Dark Pools for Institutional Crypto Users: Challenges and Innovations

Dark Pools for Institutional Crypto Users: Challenges and Innovations

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Privacy is critical for institutional crypto traders. Trades on public blockchains expose institutions to risks, including strategy theft, front-running, and MEV bots. Dark pools offer institutions a promising way to execute large trades privately. However, their adoption has been slow. One major issue is the association between Privacy Enhancing Technology (PET) and illegal activities like money laundering and terrorist financing, as seen with Tornado Cash. Other problems include concerns about compliance with regulations, inefficiencies in handling large transactions, poor integration with existing financial systems, limited scalability, and the risk of censorship.

This blog will discuss the reasons behind the slow adoption of dark pools by institutional users such as asset managers, market makers, and broker-dealers, their benefits, and how Panther Protocol will help resolve these issues. Panther is building modular, compliance-supportive DeFi access infrastructure for regulated financial market operators. The protocol will include customizable private trading Zones, strong compliance support, direct access to major decentralized exchanges, and privacy-preserving transaction methods to improve digital asset management security, efficiency, and regulatory compliance.

*For brevity, organizations with users such as asset managers, market makers, and broker-dealers are all referred to as institutions throughout this blog. 

Reasons behind the slow adoption of dark pools by institutions

Lack of regulatory compliance

Inadvertently facilitating illegal activities can result in severe penalties, loss of reputation, and operational disruptions for institutions. AML and KYC regulations are of utmost importance, ensuring that bad actors, such as sanctioned individuals and entities are off their platforms.  

Many dark pools in DeFi, such as Tornado Cash, do not align with regulatory standards. This non-compliance poses significant risks, as seen with Tornado Cash being sanctioned by the U.S. Office of Foreign Assets Control (OFAC) and other regulators around the world due to its use by malicious actors like the Lazarus Group. This has led to many institutions being cautious about using dark pools due to potential legal repercussions and the risk of funds being associated with illicit activities.

Need for liquidity and handling of large transactions

Institutions need solutions that ensure privacy without compromising transaction efficiency. Large trades can see significant slippage or delay if a Dark Pool faces liquidity issues. Any perceived transaction inefficiency naturally leads to challenges with adoption. 

Poor integration with existing financial systems

Institutions prefer solutions that easily integrate with their existing systems, allowing for seamless interoperability and efficient workflows. Poor integration capabilities hinder adoption and can lead to operational bottlenecks. Currently, most of the dark pools available in the market lack integration with existing financial systems and tools. This creates a barrier for institutions that need to incorporate these solutions into their broader financial operations.

Vulnerability to censorship 

For institutions, the risk of transaction censorship is unacceptable. Robust mechanisms are needed by these types of investors to ensure their transactions are processed fairly and securely without being subject to censorship.  A number of high-profile regulators, including the U.S. Treasury, have proposed rules that identify virtual currency mixing as a class of transactions of primary money laundering concern. Tornado Cash is a prime example of how transactions can be excluded by OFAC-compliant block builders. 

Why institutions should care about dark pools

Privacy and confidentiality

One reason why the adoption of Web3 dark pools is slow is as a result of misconceptions related to the use of CEXs. While CEXs can provide partial privacy by breaking transaction links, CEXs also custody their user’s assets, introducing exposure to risks ranging from fraud to security issues. Crypto exchanges have a history of high-profile custody issues, such as FTX, whose litany of deceptive practices, including the lending its customers’ assets to Alameda research led to one of the worst crises in crypto’s history. Other high profile examples include Mt. Gox, which lost approximately 850,000 BTC to hacking incidents; Bitfinex’s infamous security breach resulting the theft of 120,000 BTC and QuidrigaCX, where the sudden death of the CEO, who was the sole person with access to the exchange’s private keys, led to the loss of $190M in customer funds, among others.

Many institutional users find the risks associated with centralized custody unacceptable, particularly given CEXs only offer partial privacy. Dark pools provide essential confidentiality for institutions. In both traditional finance and decentralized finance (DeFi), large trades can significantly impact market prices and reveal trading strategies if executed publicly. Dark pools prevent market manipulation and front-running by hiding the details of your trades. This protection is essential for institutional investors to execute large transactions without other market participants exploiting this information. The ability to trade anonymously ensures that institutions can protect their trading strategies and investment returns from manipulative practices.

MEV Protection

MEV bots exploit the transparency and structure of blockchain transactions to extract additional value, often at the expense of other users. Their activities can lead to higher transaction costs, market manipulation, network congestion, and financial losses for other users of the platform. Dark pools such as Panther are using multiple approaches that can significantly reduce MEV risks. While no solution is entirely foolproof, the following strategies, currently under consideration for Panther Protocol’s designs will help create a more secure trading environment:

  • Approach 1: Offchain Order Book with P2P Library

Using this design choice, users communicate and negotiate trade details offchain using a peer-to-peer (P2P) library. For example, User A submits an offer, and User B handles the matching. They generate cryptographic proofs of the transaction offchain, and only one user submits a single transaction onchain for settlement via a smart contract. This approach minimizes onchain data exposure, reducing the information available to MEV bots and thereby lowering the chances of exploitation.

  • Approach 2: Onchain Order Book with Onchain Interaction

This design choice involves maintaining the order book and interactions entirely onchain. Users generate proofs and submit transactions onchain with a smart contract performing the settlement. Although this approach benefits from transparency and simpler implementation, it exposes trade details on the blockchain, making it more susceptible to MEV exploits.

  • Approach 3: Hybrid Model

A hybrid approach combines the strengths of both offchain and onchain methods. Sensitive data like user identities and trade amounts are exchanged offchain, while only cryptographic proofs are submitted onchain. This limits the onchain exposure to essential verification elements, enhancing privacy and reducing the likelihood of MEV attacks.

Dark pools inherently offer resistance to MEV bots because they typically involve peer-to-peer transactions and minimize onchain exposure, making it difficult for MEV bots to gather the information they need to exploit trades. In summary, by leveraging offchain communication, cryptographic proofs, and strategic onchain interactions, dark pools provide a robust framework for reducing MEV risks and enhancing transaction privacy.

Market efficiency and liquidity management

TradFi dark pools face significant reputational issues due to their history of exploiting information advantages to the detriment of their clients. Unlike traditional dark pools, on-chain dark pools such as Panther are working to contribute to market efficiency by allowing large trades to be executed without causing significant price movements. This stability benefits institutions that need to manage liquidity effectively without impacting market conditions. By enabling large, discrete trades, dark pools help institutions maintain optimal portfolio balances and manage risk efficiently. Efficient liquidity management is critical for institutions, and dark pools provide a platform where large orders can be matched without slippage or adverse market impacts. Mechanisms such as peer-to-peer order matching and liquidity aggregation from various sources ensure that institutions can access necessary liquidity while maintaining trade secrecy. This capability is vital for managing large transactions seamlessly.

Enhanced security and trust

Security is paramount for institutional investors, and dark pools offer a secure environment for executing trades. Privacy-enhancing technologies like zero-knowledge proofs ensure that trade data remains confidential and secure from external threats. Robust security protocols in dark pools build trust among institutional investors. Features like remote attestation and secure multi-party computation enhance the security of dark pool transactions, ensuring that the system remains trustworthy and reliable for institutional use. This trust is essential for institutions to engage in large-scale trading activities confidently.

How Panther will enable private, compliant DeFi access for institutions

Panther Protocol is set to enhance privacy, security, and efficiency in digital asset management. Panther is building compliance-enabling DeFi access infrastructure, complete with dark pool functionality for regulated financial entities. Panther Zones will enable institutions to create private trading Zones with customized asset lists, user lists, transaction limits, and access to DeFi applications. This modular approach will allow institutions to tailor their trading environments according to specific regulatory and operational needs. 

Want to learn more about Panther Zones? Reach out to us at contact@pantherprotocol.io

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