How would regulations stop another FTX scandal?

The founder of the world’s largest cryptocurrency exchange, Binance CEO Changpeng Zhao, has called for more regulatory clarity after a week of crypto market chaos and a year in which investors are estimated to have lost $2 trillion (£1.7 trillion).

“We do need to increase the clarity of regulations and the sophistication of regulations in the crypto space,” Zhao said to a gathering of G20 leaders at a summit in Bali. But it is not only regulators that bear responsibility for protecting people, the industry should also look at new models that can help.

The recent collapse of FTX – which has filed for bankruptcy protection in the US, but was valued at $32 billion earlier this year – has had significant repercussions for the entire cryptocurrency industry. Even the most established digital currency, Bitcoin, hit a two-year low following the FTX woes.

Cryptocurrencies allow traders or investors to buy and sell without the need for banks and brokerages. Blockchain technology enables peer-to-peer cryptocurrency transactions to happen on exchanges such as FTX and its rival Binance without these middlemen.

Instead, transactions are authenticated through consensus by a group of validators, typically called miners. Miners solve complex mathematical puzzles to do this, otherwise known as the proof of work system used by Bitcoin and most cryptocurrencies.

But when it comes to organising these transactions, Binance and its peers use the same 'limit order book' model as any traditional exchange such the New York Stock Exchange. This means there is a centralised structure that matches buyers and sellers, with market makers supplying liquidity and charging traders for transactions.

This kind of structure has exacerbated recent events in the crypto space to some extent. FTX’s centralised model allowed it to make loans to distressed crypto firms earlier this year. It also used exchange-issued tokens (FTT) to round out its sister company’s books. This increases the risk of exposure to a market collapse.

But an emerging model, decentralised exchanges, operates under different rules for pricing cryptocurrencies and for governance that could reduce such risks. They allow investors to buy and sell tokens at an algorithmically determined price. This automated model does not rely on professional market makers, instead individual investors supply liquidity and collect a portion of fees from trades.

Like many decentralised exchanges, Uniswap, which launched in 2018, has a governance token called UNI that individual users of the exchange can use to cast votes in decisions about how the exchange operates. In principle, no centralised entity can manipulate system decisions voted through by owners of these coins.

This helps the users of the exchange to retain control over what’s happening with their funds. Estimates suggest that up to 49,000 addresses on the Ethereum blockchain hold UNI tokens and 60 per cemt of tokens are held by investors.

Another issue that plagued FTX in its final days was that it is custodial, which means it had the right to suspend withdrawals of cryptocurrency by investors. FTX’s decision to ban withdrawals by investors meant many people have been refused access to money they used to trade on the exchange.

Decentralised exchanges are non-custodial, so they allow individual investors full access to their crypto wallet balances and they can withdraw or deposit liquidity or stop trading at any time with no risk of their assets being frozen by the exchange.

One downside of decentralised exchanges versus centralised models such as FTX and Binance, however, is that they don’t allow traders to exchange fiat (traditional currencies issued by governments or countries) for crypto – they can only trade different cryptocurrencies on the exchange. The size of any trade will depend on the size of the liquidity pool, so if the latter is too small, a trader could find it difficult to make their desired transaction happen.

Which type of exchange is likely to dominate crypto trading in the future depends on several factors.

As some customers have withdrawn their crypto deposits from FTX over the past week, approximately 60 per cent of the outflows reportedly went to FTX rival Binance. In the short term, the outflows of investors from FTX to Binance will increase its market share of crypto trading. This additional liquidity on Binance will help it to continue to dominate because it will be able to offer lower transaction costs.

But when activity is concentrated in fewer exchanges, more customers are exposed to the risk of any individual crypto provider or large trader failing. And the industry is only becoming more concentrated following recent market failures. Greater concentration means greater risk of contagion.

And over time, decentralised exchanges will be able to become more competitive and lower their transaction costs too. This is in part due to the development of 'scaling solutions' – protocols (or sets of rules) that increase activity and transaction speeds without affecting decentralisation. This will also help to bring down the amount investors must pay to validate their transactions on the blockchain, making it less costly to trade.

And while traditional financial markets are heavily regulated, crypto is not, something that looks likely to change following FTX’s recent difficulties, as well as the events of this year. The importance of developing more official structures for the cryptocurrency market has become even more apparent.

Regulators have already started to investigate FTX lending products and management of customer funds after its collapse. But what else can they do?

1 Closer monitoring of crypto assets

As Binance’s CEO has recently suggested on Twitter, one way to prevent a repeat of the FTX failure would be to monitor crypto exchange assets in real time rather than relying on annual reports with (in some cases) gross inaccuracies.

This is already possible. An independent third party can provide 'proof of reserves'. This means the organisation publishes audit reports to provide an independent review of the balance sheet of an exchange, tracking the flows of money in and out of investors’ exchange wallets. This would flag up potential systemic failures due to unexpected activity, such as the use of exchange reserves to make loans to crypto firms, as described already with FTX.

2 Better crypto risk assessments

Financial regulators also need to adopt an appropriate risk assessment framework for cryptocurrencies. This should include independent audits and stress-testing of on-chain data (information about transactions on a blockchain network).

Regulations could be imposed to restrict the use of an exchange’s tokens to make loans to crypto firms. More customer protection could also prevent exchanges from suspending withdrawals, leaving traders unable to access money held by an exchange that is in trouble.

Even amid the “crypto winter”, all is not lost for crypto. Appropriate regulations and new models could help the industry to recover and strengthen, perhaps even encouraging further adoption of decentralised finance in mainstream financial markets.

This article is republished from The Conversation. Read the original article.

Ganesh Viswanath-Natraj is Assistant Professor of Finance and teaches Empirical Finance on the MSc Finance and MSc Finance & Economics courses. He also teaches Financial Markets on BSc Accounting & Finance.

Follow Ganesh Viswanath-Natraj on Twitter @ganvisnat.

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