Regulated firms warn against crypto market lockout

After the shocking collapse of cryptocurrency exchange FTX, regulated financial firms are warning that the lack of legal clarity in major jurisdictions has forced cryptocurrency trading away from properly supervised markets, and are urging regulators to change their approach.

According to bankruptcy documents filed by FTX this month, the firm could have up to 1 million creditors, owed billions of dollars. In theory, some entities in the group were overseen by US regulators, but the functional parts of the organization were based in offshore jurisdictions. Fully authorized firms hoping to trade crypto onshore in major markets say the barriers they face have only made the asset class more dangerous.

Really, we need to think about the financial system as a whole—it’s like a water mattress: if you push down at one end, it bubbles up at the other.

Benedict Roth, Zodia Markets

“If you make it impossible for regulated institutions to run market-making or services in crypto assets, you effectively chase this business out of the institutions who know how to run it properly, and into the shadows, where it may be run by new entrants with limited experience,” says Benedict Roth, chief risk officer at crypto exchange and brokerage Zodia Markets and a former Bank of England supervisor.

“Really, we need to think about the financial system as a whole—it’s like a water mattress: if you push down at one end, it bubbles up at the other.”

Zodia is part-owned by Standard Chartered banking group, and became registered with the UK’s Financial Conduct Authority in July 2022.

The European Union has agreed a comprehensive Markets in Crypto-Assets regulation, but it will not come into effect until next year.

US Congress has not approved comprehensive new legislation that would give regulators formal powers to regulate the cryptocurrency market. Instead, the US Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) have largely depended on existing case law and regulations to prosecute bad actors and issue guidance.

Chris Zuehlke, the head of Cumberland, which is the cryptocurrency trading arm of DRW, says US regulators have sometimes tried to lead from the front: “But, for the most part, the lack of action, clarity and a clear road map to regulation has incentivized crypto-asset trading to move offshore.

“As a result, the checks and balances that exist in the US are not applicable to trading platforms, as they aren’t operating here.”

DRW is registered with both the SEC and the CFTC in the US.

By way of example, Zuehlke says he “doesn’t understand” the SEC’s decision to approve an exchange-traded fund (ETF) based on cash-settled CME bitcoin futures in October 2021, but to refuse approval for spot-based bitcoin ETFs. He believes this rejection has exacerbated the trend for US retail investors to trade cryptocurrencies offshore.

“Approving spot-based ETFs would be a great way for US regulators to bring more crypto-asset trading underneath their regulatory umbrella,” he tells Risk.net. “Doing so would give US retail investors a safe way to access this asset class using well-established rules and with proper protections in place.”

Keep your enemies closer

CFTC chair Rostin Behnam faces a potentially stormy hearing in front of the US Senate Committee On Agriculture, Nutrition and Forestry on December 1 about the failure of FTX, which held a CFTC license as a derivatives clearing organization (DCO) following its acquisition of LedgerX in August 2021.

This was only one of more than 100 entities in the group based around the world, including a headquarters in the Bahamas, FTX Trading incorporated in Antigua and Barbuda, and several entities including proprietary trading arm Alameda Research incorporated in Delaware. FTX EU, based in Cyprus, was technically subject to the Markets in Financial Instruments Directive (Mifid), and its license has now been suspended by the Cypriot authorities.

The group’s collapse has raised serious questions about the lack of effective co-ordination among regulators to understand the true financial condition of FTX.

It is not the only cryptocurrency group with a complex legal structure. The largest crypto exchange in the world, Binance, has no identified headquarters in any jurisdiction. It operates in the US only through individual state money transmitter licenses. Several states, including New York, Hawaii and Texas, have explicitly banned it.

The FCA warned in June 2021 that it would not authorize Binance in the UK, because of, among other reasons, the firm’s “refusal to answer questions about [its] wider global business model”. Binance has, however, registered as a digital-asset service provider with the French regulator, the Autorité des marchés financiers, in May 2022.

One dilemma for supervisors is whether allowing regulated players into the crypto markets will on its own drive out the bad actors. Zodia’s Roth thinks that the approach the UK government is taking may provide an answer to this.

In October this year, the UK Parliament approved an amendment to the Financial Services and Markets Act that would include crypto assets in the definition of “investments”. That would allow the Treasury to subject to regulatory authority any UK entity that wanted to offer crypto-asset services.

“If you don’t have authorization, I suppose there’s nothing to stop you opening up a legal entity on the internet or somewhere totally unregulated—but if you do that, your customers are going to need to make transfers to it, so you will need to be part of the sterling clearing system,” says Roth.

“A UK bank will not allow you to open up an account if you are coming from an unregulated jurisdiction, so the fence around the UK should be pretty hard to penetrate for ordinary consumers.”

Natural selection

Roth argues in favor of deploying conventional securities market concepts, such as asset segregation, to help clean up the market.

However, Evgeny Gaevoy, founder and chief executive of FCA-registered market-maker Wintermute, says some of these techniques may reduce efficiencies if they are imposed unamended by regulators onto the cryptocurrency markets. An outsourced cold wallet would be the crypto equivalent of a segregated custody account, but he says exchanges typically need to keep up to 5% of assets in a hot wallet to allow continuous withdrawals. But he still thinks regulation has an important role to play.

“I really wouldn’t mind regulators saying: ‘This exchange, we just cannot endorse it, it might be actually pretty dangerous, whereas this exchange has been audited, it is safe to use,’” says Gaevoy.

If regulators will allow it, licensed firms believe they can help detoxify the cryptocurrency market by becoming far more selective about who they trade with.

Gaevoy says his firm has already been reviewing all the exchanges it does business with: “We are conducting a thorough due diligence process with the majority of the exchanges, which includes reviewing financials and operational processes.

“We continue to trade on a significant number of venues under the new risk framework with ongoing monitoring, making changes as due diligence results come through.”

CK Zheng, co-founder and chief investment officer of crypto hedge fund ZX Squared Capital, says trust in the market needs to be built on verification, especially when dealing with centralized exchanges.

“It is difficult to know who to trust, which is why more and more people are using custodial services to make sure their digital assets are secure,” he says.

Additional reporting by Philip Alexander