After FTX collapse, cryptocurrency regulators should look to technology to protect users’ funds

Hong Kong is legalising retail cryptocurrency trading just as the FTX scandal has shaken investor confidence, underscoring the need for industry regulation
Among the measures needed is the separation of funds and transactions, and this is where technology can help create transparency and rebuild trust

Changhao Jiang

Published: 2:30pm, 19 Jan, 2023

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Hong Kong recently pivoted to a more crypto-friendly regulatory regime, going as far as to legalise retail trading in cryptocurrencies. The move has rekindled market enthusiasm for the crypto trade.

But with the industry still reeling from the collapse of FTX, the challenge of how to enforce a robust regulatory framework on cryptocurrency exchanges is one that must be immediately addressed.

Clearly, strengthening licensing requirements for exchanges, as well as imposing rules and regulations, is imperative. Yet in addition, owing to the unique characteristics of blockchain and digital assets, technology can play an important role in regulating these trading platforms.

FTX’s dramatic demise has been referred to as crypto’s “Lehman Brothers” moment. Indeed, the meltdown of FTX, once the poster child of cryptocurrency, has far-reaching consequences. Most importantly, confidence in centralised exchanges has been severely shaken and may take years to rebuild.

Data from on-chain analysis firm, CryptoQuant, showed that investors took over US$8 billion out of centralised exchanges in the seven days post-FTX.

Even so, with centralised exchanges still facilitating some 99 per cent of all cryptocurrency transactions, the dominance they hold is unlikely to be loosened any time soon.

As the crypto world struggles in the aftermath of the FTX fiasco, discussions on how the industry can move forward centre around three possibilities.

One, the top-down implementation of a licensing regime and enforcement of rules and regulations by a regulatory authority. Many have advocated for crypto exchanges to be regulated to a similar standard as other traditional exchanges.

Calls for regulation appear justified and also consistent with the current policies of Hong Kong’s regulators. However, establishing a rigorous yet practical framework will take time, as regulators seek to understand a new industry.

Two, a shift to the use of decentralised exchanges (DEXs). DEXs offer strong advantages in mitigating the moral hazards seen in centralised exchanges. However, DEXs are still in their infancy and come with various drawbacks including low efficiency and poor user experience.

The FTX Cryptocurrency Derivatives Exchange website. Exchanges allow people to buy and sell cryptocurrencies, but their funds are also typically stored on the platform, putting them at risk of being misused. Photo: Bloomberg

DEX trading volumes have seen an uptick post-FTX but that by no means signals the start of a structural shift away from their centralised counterparts. While we are optimistic that DEXs will take a bigger share in the long-term, centralised exchanges are likely to maintain their stronghold for the foreseeable future given their ease of use and deep liquidity.

Three, the separation of transactions and funds. The more realistic and feasible way forward is to redefine the roles of different actors within the trading ecosystem and enforce the separation of transactions and funds through technological innovations.

The biggest problem exposed by FTX’s collapse is that clients’ funds were stored on the exchange, and with minimal supervision, funds could be misappropriated by the exchange at will.

The separation of trading, clearing and settlement functions is a long-standing model in traditional finance. This model eliminates or minimises conflicts of interest, which helps to build trust among market participants and contributes to the overall integrity of the financial system.

In cryptocurrency, however, these functions are combined under one roof by centralised exchanges from the beginning. Many market participants have come to realise the associated risks and are demanding independent middlemen, specifically off-exchange custodians and prime brokers.

While there have long been calls for this, few, if any, middlemen have been successful in chipping away at the exchanges’ power. This is about to change. With increased pressure, there is now greater willingness among exchanges to accept this new paradigm.

The separation of transactions from funds can technically be self-enforced by centralised exchanges themselves. Exchanges can allow clients to keep their funds in segregated wallets while trading on the platform. However, since the custody function ultimately exists under the same corporate group as the exchange, the risk of misconduct is not fundamentally eliminated.

The better way is for a neutral third-party to custody clients’ funds and facilitate trading, which mitigates counterparty risks for both parties. This role can be undertaken by a traditional financial institution or a crypto custody provider to ensure true separation of duties that should not have been commingled in the first place.

Now is an opportune time for regulators to step in and encourage, or even enforce, the separation of transactions from funds through technology. In fact, technological innovations in the space began as early as 2019 with custodians such as Cobo’s off-exchange custodian and settlement network SuperLoop (previously Loop), which allows asset managers to trade while maintaining their funds in independent custody.

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For example, asset managers can make use of multi-party computation custody solutions to co-manage their funds with an independent custody platform, and trade these funds on cryptocurrency exchanges that are integrated with settlement networks hosted by that custody platform.

First, asset managers deposit funds with the custody platform. Next, the custody platform locks the funds (just before the trade) and mirrors the funds 1:1 on the exchange. Asset managers can then proceed to trade as per usual and settle via the custody platform once done.

While the FTX debacle has raised serious concerns about security in cryptocurrency trading, it also offers a valuable learning opportunity for all stakeholders. To ensure the healthy development of the crypto ecosystem, it is important for regulators and other market players to use this chance to establish appropriate supervision and embrace technological innovation to create transparency and rebuild trust.

Dr Changhao Jiang is the co-founder and chief technology officer of Cobo, a leading global crypto custodian service provider and blockchain infrastructure developer

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