inc has another subsidiary, Payward Financial, Inc, that owns a state-charted bank -- Kraken Bank. Notably, when you sign up as a customer of the Kraken crypto exchange, you are entering into a relationship with Payward Ventures, not Payward Financial. There is no indication in the exchange's terms of service that Kraken Bank is in any way involved in custody. Which seems... odd? Why wouldn't Kraken use its bank for custody?

When Kraken first applied to do business in Canada earlier this year, it said it wanted to use Kraken Bank as its custodian. Given that Kraken is in fact using Anchorage Bank as we speak, I suspect that Canadian regulators told Kraken: "Hey, guys. Kraken Bank is not sufficiently independent, you're going to have to use a third-party." And I suspect they were right about this.

Meanwhile, what about Canada's most popular exchange, Coinbase? Coinbase's Canadian terms of service doesn't indicate that it is using a qualified custodian. Customer assets are "held by the Coinbase Group for your benefit." Yeah, that's not going to fly with the regulators. I suspect that within a few months you're going to see it using a third-party like Anchorage, or its just going to leave Canada.


  1. you are wrong.
    Sure, here is the translation of my previous response in English:

    Coinbase and Kraken both use third-party custodians to hold their users' assets. Both companies store their users' assets in cold wallets, which are offline wallets that are not connected to the internet.

    Coinbase works with two third-party custodians: BitGo and Gemini Trust Company. Kraken works with two third-party custodians: BitGo and Ledger Vault.

    Both Coinbase and Kraken have agreements with their custodians that outline the custodians' responsibilities and obligations. These agreements state that the custodians must:

    Store users' assets in secure cold wallets.
    Take steps to prevent assets from being stolen or damaged.
    Comply with Coinbase's and Kraken's security and compliance policies.

    1. Kraken's US terms of service says customer asset are held "by us for you." There's no mention of BitGo, which is an actual regulated custodian. Ledger, by the way, is not a custodian; it is a technology provider. So I can only conclude that Kraken is doing the custody, not a third party, contra your claim.

      Feel free to show evidence otherwise in Kraken's terms of service.

  2. This entire argument is ignoring the reason why equity/debt exchanges are socially useful. Those exchanges supply safety and liquidity for primary investors, who buy stock and debt issuances by companies that INVEST, i.e., spend resources in order to make a profit by creating goods or services that people are willing to buy. Crypto and NTFs, however are not investments. They are collectables, with almost no rationale other than gambling. They should be isolated from the real economy (e.g., forbidden to be used as collateral or to be held by banks and insurance companies); and goverments should by policy refuse to expend any enforcement resources on them.

    1. Rick, I agree with you that a lot of crypto is just gambling.

      However, even gambling venues like casinos are regulated by governments in a way that makes it safer for gambling customers. Likewise, customers of crypto exchanges deserve the protection afforded by a well-written set of standards (and enforcement of those standards). And to start off with, the single best rule is third party custody.

  3. I teach Digital Money and Property in law school. This is an excellent and accurate article! Americans are so used to being protected by securities and banking regulations/regulators (eg SVB) that they assume crypto exchanges are safe - which they generally are not. If you want to know what our financial system would be like if their were no consumer safegaurds and protections in place, just look at Crypto. Satoshi's vision of a government-free money/monetary system doesn't work in the real world unfortuneately.