FTX was anything but a traditional exchange

Cryptocurrency exchanges such as FTX have gained some legitimacy in recent years by marketing themselves as exchanges, creating a connection with stable and reliable financial institutions such as 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 must adhere to strict rules about what they can and cannot do. Cryptocurrency exchanges face few such obstacles, especially if they are located outside the United States — and most of them do. They don’t have to disclose how customers’ money is handled, either to investors or to a regulator. Internal financial controls may be inadequate.

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. FTX was founded by Sam Bankman-Fried in 2019 and used client funds to fund political donations, buy real estate and invest in other businesses, U.S. authorities said this week. FTX filed for bankruptcy in November after failing to honor about $8 billion in withdrawal requests from customers.

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 evidence”

“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 keeping our money and how,” she said. It is really important. »

The traditional financial industry has been heavily regulated after decades of scandals, fraud and other costly mistakes that have led to huge losses for customers and major market contagion.

The financial crisis in 2008 alone gave rise to a number of new rules aimed at protecting investors’ assets and limiting the risk-taking of banks and other companies.

The cryptocurrency industry has grown outside of the traditional financial system. He built his market structure from the ground up, creating new rules to streamline business by combining a wide range of tasks that are usually separated on more regulated exchanges – such as trading, customer custody and transaction settlement.

Customers who traded 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 customer’s personal wallet to their FTX account. If a customer sent money in cash, the money was converted into “e-money,” according to FTX’s terms of service, which was then used to buy cryptocurrencies.

FTX’s terms of service did not specify how or where client assets would be stored. Instead, there was a brief passage that said legal ownership of all digital assets transferred to FTX remained with the customer.

“None of the digital assets in your account are owned by, or should or can be loaned to FTX Trading; FTX Trading does not represent or treat digital assets in user accounts as belonging to FTX Trading,” the terms of service state. There was no corresponding statement for cash assets.

Unlikely on a real stock 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 exchange and can trade on behalf of his clients. Large institutional investors typically keep their money with a custodian bank such as State Street or BNY Mellon and send trade information to the exchange through their brokers. Custodians are responsible for protecting investors’ assets and are subject to strict rules on what they can do with them.

The exchange simply acts as a meeting place between buyers and sellers and charges transaction fees and other fees for this service.

Every transaction made on an exchange contains instructions on how to ensure that the money goes to the right accounts and that the ownership of the stock bought or sold is transferred to the buyer.

Most banks are also brokers, primarily catering to professional and wealthy investors. Robinhood, Charles Schwab and other brokerages target retail investors. Exchanges may not 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 on derivatives trading, introduced after the global financial crisis. These rules are monitored 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 US regulatory approval to use its customers’ 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 it still lacks the security, evidence and oversight of more regulated markets.

“What’s the lesson?” 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 rules are perfect, a scam is a scam. The key is transparency. »

This article was originally published in New York Times.

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