The term ‘crypto’ is so pervasive in the world of fintech that it is hard to believe that the industry in its current form is just over a decade old.
A concept appealingly simple – digital currency relying on decentralising transaction records – is in practice highly complicated; new ‘coins’ can appear at the drop of a hat, as can trading mechanisms and exchanges, which, while professing roots in the principles of traditional, regulated asset classes and markets, bear little if any resemblance.
The fast-moving, international, retail-driven and decentralised nature of crypto has meant that traditional methods of oversight have struggled to keep pace, and to deliver investors the protections they have become accustomed to through centuries of regulation in traditional assets.
This is not a new issue, and ironically, Sam Bankman-Fried, founder of FTX, was vocal on this issue prior to the firm’s demise last week – the latest in a long line of crypto exchange failures from Mt.Gox to QuadrigaCX.
Crypto currently has a very immature framework, meaning loopholes in business practices and regulation exist in droves.The full extent of what occurred with FTX is still being determined, and no doubt there will be a lengthy legal process over culpability. But at a basic level, governance and oversight is a factor, along with a problematic relationship between the founder’s exchange and trading firm.
The dramatic collapse of FTX has been headline fodder for evangelists and haters alike, but it is important to note that this is not the beginning of the end of the crypto industry itself. As failures occur, an industry learns and corrects.
But with the scale of capital on the line, mistakes are costly, progress is imperative and collaboration encouraged.
Learning from the past
A lot of these lessons have been learnt before; regulation and management oversight in the financial services industry exists in large part because bad actors in the past have taken actions that ultimately resulted in consumer/investor detriment.
I am reminded of the December 2017 statement on cryptocurrencies made by Jay Clayton, then-chair of the Securities and Exchange Commission, in which he put forward a list of simple questions that crypto investors should ask themselves before putting money at risk. The first: 'Who exactly am I contracting with?'
The traditional, regulated investment asset classes may not need to ask these simplest of questions at the beginning of every transaction any more, but that’s due to inherent trust in the system that is built and rebuilt over decades and centuries of regulation, failures, oversight mitigation and repeat.
Now is not the time for anyone to be prophesying the death of crypto.Regulated industries are in no way immune to failure, but what is known in the tech industry as the 'mean time between failures' becomes longer every time more loopholes to abuse the system are closed.
Crypto currently has a very immature framework, meaning loopholes in business practices and regulation exist in droves, but in the distant past the same could be said of equities.
Modern, regulated exchanges and trading venues need significant oversight, distributed management power structures, market supervision that monitors continuously for abusive trading patterns and significant financial reserves to allow for buffers in the event of unforeseen risks occurring that may lead to consumer detriment.
Traditional capital markets have had centuries to grow up and ensure that we have the proper controls, procedures, technological solutions and knowledge in place to maximise investor protection.
Now is not the time for anyone to be prophesying the death of crypto, but one for us all to engage and to work on bridging the gap.
There are lessons that the crypto industry can learn from a regulated stock exchange – and certainly areas in which legacy players could reciprocate.
The basic idea that exchanges should be able to 'do things' with client funds is erroneous.For example, one suggestion that has arisen directly from this situation is that crypto exchanges should develop proof of reserve capabilities; interesting but ultimately attempting to ensure that exchanges are not doing what they fundamentally should not.
The basic idea that exchanges should be able to 'do things' with client funds is erroneous; exchanges should do nothing with client funds other than move them for settlement of transactions undertaken by the client.
Proprietary trading, lending, anything that means that something akin to fractional reserve banking is undertaken by an exchange to make client money 'more efficient' should simply not be tolerated in the industry.
Major global regulators are getting to grips with crypto and serious institutions are putting high calibre people and large sums of money into the industry to create the future of properly managed exchanges with significant management and regulatory oversight to prevent fiascos like FTX from happening again.
Adrian Ip is managing director of Aquis Exchange
