Imagine opening your cryptocurrency exchange platform one morning to discover the site unavailable, your funds missing, and no one available to address your concerns. This scenario, which sounds like a nightmare, has become a stark reality for thousands of investors, with nearly 500 cryptocurrency exchanges collapsing. A new study by the University of Vaasa in Finland sheds light on the risk factors associated with cryptocurrency exchanges.

In his research, which has been published in the esteemed Journal of International Financial Markets, Institutions & Money, Assistant Professor Niranjan Sapkota examines data from 845 cryptocurrency exchanges to explore the reasons behind the failure of nearly half of these platforms since 2014 and how to foresee such defaults. He points out several critical indicators, such as transparency, centralisation, geographical access, fee structures, cryptocurrency offerings, and referral programs, providing crucial insights into mitigating risks in this rapidly evolving sector.

The study delves into the paradox of transparency. While centralised exchanges in advanced, well-regulated jurisdictions like the United States and Singapore are often viewed as the most secure, they are surprisingly vulnerable. This vulnerability stems from various pressures, including strict regulatory requirements, high compliance costs, and sophisticated infrastructures that can be manipulated for malicious purposes. Conversely, such pressures are significantly lower in developing countries where cryptocurrency adoption is still under discussion.

Interestingly, the study reveals that exchanges that permit U.S. customers to trade are more likely to fail than those that do not allow U.S. clients. This insight underscores the unique risks associated with operating in the U.S. market.

Regarding exchange models, centralised exchanges, which manage wallet custody for users like banks manage accounts, exhibit a higher default risk than decentralised exchanges (DEXs). DEXs, where users maintain control over their assets and transactions occur directly on the blockchain, have a 31.2% lower chance of failure. This reduced risk is attributed to the distributed nature of DEXs, which helps avoid issues related to fraud, operational mismanagement, and liquidity crises.

The research also identifies warning signs of potential exchange failures: high withdrawal fees, limited cryptocurrency offerings, and poor user ratings. Exchanges that have defaulted in the past tended to charge withdrawal fees that were, on average, 1.5 times higher than those still operational. Furthermore, platforms offering a diverse array of cryptocurrencies and maintaining high user ratings were more robust due to their ability to attract a more extensive user base and generate stable revenue streams. Additionally, exchanges offering referral incentives were found to be less likely to fail.

Assistant Professor Sapkota highlights the practical applications of his findings, advising policymakers to utilise this knowledge to formulate policies that enhance user protection and market stability. Meanwhile, investors and traders can use these insights to identify critical warning signs—poor ratings, excessive withdrawal fees, limited coin offerings, reliance on centralised systems, and accessibility to U.S. clients—to avoid unreliable platforms and secure their investments.

The robust nature of this research not only fills a crucial gap in understanding cryptocurrency exchange risks but also offers actionable solutions to navigate the market with greater confidence and establish more secure digital asset trading platforms. The study further underscores the effectiveness of traditional statistical methods like logit and probit models, which achieved an accuracy rate of about 81% in predicting exchange bankruptcies. Advanced machine learning techniques such as Random Forest, Support Vector Machine, and Stacked Ensemble were used to validate these findings, highlighting the value of combining classical and modern analytical methods in this field.

More information: Niranjan Sapkota, The crypto collapse chronicles: Decoding cryptocurrency exchange defaults, Journal of International Financial Markets Institutions and Money. DOI: 10.1016/j.intfin.2024.102093

Journal information: Journal of International Financial Markets Institutions and Money Provided by University of Vaasa