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Regulating CEXs won’t stop bad actors: lessons from the FTX trial | Opinion

source-logo  crypto.news 28 April 2024 13:58, UTC

Disclosure: The views and opinions expressed here belong solely to the author and do not represent the views and opinions of crypto.news’ editorial.

The fallout from the FTX collapse and the accompanying media circus left unexpected and wide-reaching disruption. Still, the truth is that it expedited the realization that centralized exchanges (CEXs) are broken. How we pick up the pieces will have a long-lasting impact on our industry. It is not the role of regulators to prevent another FTX collapse.

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Without meaningful change, this new money system will continue to repeat mistakes from the past. Our industry and our emerging technologies must show the world that complaint decentralization is possible.

Compliance is the starting point

The FTX case highlights the risks of neglecting corporate compliance. One big lesson to take away from the FTX case is that better compliance is needed. We have to do a better job of tracking the money. With almost $9 billion of customer funds lost from the troubled exchange, it’s evident that CEXs must be built on a robust framework. This will serve as a foundation of trust and security for industry growth.

In a post-FTX world, compliance and transparency must be prioritized. The FTX case emphasizes why we need corporate governance, covering cash controls, HR protocols, approval mechanisms, financial reporting, as well as internal and external audits.

Yet better regulation is just a good start.

Regulation alone is not enough

Following FTX’s collapse, regulated exchanges quickly began promoting their regulated custodial services. In the United States, regulated CEXs are obligated to segregate customer funds from their own in order to ensure funds are solely used as permitted by their users.

Regulators have also been increasingly keen on enforcing new rules, yet this doesn’t eliminate significant risks. Traditional finance—despite its strict regulations aiming to prevent centralized failures—has seen repeated instances of risk mismanagement. The collapses of Bear Stearns, Lehman Brothers, and, most recently, Credit Suisse have also spelled the dangers of relying too much on human intervention.

Regulation alone is not enough. Bad actors can still wreak havoc when they literally control the purse.

Self-custody is the key

So, the other big lesson is self-custody. It is talked about a lot in the industry, but what this means in practice is often disputed. The Bitcoin whitepaper still stands as a reminder of the basics: if you entrust exchanges and other third parties with your private keys, you relinquish control over your money.

Once billed as a reputable exchange, FTX was considered a well-run, safe destination for crypto transactions. More than that, FTX was something of an industry darling. Yet, the reality was starkly different. A secret backdoor had been established that allowed Alameda Research, the trading firm linked to FTX’s downfall, to withdraw billions of customer funds. While beneficial in bullish markets, Alameda’s excessive leverage significantly magnified losses during downturns. When confronted with margin calls during the crisis, selling off collateral risked substantial value depreciation.

Part of the trauma caused to investors was the swift and unexpected collapse of the world’s second-largest exchange. The industry darling’s fortunes had seen a swift reversal practically overnight. In truth, optics and public perception coupled with FTX’s ludicrous marketing spending meant that the whole world took notice.

Sadly, these same public optics led customers to mistakenly assume their funds would be shielded from speculative activities like those practiced by Alameda Research. In reality, following FTX’s bankruptcy, the U.S. Securities and Exchange Commission (SEC) described FTX as providing Alameda Research a “virtually unlimited line of credit,” creating a multibillion-dollar deficit for retail investors in FTX.

The lesson learned was as shocking as it was damaging. Storing cryptocurrencies in any and every centralized exchange is hazardous. This was evidenced by the number of platforms suddenly halting withdrawals with little warning due to fears of a bank run, where everyone runs to a bank to withdraw their funds at once, and the bank, or in this case, centralized exchange, cannot meet the withdrawal demand.

That’s why self-custody matters. Keeping assets under your control is the sole means of mitigating loss risks. However, in the event of a crypto exchange failure, retail investors should not be fine with accepting only a small portion of their assets years later. They deserve immediate access to 100% of their crypto at all times. Yet, while regulation and compliance are still valuable safeguards for an exchange, newer models are emerging that marry traditional legal funds management controls with self-custody.

Shifting the paradigm with hybrid models

No amount of regulation will make a financial platform completely immune to failure. Even within regulated exchanges, users give up control of their assets to third parties for safekeeping. However, the means for a paradigm shift already exists. What if there was a way for CEXs to offer 100% self-custodial solutions?

In recent years, hybrid exchanges have emerged as an answer. Blending the best of CEXs and decentralized exchanges (DEXs) will enable innovation and strengthen asset security. Users can trade directly on-chain without intermediaries. At the same time, traditional institutions can access decentralized finance features while benefiting from CEX security and liquidity.

More importantly, the hybrid model, with its trustless risk management and self-custody, addresses concerns by relying on code rather than human intervention to manage risk effectively. Hybrid exchanges blend regulatory compliance with decentralized features, allowing users to engage directly with cryptocurrencies in secure wallets via smart contracts. Users also maintain direct control over their funds, bypassing custodians. All these take place within accessible, user-friendly interfaces akin to CEXs. The result is an advanced trading system that mitigates the traditional weaknesses of both CEXs and DEXs, positioning hybrid crypto exchanges as potential game-changers.

A wake-up call for crypto

As the FTX trial continues to garner attention, it’s worth noting that industries commonly experience such upheavals. Wall Street itself has weathered scandals and challenges similar to those in the crypto space. Think of the Enron Scandal and Bernie Madoff Ponzi Scheme of the early2000s.

Still, as crypto industry custodians, we must not dismiss this case as a mere glitch. Such scandals tarnish the industry’s reputation, setting us back each time. The crypto industry is still evolving and maturing over time, but there are increasingly better ways forward.

Read more: The fall of FTX: A tale of hubris in the crypto world | Opinion
Hong Yea

Hong Yea is the founder of GRVT, a crypto exchange that offers self-custody. He was previously an executive director at Goldman Sachs and a banking associate at Credit Suisse for over nine years combined.