Changpeng Zhao, CEO of Binance, founder of the world's largest cryptocurrency exchange, called for regulatory clarity after a week of turmoil in the cryptocurrency market and a year in which investors reportedly lost $2 trillion (£1.7 trillion).
"We need to increase regulatory clarity and regulatory complexity in cryptocurrencies," Zhao said at a meeting of G20 leaders at the Bali Summit. But not only do regulators have a responsibility to protect society, the industry also needs to consider new models that can help.
The recent bankruptcy of FTX, which filed for bankruptcy protection in the US but was valued at $32 billion earlier this year, had a significant impact on the entire video industry. Even Bitcoin, the most established digital currency, has hit a two-year low since the FTX issue.
Cryptocurrencies allow traders or investors to buy and sell without the need for banks and intermediaries. Blockchain technology enables peer-to-peer cryptocurrency transactions without these intermediaries on exchanges such as FTX and its competitor Binance.
Instead, transactions are validated by consensus by a group of validators, collectively called miners. To do this, miners solve complex mathematical puzzles, otherwise known as the proof of work system used by Bitcoin and most cryptocurrencies.
But when making these trades, Binance and its partners use the same "limited order book" model as traditional exchanges like the New York Stock Exchange. Meaning there is a centralized structure connecting buyers and sellers, market makers provide liquidity and charge traders for transactions.
This type of structure has been exacerbated somewhat by recent events in the crypto space. FTX's decentralized model allowed it to provide loans to struggling crypto companies earlier this year. It also uses Exchange Issued Tokens (FTT) to fill the books of its subsidiaries. This increases the risk of a market crash.
But an emerging model — a decentralized exchange — operates under different cryptocurrency prices and governance rules that can mitigate this risk. They allow investors to buy and sell tokens at an algorithmically determined price. This automated model does not rely on professional market makers, but individual investors provide liquidity and receive a portion of transaction fees.
Different cryptocurrency trading models
Like many decentralized exchanges, Uniswap, launched in 2018, has a governance token called UNI, which can be used by individual users of the exchange to make decisions about exchange operations. In principle, no centralized organization can manipulate the decisions of the system where the owners of these coins vote.
This helps exchange users manage what happens to their funds. Estimates suggest that there are up to 49,000 UNI token addresses on the Ethereum blockchain, with 60% of the tokens owned by investors.
Another issue that plagued FTX in its last days was that FTX was a custodian, meaning it had the right to stop investors withdrawing cryptocurrency. FTX's ban on investor withdrawal means that many people have been denied access to the money they used to trade the stock market.
Decentralized exchanges are not custodians, so they give individual investors full access to their crypto wallet balance and can redeem or cash out or stop trading at any time without the risk of the exchange freezing their assets. .
One of the drawbacks of decentralized exchanges compared to the centralized FTX and Binance models is that they do not allow traders to buy cryptocurrency for fiat (traditional government or state-issued currency); they cannot exchange with different cryptocurrencies. The size of each trade will depend on the size of the liquidity pool, so if the pool is too small, traders may struggle to execute the desired trades.
The type of exchange that is likely to dominate cryptocurrency trading in the future depends on several factors.
About 60% of withdrawals go to Binance rival FTX, as several customers withdrew their cryptocurrency deposits from FTX over the past week. In the near future, the flow of investors from FTX to Binance will increase the trading share of cryptocurrencies. For Binance, this additional liquidity will help it continue to dominate as it can offer lower transaction fees.
But as businesses focus on fewer exchanges, more customers are exposed to the risk of default by cryptocurrency providers or wholesalers. And the industry has only gotten more attention after the recent market failure. Higher concentration means higher risk of infection.
And over time, decentralized exchanges can become more competitive and lower transaction fees as well. This is partly due to the development of "scalable solutions" - protocols (or rule sets) - which increase the speed of operations and transactions without affecting decentralization. This will also help reduce what investors have to pay to confirm their transactions on the blockchain, which will reduce transactions.
New rules
While traditional financial markets are heavily regulated, cryptocurrencies are not, which is about to change after the recent FTX fight and this year's event. The importance of creating a more formalized structure for the cryptocurrency market is becoming increasingly apparent.
Regulators have started investigating FTX's loan products and handling of customer funds since its collapse. But what else can they do?
1. Closer monitoring of crypto assets
As the CEO of Binance recently suggested on Twitter (above), one way to prevent FTX debacle from repeating (in some cases) is to monitor crypto exchange assets in real-time rather than relying on annual reports with errors.
This is now possible. An independent third party can provide "evidence of requirements". This means that organizations issue audit reports to provide independent reviews of stock exchange balance sheets and to monitor the flow of money into and out of investors' stock market portfolios. This can indicate possible system failure due to unforeseen activity, such as the use of foreign exchange reserves to lend to crypto companies, as previously described with FTX.
2. Better cryptocurrency risk rating
Financial regulators must also adopt an appropriate framework for assessing cryptocurrency risks. This should include independent audits and stress testing of chain data (transaction data on the blockchain network).
Rules can be set to limit the use of exchange tokens for lending to cryptocurrencies. Enhanced customer protection can also prevent exchanges from suspending withdrawals, preventing traders from accessing funds held by ailing exchanges.
All is not lost for cryptocurrencies, even in the midst of a “crypto winter”. Appropriate regulations and new models can help restore and strengthen the sector and even promote the adoption of decentralized finance in traditional financial markets.