My thoughts on FTX, DEX integration for Jesse, and how to limit your exposure to centralized exchanges

I’m sorry about anyone who lost money on the FTX exchange. I cannot imagine it. It sucks and it shouldn’t have happened especially on an exchange that was thought to be the most regulated crypto exchange.

For my KYC process on FTX, they asked for 10 years of residency and job employment documents! You would think they are very serious about regulations, and are hoepefully very comitted. And yet, they did this...

I want to share my thoughts about exchanges for trading, and decentralized exchanges, and also share a few tips on how to stay a little safer in case of this kind of disaster happens in the future.

Regulations are not the answer

I see many people asking for more regulations to prevent such things from happening in the future. I have one question for these people. Can a crypto exchange get as regulated as a bank? I don’t think so and guess what? Banks have the exact issue that FTX had and they’re fully regulated. If only 10% of bank customers withdraw their money at once, they go bankrupt. They just don't have enough reserves to cover all the withdrawals.

The way I see it we have only two options and each of them has its cons and pros.

Centralized exchanges with proof of reserves
Decentralized exchanges

Let's talk about them.

Centralized exchanges with "Proof of reserve"

Binance recently announced this feature. This feature should become a new standard for centralized exchanges going forward.

Here are a few exchanges that are working on this feature that I could find so far:

Right there is something a bank would never do.

Decentralized exchanges

I am a big fan of decentralized exchanges. They are censorship-free, and truly open to everyone.

Decentralized exchanges look like the future of trading. They are transparent by design, so proof of reserve is already included in them, and you keep custody of your funds at all times which is great, but they aren’t risk-free.

The risk of using a DEX just like any other DeFi platform is the smart contract getting hacked. This has happened over and over in recent years.

The other issue with DEXes are liquidity and the execution speed.

Sure the liquidity has improved a lot on the DEXes recently and I’m not saying that it’s currently awful. I’m just saying it is not as good as it is on a CEX. Less liquidity leads to more slippage, which affects the performance of your trading strategy.

The other issue as I mentioned, is the execution speed which varies based on the blockchain the DEX is deployed on, and blockchains (even L2) just aren't as fast as a traditional server. Not even Salona (RIP). This again leads to more slippage.

Another thing to remember is the security of your private keys. Because to run a trading bot smoothly you have to run it on a remote server. And to trade on a DEX you need to have your private keys present on that server to sign every single transaction. This makes a new point of failure in your setup.

Of course, there are ways to secure that server but as I have seen over and over most users do not set up the required firewall measurements. Hence, we are going to see people getting hacked and losing their funds because of using a DEX, which wouldn’t have happened if they were trading on a CEX.

Will Jesse support DEXes?

Yes. I already have it in our long-term roadmap. But after the recent FTX incident, the need for it has become more urgent. So I’m going to start working on it as soon as possible.

At the moment I am researching our options. What platforms are out there? What challenges we might face? And how we can overcome them.

If you have any suggestions or ideas, please let me know on Discord.

Avoid cloud-based trading bots

Using a cloud-based trading bot is good for getting started but you lose the privacy of your strategies and API keys in exchange. Today I saw this tweet from CZ which is yet another proof why you should only use self-hosted trading bots:

<blockquote class="twitter-tweet"><p lang="en" dir="ltr">We seen at least 3 cases of users who shared their API key with 3rd party platforms (Skyrex and 3commas), and seen unexpected trading on their accounts. If you used such a platform before, I highly recommend you to delete your API keys just to be safe. 🙏</p>— CZ 🔶 Binance (@cz_binance) <a href="https://twitter.com/cz_binance/status/1591974155783909377?ref_src=twsrc%5Etfw">November 14, 2022</a></blockquote> <script async src="https://platform.twitter.com/widgets.js" charset="utf-8"></script>

Obviously, this is not the case with Jesse. You can run it on your own server and keep your strategies and API keys private.

How to manage the risk of losing your capital on a CEX

Let's say you chose the best CEXes that you know. They even have the "proof of reserve" feature. But how can you limit your exposure to their failure?

So far I know two ways:

Diversify your capital across multiple exchanges (the obvious one)
Limit your exposure to the exchange using leverage (a little tricky one)

Diversify your capital across multiple exchanges

It's pretty obvious. Divide your capital into multiple parts and spread them across multiple exchanges. If you're trading using Jesse, here is the list of exchanges that Jesse supports.

Limit your exposure to exchange risks using leverage

People say leverage is dangerous and evil but in fact, it can be good sometimes. For instance, You can use it to limit your exposure to centralized exchanges, and here’s how:

Imagine that you have $20,000 and want to go long on BTC for the whole amount. Instead of depositing all the 20,000 into the exchange, you can deposit only half of it ($10,000), and open the same position ($20,000) but with 2X leverage. And keep the other $10,000 in your cold wallet, sitting safe and sound.

Your exposure to BTC would still be the same amount ($20,000). Which means your profits or losses will be the same. And you will even pay the same funding fees too (because funding fees are calculated based on the value of your position and not the collateral you keep on the exchange).

This way, if the exchange blocks your money for whatever reason, you will only lose half of your capital. Depending on your strategy, you could put 1/3 of your capital and use a 3x leverage, and so on. You get the idea.

All right, what’s the caveat then? Well, the liquidation price of your position would be different this way so you need to make sure that your position isn’t going to get liquidated. You need a well-measured stop loss in place.

In the example above, the price of BTC should go 50% against my position for it to get liquidated, which is very unlikely because I’m not going to have a stop loss that far away from my entry price in the first place.

Stay safe,

— Saleh