Cryptocurrency exchanges such as FTX have gained some legitimacy in recent years by marketing themselves as exchanges, creating an association with stable and reliable financial institutions like the New York Stock Exchange and NASDAQ.
But the FTX implosion shows how different cryptocurrency exchanges are from their more well-known and highly regulated counterparts. They have to abide by strict rules about what they can and cannot do. Cryptocurrency exchanges face few such hurdles, especially if they are located outside of the United States – and most of them do. They don’t have to disclose how clients’ money is handled, either to investors or to a regulator. Internal financial controls may be insufficient.
The lack of oversight contributed to what prosecutors said was widespread fraud that spanned years at FTX, once the crypto world’s second-largest exchange. Founded by Sam Bankman-Fried in 2019, FTX used client funds to fund political donations, buy real estate and invest in other companies, US authorities said this week. FTX filed for bankruptcy in November after failing to meet around $8 billion in customer withdrawal requests.
In contrast, LedgerX, a crypto derivatives exchange owned by FTX, was established in the United States and was more strictly regulated. She is still active.
FTX did not respond to our requests for comment.
“We need proof”
“Where is the industry exposed? It is still exposed on exchanges,” said Nicola White, CEO of cryptocurrency trading firm B2C2. Mme White said B2C2 had limited the assets it held on FTX, but still had a small amount trapped on the defunct platform.
“We need proof of where the exchanges are holding our money and how,” she said. It’s really important. »
The traditional financial industry has become highly regulated after decades of scandals, frauds and other costly failings that have led to huge losses for customers and greater market contagion.
The 2008 financial crisis alone gave rise to a host of new rules aimed at protecting investors’ assets and limiting risk-taking by banks and other businesses.
The cryptocurrency industry has grown outside of the traditional financial system. He built his market structure from scratch, creating new rules intended to make business more efficient by combining a large number of tasks that are usually separated on more regulated exchanges – such as trading, safekeeping of customers and the settlement of transactions.
Clients trading on the Bahamas-based FTX Main Exchange had to send cash or cryptocurrency to the platform before they could trade. Cryptocurrency deposits were sent from the client’s personal wallet to their FTX account. If a customer sent funds in cash, the money was converted into “e-money,” according to FTX’s terms of service, which was then used to purchase cryptocurrencies.
FTX’s terms of service did not specify how or where client assets would be stored. Instead, there was a brief passage saying that legal title to any digital assets passed to FTX remained with the client.
“None of the digital assets in your account are owned by, or should or may be lent to FTX Trading; FTX Trading does not represent or treat digital assets in user accounts as belonging to FTX Trading,” the terms of service stated. There was no similar statement for cash assets.
Unlikely on a real exchange
FTX’s alleged use of client assets to fund its business would be highly unlikely on US exchanges, which do not touch client money. Instead, stock market investors send their money to a broker who is a member of the stock exchange and can act on behalf of its clients. Large institutional investors typically hold their money with a custodian bank such as State Street or BNY Mellon, and send trade details to the exchange through their brokers. Custodian banks are responsible for protecting investors’ assets and are subject to strict rules as to what they can do with them.
The Exchange simply serves as a meeting place between buyers and sellers and collects transaction fees and other fees for this service.
Each transaction made on an exchange contains instructions on how to ensure that the money arrives in the correct accounts and that the ownership of the stock bought or sold is transferred to the buyer.
Most banks are also brokers, catering primarily to professional and wealthy investors. Robinhood, Charles Schwab and other brokerage firms target retail investors. Exchanges are not allowed to own brokerage firms except to send trades to other exchanges if the price of a stock is better elsewhere. Brokers can hold a maximum of 20% of an Exchange.
These rules are intended to prevent conflicts of interest that may arise if a brokerage firm shares its ownership with the Exchange where the transactions take place and where the broker or his client may gain or lose money on the transactions.
“The key is transparency”
LedgerX is subject to stricter rules regarding derivatives trading, introduced after the global financial crisis. These rules are overseen and enforced by several regulators, primarily the Commodity Futures Trading Commission, and compliance with them is arguably what helped LedgerX avoid bankruptcy.
Still, FTX had planned to export elements of its business model to LedgerX. Last December, it sought approval from US regulators to use its clients’ money for LedgerX’s “temporary” needs. The changes were not approved until FTX collapsed.
Other cryptocurrency exchanges have since sought to allay investor concerns about how their assets are being treated.
But that still falls short of the assurance, evidence and oversight of more regulated markets.
“What is the lesson learned? asked Chris Perkins, president of crypto investment firm Coinfund. The regulated part of the business worked. The other part was fast and loose. But even if the regulations are perfect, a fraud is a fraud. The key is transparency. »
This article was originally published in the New York Times.