On October 25, 2022, two weeks before the collapse of FTX, the world's third largest cryptocurrency exchange, DeFi architect Andre Cronje published an important article with a dire warning about the state of central exchanges.
"Under the current regulatory regime, collateral is ineffective. Most investors sign away their cryptocurrency rights to crypto exchanges with excellent terms, and if those exchanges were to go bust, many would be classified as (at best) unsecured creditors." Cryptocurrency Exchanges and Crypto Investments service providers essentially operate like banks, but without the security measures and regulations that banks must follow."
What happened next is history. With the sudden collapse of FTX, customers suddenly found that, despite all previous assurances, their assets were frozen after the company filed for bankruptcy due to an $8 billion shortfall; Top executives at hedge fund Alameda Research instructed the client to trade. . . Although the new management claims to have recovered some of the client's assets, the client's funds are still frozen in the bankruptcy process, with no closure and no significant legal fees.
After that, the crypto community expressed serious concern about the state of CEX. Requirements such as proof of assets and liabilities, segregation of client funds and voluntary registration as a broker-dealer have resonated with the industry. So the CEXs didn't go that far in trying to legitimize their activities? Therefore, the question is more complicated than it seems.
Why not adapt?
Jack Graves, an assistant professor at Syracuse University, told the magazine: "As far as I know, in the US it's not registered with the SEC as a cryptocurrency and digital asset exchange. Instead, they say they don't. Trade securities. And that's important.''That's the difference.'' '.
Graves explained that while exchanges like Coinbase are authorized money transmitters, they are not broker-dealers. "When you're talking about stockbrokers, that creates a lot of disclosure and retention requirements," Graves said. “I use Fiduciary as my broker, and if Fiduciary goes bankrupt, I'm not an unsecured creditor in bankruptcy. Therefore, all unsecured creditors have claims on my assets."
At least in the US, crypto exchanges cannot be broker-dealers because the digital assets they offer are not classified as securities by the SEC. However, there is a lot of confusion about this issue.
"Gary Gensler basically said everything, but Bitcoin and maybe Ether is a security," Graves said. "So exchanges think that as long as the SEC says it's a security, they're going to trade it. And when the SEC says cryptocurrencies are securities, they're going to stay out."
The problem is not just the United States. Lennix Lai, CEO of Seychellois cryptocurrency OKX, explained to the magazine that crypto exchanges cannot register as broker-dealers due to a fundamental change in their business models;
"By definition, a cryptocurrency exchange is basically an engine that matches the requests of buyers and sellers. A broker-dealer license only regulates relationships where you, as a company, can handle customer requests and route them to the exchange. However, business transactions that occur in the crypto world most models are not a broker-dealer model, but an 'exchange' model. So it puts the government at a regulatory disadvantage because we don't have an exchange license to fall back on."
Canada is one of the few jurisdictions that offers a clear regulatory path for exchanges to become registered broker-dealers, likely due to the sudden collapse of Canadian cryptocurrency leader QuadrigaCX in 2019.
In Canada, all potential cryptocurrencies must be registered with the Investment Industry Regulatory Authority of Canada and the relevant provincial regulatory authorities in order to do business. On June 22, 2022, the Ontario Securities Commission announced enforcement action against ByBit and KuCoin, alleging that they were operating two unregistered cryptocurrency trading platforms in the country.
Once registered, Canadian cryptocurrency exchanges become broker-dealers just like their stock-traded counterparts, although regulators have ruled that exchange-traded assets are not securities. Coinsquare's Canadian exchange general counsel, Katrina Prokopi, explained to the magazine.
"Coinsquare is the first cryptocurrency trading platform to move forward with registration as an investment dealer and IROC [Investment Industry Regulatory Authority of Canada] member. It took two years of intensive work with regulators. Investors can rest easy knowing that IROC dealers have sufficient regulatory capital and operational -controls, financial controls, compliance, performance requirements, risk management, insurance requirements and surveillance requirements are in place when using IROC counterparties. amount. It is highly unlikely that the same situation as FTX would occur without capital fraud, open fraud, regulated by IIROC without a platform
In addition, offshore CEXs may choose administrative jurisdictions far from where users live, making dispute resolution difficult. For example, under Binance's terms of service, the Hong Kong International Arbitration Center is authorized to resolve disputes between the exchange and its customers. Although Binance previously agreed to hear disputes in the aforementioned courts, users complain that the process is quite expensive. Meanwhile, Prokopi explained that Coinsquare's operational jurisdiction is in Ontario, Canada. Thus, users do not need to travel abroad or hire foreign international law lawyers to resolve their disputes with exchanges;
"Customers have access to our regulators, they have access to our legal and compliance departments to help resolve issues, and they have access to the Canadian justice system as a last resort. You know we have a registered address for service as a registered corporation in Ontario.
Are user funds protected by law?
Graves summarizes the rules by which offshore cryptocurrency exchanges operate: But if we fail, you're a general unsecured creditor."
According to Graves, US lenders typically charge 10 cents on the dollar. "I think we're dealing with a very reasonable option without breaking the contract," Graves said. "And when you're bankrupt, it's not worth breaking the contract."
"Let's say everyone is doing their best, they're trying to make money and it's not working, and the exchange fails, you're still not protected as a customer."
For example, Coinbase's terms of use state that the company has liability insurance that protects digital assets from theft and cyber security breaches. However, the policy does not cover "unauthorized access" to a Coinbase account due to compromised credentials. In addition, US customer deposits up to $250,000 are covered by the Federal Deposit Insurance Corporation, but if the bank deposit defaults, the same protection does not extend to their digital assets.
Another exchange, OKX, clearly states in its terms of service: "Users' digital assets are not protected by deposit protection or deposit insurance schemes. In the event of an irrecoverable shortfall, you may lose all or any of the assets or funds you have contributed will also receive. ".
OKX lies that this is because the insurance industry is not fully equipped to insure risks in the cryptocurrency industry;
"At the moment, most insurance policies only cover a fairly limited amount because they want to meet their risk appetite and also cover a specific area of risk, such as domestic work."
Coinsquare's Prokopy confirms limits on insurance policies covering crypto companies Coinsquare customers currently have insurance policies covering $1 million of their fiat Canadian dollar deposits, but Prokopy said the coverage does not extend to digital assets . He explained that the company agrees to expand coverage because they currently pay the same rate as other IROC members for asset insurance;
"In the crypto space, there is the Canadian Investor Protection Fund, which is an insurance cover for the assets of clients of IROC member companies. A cash component is available in the trading account. However, the CIPF does not currently cover cryptocurrency. So IROC if a merchant goes bankrupt, there will be insurance protection for the monetary component, not the crypto component."
Is proof of booking valid?
According to Lain, the only way to ensure customer funds are safe is to double check.
"The evidence of reserves we have identified includes evidence of liability," Lai said.
The executive explained that by allowing users to independently verify the exchange's disclosures using open source methods, OKX shows its clients that asset-liability hedging is "many times over." Exchange updates the backup test monthly.
Other stakeholders, such as former Kraken CEO Jesse Powell, disagree. For Powell, Merkel's tree-verification security proof is "hand-waving nonsense" and cannot be fully used as a substitute for traditional accounting. "Reporting assets without liabilities makes no sense," he tweeted in November 2022.
Graves also noted the difficulty of finding auditors to do the work in the first place. "Now the problem, as I understand it, is that the auditors don't know how to audit," he said.
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"They don't know how to manage it. You can keep track of how many assets a cryptocurrency exchange has, but how many of them are pawns. It's hard to understand that you don't have access to your services, books and financial data. [...] We saw that with FTX. Yes, FTX- has some money, but it's all been moved to Alameda, and Alameda invests in leveraged exchanges. And so you can check that by looking at the chain's assets, but it doesn't tell you anything in terms of liabilities and leverage."
Currently, Coinbase is one of the few cryptocurrency exchanges with a Deloitte auditor, although much of this can be attributed to the fact that it is a public company. South African auditor Mazars previously said Binance users were "fully parallel" on the Bitcoin platform, but then removed proof-of-reserve verification from its site, along with other cryptocurrencies, about a week later. Binance says it has contacted several large auditing firms, but "they are not currently willing to do a PoR for a private cryptocurrency company."
Can we still trust CEX?
Even if cryptocurrency users agree on the need for CEX regulation following the collapse of FTX, this may not be possible due to the lack of a regulatory pathway at this time. Coinsquare's Prokopy certainly expresses confidence in CEX, while the way forward is clear. However, both Lai and Graves raised the issue of the chaotic regulatory framework in the US and other parts of the world, which makes obtaining a broker-dealer license impossible.
That said, regulators are stepping up their efforts in this new area. In a White House briefing on January 27, lawmakers said they are working on "security" to complement the development of new digital asset technologies and prioritize blockchain research. Right now, CEXs face an uphill battle to demonstrate legitimacy to users. But, Graves said, some key corporate guarantees remain, minus contractual obligations to customers.
“I don't think the current structure is a problem for offshore exchanges. If exchanges like Binance.US and Binance International don't keep themselves independent, US regulators will go after Binance International and say we have jurisdiction because you're dealing through a US entity. if they raise funds, local lenders can also follow Binance International to pay off those debts.”