Introduction

The integration of the “Nesting” concept from traditional finance (TradFi) into decentralized finance (DeFi) was driven by several factors like improved accessibility, rapid deployment, cost efficiency, and the ability to bypass certain regulatory hurdles. Nested exchanges are a DeFi adaptation of nesting, a process where smaller crypto platforms leverage a large, regulated cryptocurrency exchange’s Application Programming Interface (API) to render crypto services to their users.

This model has facilitated the swift creation of platforms offering crypto services to users. However, Nesting has raised concerns among stakeholders because of its dependence on larger exchanges and potential vulnerabilities.

What is Nesting?

Source: Corporate Code

Originally a TradFi term, Nesting is the process where a financial institution (a nested account holder) uses another’s services (a nested account) to provide solutions to its customers, often in a multi-tiered or indirect way. The nested account holder plays an intermediary role in fulfilling the financial obligations of their clients using the services of an established parent institution, the nested account.

Nesting became popular as a solution to the constraints associated with traditional transaction processing, providing users with a simplified and less regulated way to trade. These limitations also include long-distance transfers and sophisticated trading processes.

In practice, Nesting takes various forms such as correspondent banking, cross-border payment solutions, sub-brokering, and Nested exchanges.

What are Nested Exchanges?

Source: Elliptic

A Nested exchange is a cryptocurrency trading platform that utilizes the protocol of a bigger exchange to provide cryptocurrency trading services to its customers. On the front end, users transact with the Nested exchange’s user interface, but on the back end, their transactions are processed by a third-party exchange.

Also, in the front end, Nested exchanges provide a unique Ul/UX where users see their branding and experience specialized services such as localized language support, regional payment options, unique trading tools, and educational resources, to target a specific demographic. On the backend, the exchange is powered by the services and security of the parent exchange’s API, which helps provide liquidity, security, regulatory compliance, order matching, and execution.

In simpler terms, Nested exchanges borrow the infrastructure, order book, and liquidity of their parent exchange—often a centralized exchange (CEX)—while presenting a separate UI to their users. Nested exchanges generate revenue by charging trading fees, markup on spread, and subscription services.

How Nested Exchange Transactions Work

Source: Self

The simple front end of a Nested exchange is powered by a complex backend operation. Here is a step-by-step breakdown of how user transactions are processed:

User Interaction

A user interacts with the Nested exchange’s interface—web app or mobile app. This helps users to buy or sell a trading pair, make withdrawals and deposits, and bridge digital assets.

Order Transmission

The transactions are initiated and processed in the backend via the API integrated on the Nested exchange.

Transaction Execution

The parent exchange executes the trades or transactions using their own order book and liquidity.

Transaction Status

The progress of the trades is then relayed back to the Nested exchange, and necessary updates are made to the user’s assets balance and transaction history.

How to Spot Nested Exchanges

With several cryptocurrency exchanges available in the ecosystem, it is important to know the key factors to consider when choosing one for trading and keeping digital assets. Identifying these signs can help avoid potential risks.

Lack of Stringent Regulatory Transparency

Nested exchanges are neither verified by reputable regulatory compliance and licensing platforms nor conduct thorough “Know Your Customer” (KYC) and “Anti-Money Laundering” (AML) procedures while onboarding their users.

Unclear Operational Practices

Nested exchanges have murky operational procedures, making it difficult to understand the flow of transactions—how trades are executed and funds handled. Also, they have a ridiculously large amount of trading pairs with very low trading volume suggesting that these data are collected from another exchange.

Insufficient Company Information

Nested exchanges do not provide explicit information about their location, leadership, and operational history. In addition, their lack of publicly accessible API documentation raises concerns that these platforms may not be running as fully independent exchanges.

Why You Should Avoid Nested Exchanges?

Interacting with Nested exchanges comes with significant risks, making them an unreliable option for storing and trading digital assets. Their weak infrastructure has made them a prime target for malicious actors seeking to perpetrate financial scams within the cryptocurrency ecosystem.

Amplified Financial Crimes

The structure of Nested exchanges makes it harder to track the records of funds since they don’t have KYC/AML features or keep records of individual transactions on the blockchain. Malicious actors can use this medium to carry out crimes such as money laundering and fraud.

Source: DeFi Planet

In 2021, Suex cryptocurrency exchange, a Czech company, faced sanctions from the U.S. Office of Foreign Assets Control (OFAC). Suex’s OTC utilized the Nested crypto exchange service provided by a major CEX to facilitate its customers’ transactions. Suex also had extremely lenient KYC procedures, allowing its users to use physical cash transactions to purchase cryptocurrency.

The sanction on Suex happened when Chainalysis, a blockchain forensic company, reported its involvement in laundering funds from hacks and ransomware attacks. Upon this discovery, the parent company deactivated all known accounts associated with Suex and OFAC blacklisted over 30 wallets holding BTC, ETH, and USDT. This left everyone involved with Suex exposed to legal and financial risks.

Malicious Nested Exchanges

Nested exchange operators are difficult to trace due to a lack of transparency around their administrative structures. Since they take full custody of users’ funds, they can manipulate data to generate illegal gains without being held accountable. In extreme cases, they can decide to shut down operations and destroy their users’ data and funds without compensating them.

API Vulnerability and Exploitation

Nested exchange relies on the API of another exchange and upon compromise or vulnerability, cyber attackers can steal sensitive data and manipulate trading data.

Differences Between Nested and Decentralized Exchanges

Source: Self

Nested and decentralized exchanges are used to help users process cryptocurrency transactions on their established platforms. However, a few attributes are used to distinguish between them.

Infrastructural Dependency

Since Nested exchanges act like transaction agents, they are built on the protocol of an established cryptocurrency exchange. With DEX, users interact directly with the blockchain through smart contracts without the need for intermediaries.

Fund Custody

To help users process their transactions, Nested exchanges take total control of users’ funds. However, DEX users are totally in charge of their assets, and their transactions are executed directly from their wallets.

Transaction Transparency

Users do not know the movement of their funds on Nested exchanges, as no on-chain records are typically kept. On the other hand, transactions on DEXs are recorded on the blockchain, making them transparent and auditable.

Conclusion

Although Nested exchanges promise a localized user experience and ease of use, their structure introduces risks such as a lack of transparency, weak regulatory oversight, and the potential manipulation of users’ digital assets.

The risks associated with transacting on Nested exchanges outweigh the benefits; thus, users are expected to do their due diligence before choosing these platforms to transact their cryptocurrencies.

To safeguard transactions and digital assets in Web3, traders and cryptocurrency adopters are encouraged to use highly established and regulated cryptocurrency exchanges that offer thorough KYC/AML measures, such as Gate.io.