CXDS White Paper

Centralized Exchange Default Swaps (CXDS): Mitigating Risks in Centralized Exchange Deposits

Canza Foundation

DRAFT Version 1.0

Abstract

The Centralized Exchange Default Swaps (CXDS) protocol offers an innovative solution to mitigate risks associated with deposits in centralized exchanges (CEXs). By enabling users to create credit default swaps (CDSs), CXDS provides protection against exchange defaults while offering yield opportunities through a decentralized marketplace.

This white paper highlights CXDS’s role in addressing vulnerabilities exposed by past CEX failures. It leverages smart contracts and community governance for automated collateral management and efficient risk mitigation. With its scalable design and transformative potential, CXDS aims to enhance trust, stability, and financial inclusion in the cryptocurrency ecosystem.

1. Executive Summary

Centralized Exchange Default Swaps (CXDS) is an innovative financial product designed to mitigate the risks associated with deposits held in centralized exchanges. By enabling users to create credit default swaps (CDSs) that track the performance and solvency of centralized exchanges, CXDS provides a safeguard against potential exchange defaults. Participants can purchase CDSs for specific exchanges to secure their deposits or sell CDSs to earn a weekly yield.

What sets CXDS apart is that it diverges from traditional insurance protocols, which often focus on specific risks and require purchasers to demonstrate that they have personally incurred a loss. CXDS opens the gateway to more advanced and dynamic markets, offering a broader and more versatile approach to mitigating risks associated with centralized exchange deposits.

2. Introduction

Centralized exchanges (CEXs) play a pivotal role in the digital asset ecosystem, offering liquidity and accessibility to users worldwide. However, past failures, such as those of FTX, QuadrigaCX, and Mt. Gox, have exposed significant risks to user deposits. CXDS addresses this vulnerability by enabling users to hedge against potential exchange defaults. By providing a mechanism to secure deposits or earn yield, CXDS ensures a more resilient and trustworthy ecosystem for digital asset trading.

What sets CXDS apart is that it diverges from traditional insurance protocols, which often focus on specific risks and require purchasers to demonstrate that they have personally incurred a loss. CXDS opens the gateway to more advanced and dynamic markets, offering a broader and more versatile approach to mitigating risks associated with centralized exchange deposits.

3. Background

3.1 Credit Default Swaps Explained

Credit default swaps (CDSs) are financial instruments that act as insurance against the default of a loan or obligation. In the context of CXDS, the CDS mechanism is adapted to protect users against the default of centralized exchanges. Buyers pay a premium to secure collateral coverage, while sellers lock collateral in exchange for yield, taking on the associated risks.

Example

Imagine Alice wants to lend money to Bob. She is worried that Bob might not be able to repay the loan in the future. To protect herself, Alice enters into a credit default swap with Charlie, who agrees to compensate Alice if Bob defaults on the loan. In return, Alice pays Charlie regular premiums. If Bob defaults, Charlie compensates Alice as per their agreement; if not, Charlie keeps the premiums.

This mechanism enables lenders to transfer risk to another party in exchange for regular premium payments, serving as a critical tool for managing credit risk.

3.2 Losses in Centralized Exchanges

The centralized exchange (CEX) sector has seen significant losses due to defaults, hacks, and fraudulent activities. A 2023 Chainalysis report estimated that over $3.5 billion in user funds were lost due to exchange insolvencies and malicious activities in the past decade. Notable examples include the $850 million lost in the QuadrigaCX scandal, $450 million from the Mt. Gox hack, and $8 billion during the FTX collapse.

These events highlight the inherent risks of centralized custody, where users trust exchanges to safeguard their assets without adequate protection mechanisms. The frequent occurrence of such losses underscores the need for innovative financial instruments like CXDS, which can provide a safety net for depositors.

3.3 Opportunity for Insurance Companies

The recurring losses in centralized exchanges present a significant opportunity for traditional insurers to expand their asset class portfolios to include crypto assets. By leveraging blockchain technology and decentralized architectures, insurers can offer tailored products to address these risks. Blockchain's inherent transparency and immutability align well with the insurance sector's need for accurate and auditable risk management.

3.3.1 Advantages for Insurers

1. New Revenue Streams: By incorporating crypto-specific coverage, insurers can tap into a growing market of digital asset users.

2. Enhanced Risk Assessment: Smart contracts can automate and enhance risk evaluation processes, ensuring that payouts are triggered transparently and accurately.

3. Increased Market Trust: Offering insurance for digital assets could increase user confidence in centralized exchanges, fostering broader adoption of cryptocurrencies.

3.3.2 Implementation Strategies

1. Tokenized Insurance Pools: Insurers can tokenize their risk reserves, enabling real-time transparency and efficient allocation of resources.

2. Dynamic Premium Structures: Leveraging blockchain data, insurers can offer dynamic premiums based on user behavior and market conditions, enhancing fairness and profitability.

3. Partnership with DeFi Protocols: Collaborations with DeFi platforms like CXDS can help traditional insurers bridge the gap between conventional and crypto-native financial ecosystems.

4. History of Credit Default Swaps

Credit default swaps were introduced in the mid-1990s by JPMorgan Chase as a financial innovation to manage credit risk. Initially designed for use in interbank lending, CDSs quickly gained popularity for their ability to hedge against loan defaults. By the early 2000s, the CDS market had expanded dramatically, becoming a cornerstone of modern finance.

One notable milestone in CDS history was their role during the 2008 global financial crisis. At its peak, the CDS market was valued at over $60 trillion, and these instruments were widely used to hedge risks in mortgage-backed securities. However, the financial crisis exposed the systemic risks associated with over-leveraged CDS contracts, leading to significant reforms and increased regulatory scrutiny in subsequent years.

4.1 Modern Use Cases

Today, credit default swaps are used by a variety of market participants, including:

1. Banks and Financial Institutions: To hedge against potential defaults in their lending portfolios.

2. Investors: To speculate on the creditworthiness of companies or sovereign entities by buying or selling CDS contracts.

3. Corporations: To protect against the risk of counterparty defaults in supply chains or large contractual agreements.

4. Insurance Companies: To diversify risk exposure and manage their liability portfolios.

CDSs' flexibility and efficiency have solidified their role as a key financial instrument for managing credit risk in global markets.

Traditional CDS vs CXDS

Feature	Traditional CDS	CXDS
Underlying Asset	Corporate or sovereign debt	Deposits held in centralized CEX
Participants	Banks, financial institutions, corporations	Retail and institutional crypto investors
Premium Payment	payments over the contract’s duration	Upfront payment at the time of contract
Payout Trigger	Default event in the underlying asset	Default event in a centralized exchange
Risk Evaluation	Credit ratings, market data	Blockchain-based transparency
Market Size	Trillions of USD globally	Emerging market within the Web3
Transparency	Limited, reliant on intermediaries	auditable on-chain
Regulatory	Highly regulated	Evolving regulatory landscape
Settlement	centralized clearinghouses	Automated via smart contracts

Table 1: This table contrasts traditional credit default swaps (CDS) with the innovative Centralized Exchange Default Swaps (CXDS). While traditional CDS focuses on corporate or sovereign debt and relies on credit ratings and intermediaries, CXDS targets deposits in centralized exchanges using blockchain transparency. CXDS offers automated settlements via smart contracts, caters to the emerging Web3 market, and is designed for retail and institutional crypto investors, providing a decentralized and auditable alternative to traditional financial instruments.

5. CXDS Mechanism

5.1 Core Mechanism

The CXDS platform operates through liquidity pools that represent specific centralized exchanges. Participants can either buy CDSs to secure their deposits or sell CDSs to earn yield. The key steps include:

5.1.1Buying a CDS

• Buyers pay an upfront premium as a percentage of the collateral they wish to cover. The premium is calculated as:

• Collateral is locked in the pool and becomes accessible to the buyer only in the event of a default.

• If a default occurs, the collateral payout is calculated as:

• If no default occurs, the locked collateral is released to the seller at the maturity date.

5.1.2 Selling a CDS

• Sellers deposit collateral into the pool and earn a premium from buyers. The yield for sellers is calculated as:

• Collateral is proportionally locked across all active CDS positions. Sellers’ potential loss in case of default is:

• Sellers can claim their premium immediately but cannot withdraw locked collateral until the maturity date unless a default occurs.

5.1.3 Determining Defaults

To determine whether a default has occurred, the Decision Board evaluates five specific conditions:

1. Significant security breaches involving unauthorized access and fund loss.

2. Systemic infrastructure failures exceeding 24 hours.

3. Insolvency or bankruptcy declarations.

4. Unauthorized transfers or misappropriations of user funds.

5. Regulatory interventions resulting in operational suspension.

The Decision Board uses a scoring mechanism to assess these conditions:

Where:

• The weight assigned to the condition reflects its severity.

• Binary variable indicating whether the condition is met (1 if met, 0 otherwise).

• Total number of conditions.

A default is declared if:

The protocol's governance structure determines the threshold value, ensuring that only significant breaches result in a declared default.

The voting process is incentivized to align with rational decision-making, where rewards are distributed to voters in proportion to their rationality:

5.1.4 Decision Board

The Decision Board for each pool will consist of seven individuals selected from the DeFi and TradFi sectors. These individuals are known for their reputation as trustworthy and good-faith actors. Their primary role is to assess whether a default has occurred by evaluating the five conditions. In recognition of their participation, they will receive a reward equivalent to 0.1% of the notional balance traded on the protocol, which is held in the voter reserve.

5.1.5 Voting Mechanism

Process To Trigger a Default

Figure 1: Depicts the process of triggering a default event in the CXDS Protocol. If two decision board members vote to default on a specific CEX, the CXDS contract is paused until all remaining voters vote then a decision mechanism is achieved, and the reserve pool is shared among voters of the actual outcome.

To ensure that voters make rational decisions and prevent collusion or exploitation of the voting system, we have implemented specific incentives for the Decision Board.

In order to initiate a Default vote, a minimum of two voters must cast a "Yes" vote indicating a default event. Once two "Yes" votes have been registered, the protocol will temporarily halt the pool, preventing any further buying or selling of CDSs. This effectively freezes the market until the full voting procedure is completed.

Subsequently, the remaining five voters will be notified and asked to evaluate whether the pool has indeed defaulted, and they can vote "Yes" or "No." Following the conclusion of the vote, the funds from the Voter Reserve will be distributed among the voters in the majority that voted rationally (i.e., in accordance with the majority decision).

It's important to note that votes are kept confidential during the voting process. This secrecy encourages rational decisions, as voters will only be eligible to receive their rewards if they align with the majority's rational decision.

If the voters collectively decide on a Default, the contract will permit CDS buyers to claim their covered collateral. Conversely, if the voters opt for "No Default," the contract will be unpaused, allowing further purchases and sales of CDSs to resume until the maturity date, at which point it will roll over to the new period.

5.1.6 Voter Reserve

The Voter Reserve pool is a repository for all the accumulated fees reserved for the voters in the event of a default. In addition to being disbursed upon the conclusion of each vote, 25% of the voter pool will be distributed among the decision board members at the end of each maturity period. This monthly allocation is designed to encourage ongoing participation and support for the protocol, ensuring the continued engagement of Decision Board members.

5.1.7 Claim Collateral

If the exchange has defaulted, the buyer can claim the collateral. To do so,

1. Under the " Buy CXDS " section in the drop-down menu, click on the "Claim" button.

2. The collateral will then be transferred to the buyer's wallet.

5.1.8 Withdraw

A CDS seller has the option to withdraw any unsold collateral. To initiate a withdrawal, follow these steps:

1. Click on the "Withdraw" button.

2. Specify the desired amount you wish to withdraw.

3. If the cxds matures without defaulting, all locked collateral will become available for withdrawal.

4. If the loan has matured but the collateral hasn't been unlocked, click the "Execute" button to unlock it.

Please be aware that you can withdraw only available collateral, so make sure that the specific collateral you intend to withdraw is indeed available.

5.1.9 Claim Premium

After a CDS is sold, the premium paid by the buyer is instantly available for the sellers to claim. To do so, follow these steps:

1. Click on the "Claim" button within the "Sell CDS" section in the drop-down menu.

2. The premium will then be directly paid to your wallet.

CXDS Protocol Structure

Figure 2: Depicts the CXDS protocol structure, where sellers deposit collateral and receive premiums as compensation. The CXDS core manages collateral from sellers, disburses premiums, and collects payments from buyers. In case of default, it releases locked collateral to buyers. The protocol works with the Decision Board and Voter Reserve, using a voting mechanism to ensure fair and transparent default determinations.

6. Risks

As of the current date, CXDS has not undergone an audit. Therefore, it is strongly advised to exercise caution when using the protocol. Only invest in assets that you are prepared to lose. Additionally, the protocol's functionality relies entirely on the good faith of the Decision-Making Board's voters.

6.1 Additional Risks

1. Market Volatility: The crypto market's inherent volatility can lead to rapid changes in collateral valuation, potentially increasing the risk of default.

2. Cross-Chain Vulnerabilities: As CXDS integrates cross-chain liquidity, vulnerabilities in one blockchain could cascade into others, leading to broader systemic risks.

3. Regulatory Risks: Changing regulatory landscapes may impact CXDS's operational capabilities, especially in jurisdictions with stringent crypto regulations.

4. Smart Contract Risks: Potential vulnerabilities in the smart contract code could expose the protocol to exploits, underscoring the need for rigorous audits and testing.

5. Liquidity Risks: Insufficient liquidity in CDS pools could hinder the protocol's ability to meet payout obligations during high-default scenarios.

6. Counterparty Risks: Sellers might default on their obligations, especially during periods of market stress, leading to collateral insufficiencies.

7. Revenue Model

Whenever a buyer purchases a CDS instrument, they incur a 0.3% maker fee based on the notional balance they are covering. Out of this fee, 0.1% is allocated to the voter reserve. This specific allocation ensures that voters' rewards are directly tied to their rational and commendable participation in the protocol, reinforcing the alignment of incentives for good-actor involvement.

7.1 Expanded Revenue Streams

1. Dynamic Fee Structures: CXDS may introduce tiered fees based on transaction size, encouraging higher-value participation while ensuring accessibility for smaller investors.

2. Partnership Incentives: Collaborations with other DeFi protocols could yield revenue-sharing agreements, expanding CXDS's earning potential.

3. Premium Staking Rewards: A portion of collected premiums could be reinvested into staking pools, offering additional yield to protocol participants.

4. Cross-Chain Revenue Sharing: Integration with multiple blockchains may generate transaction fees, further diversifying revenue streams.

8. Projected Impact of the CXDS Implementation

The projected impact of the CXDS implementation demonstrates its potential to recover a significant proportion of funds lost due to centralized exchange defaults. This projection is based on realistic assumptions about user behavior and operational efficiency. Key factors include a 60% portfolio insurance rate, a 75% cap on loss coverage, an 85% efficiency in pooling and distributing funds after operational costs, and a 20% default severity rate. These inputs yield a recovery rate of approximately 43.2%, which is then applied to the total losses reported by each exchange to estimate the recovered funds. This analysis underscores CXDS's capacity to mitigate financial risks through innovative mechanisms that align user incentives and optimize resource allocation, offering a transformative solution for safeguarding assets within the cryptocurrency ecosystem.

8.1 General Assumptions:

• Portfolio Insurance Rate (P): 60% of user portfolios are insured by the CXDS protocol.

• Coverage Cap (C): 75% of the losses are covered under the CXDS mechanism.

• Pooling Efficiency (Le): After accounting for operational and administrative costs, 95% of the pooled funds are effectively distributed.

• Default Severity (Ds): 5% of the insured pool is impacted by a default event.

• Recovery Rate (Rr): Calculated as the product of the above factors, leading to a recovery rate of 40.1% across exchanges.

8.2 General Calculations:

1. Total Losses (L):

   • Based on historical data from FTX, Mt. Gox, QuadrigaCX, and other centralized exchanges.

   • Total losses for the selected exchanges are aggregated for comparison.

   • Loss figures include:

     • FTX: $8,000 million

     • Mt. Gox: $450 million

     • QuadrigaCX: $850 million

     • Other CEXs: $2,200 million

2. Recovery Rate (Rr):

   • Calculated based on the proportion of insured assets, coverage cap, pooling efficiency, and severity of default.

   • Applied uniformly across all exchanges in the analysis.

3. Recovered Funds (F):

   • Total losses for each exchange are multiplied by the calculated recovery rate.

   • Reflects the estimated recoverable funds for each exchange through the CXDS protocol.

8.3 Chart-Specific Assumptions and Projections:

• Red Bars: Represent the total reported losses for each exchange based on historical data.

• Green Bars: Represent the estimated recoverable funds calculated using the 43.2% recovery rate derived from the assumptions above.

• Comparative Visualization: The chart demonstrates the proportion of losses that could be mitigated by implementing the CXDS protocol.

8.3.1 Total Losses

Formula:

Variables: L: Total losses for all exchanges in millions of USD.

n: Number of exchanges considered.

Li: Losses for each individual exchange.

For the selected exchanges:

Specific Values:

8.3.2 CXDS Recovery Ratio

Formula:

Variables:

R: Recovery ratio for an exchange (expressed as a decimal, e.g., 0.401 for 40.1% recovery).

F: Funds recovered via CXDS.

L: Total losses for that specific exchange.

Assumed recovery ratios for each exchange:

8.3.3 Recovered Funds via CXDS

Formula:

Variables:

R: Recovery ratio for an exchange (expressed as a decimal, e.g., 0.401 for 40.1% recovery).

F: Funds recovered via CXDS.

L: Total losses for that specific exchange.

For the selected exchanges:

8.3.4 Chart Representation

Variables:

X: Exchange names (categories: FTX, Mt. Gox, QuadrigaCX, Other CEXs).

: Total losses (L) for each exchange.

: Recovered funds (F) for each exchange.

The bar chart compares:

Total Losses (red bars):

Recovered Funds (green bars):

CXDS Projected Impact on Past CEX Default Events

Figure 3: The chart above illustrates the projected impact of the CXDS implementation on centralized exchange defaults, showing the total losses and the corresponding recovered funds based on a recovery rate of 40.1%. The red bars represent the total losses for each exchange, while the green bars indicate the funds recoverable through the CXDS protocol.

9. Roadmap

Q1 2025

• Finalize Smart Contract Development: Complete the design and coding of CXDS smart contracts, ensuring robust functionality and security for credit default swaps.

• Funding and Grants: Secure grants and funding to support the finalization of smart contract development and third-party security audits.

• Smart Contract Audits: Partner with top-tier blockchain security firms to conduct comprehensive audits and address any identified vulnerabilities.

Q2 2025

• Beta Version Launch: Deploy the beta version on a testnet, allowing limited participants to test the CXDS protocol in a controlled environment.

• Efficiency Testing: Conduct rigorous testing of the CXDS mechanism, focusing on the efficiency of collateral management, premium distribution, and default handling.

• Optimization for V1 Launch: Analyze beta test data to refine smart contract parameters and optimize the protocol for CXDS V1.0.

Q3 2025

• Insurer Partnership: Secure partnerships with major insurers to underwrite and strengthen CXDS offerings, ensuring additional credibility and risk management.

• Integration with Tier 2 CEXs: Collaborate with 10 Tier 2 centralized exchanges to integrate CXDS and validate its usability in diverse ecosystems.

• CXDS V1.0 Launch: Officially release CXDS V1.0 on the mainnet, enabling real-world credit default swaps for centralized exchange deposits.

Q4 2025

• Scaling Across CEXs: Expand partnerships to Tier 1 and additional Tier 2 centralized exchanges, increasing CXDS adoption and liquidity depth.

• Global Marketing Campaigns: Launch marketing initiatives targeting crypto users worldwide to drive awareness and adoption of the CXDS protocol.

• User Education and Support: To facilitate smooth onboarding, provide comprehensive user resources, including tutorials, webinars, and 24/7 support.

10. Glossary

Asynchronous A non-linear process for executing liquidity provisions or actions over time, avoiding the constraints of real-time execution.

Collateral Assets locked as security for financial obligations, such as CDS contracts, which can be claimed in the event of a default.

Cross-Chain Operations involving multiple blockchain networks, enabling liquidity and asset interactions across diverse ecosystems.

Centralized Exchange (CEX) A cryptocurrency trading platform managed by a central authority, where users can trade, deposit, and withdraw digital assets. Examples include Binance and Coinbase.

Credit Default Swap (CDS) A financial instrument that provides insurance against the default of a financial obligation or entity.

Centralized Exchange Default Swaps (CXDS) A decentralized mechanism enabling users to create CDS contracts to protect deposits held in centralized exchanges.

Decentralized Finance (DeFi) A blockchain-based financial system providing trustless and permissionless financial services through smart contracts, eliminating intermediaries.

Default A condition where an entity, such as a centralized exchange, fails to meet its financial or operational obligations.

Liquidity Pool A collection of funds locked in a smart contract to facilitate trades, staking, or financial derivatives within a decentralized platform.

Premium The upfront payment made by CDS buyers to secure protection against potential defaults.

Voting Mechanism A governance process where decisions, such as determining defaults, are made collectively by verified participants through a structured voting system.

Yield The return or earnings generated from an investment, such as the premium earned by CDS sellers.

11. References

1. Chainalysis, “The Role of Efficient Liquidation Mechanisms in DeFi Stability,” Available at: https://blog.chainalysis.com/reports/liquidation-mechanisms

2. Chainalysis, “Crypto Crime Report 2022: A Deep Dive into Cryptocurrency-Related Cybercrime,” Available at: https://blog.chainalysis.com/reports/crypto-crime-2022

3. Coindesk, “Cross-Chain Liquidity Solutions for DeFi Applications,” Available at: https://www.coindesk.com/cross-chain-liquidity

4. Ethereum Foundation, “Understanding Smart Contracts and Decentralized Finance,” Available at: https://ethereum.org/en/developers/docs/smart-contracts/

5. European Commission, “Markets in Crypto-Assets Regulation (MiCA),” Available at: https://ec.europa.eu/finance/mica

6. Financial Action Task Force (FATF), “Guidance for Virtual Asset Service Providers (VASP),” Available at: https://www.fatf-gafi.org

7. Financial Stability Board (FSB), “Addressing Financial Stability Risks from Crypto-assets,” Available at: https://www.fsb.org/crypto-assets

8. JPMorgan Chase, “A Brief History of Credit Default Swaps,” Internal Financial Analysis, 2023.

12. Version Review

Version 1.0 (Current)

• Date: January 2025

• Key Updates:

  • Comprehensive recovery rate analysis with updated assumptions and methodologies.

  • A detailed roadmap outlining the CXDS development and adoption phases is needed.

  • Refined comparison between traditional CDS and CXDS, emphasizing blockchain-driven transparency and efficiency.

  • Introduction of a structured voting mechanism and enhanced risk assessment framework for default events.

  • Inclusion of updated charts reflecting realistic recovery rates based on current assumptions.

  • Abstract refined for clarity and brevity.

Version 0.9 (Previous Version)

• Date: October 2024

• Key Features:

  • Initial conceptualization of CXDS with basic mechanisms for buying and selling CDS.

  • Limited explanation of recovery rate assumptions and their implications.

  • Early comparison of traditional CDS and CXDS without specific metrics or market dynamics.

  • Preliminary roadmap lacking phased development and adoption strategies.

  • Simplified risk evaluation model with minimal details on governance and operational processes.