Crypto exchanges: Why they should be regulated and how?

Against the background of reports from several cryptocurrency exchanges that work with clients in Ukraine, about the impossibility of withdrawing funds to the cards of Ukrainian banks, it is more timely than ever to talk about the regulation of this area. Yes, recently Mind talked about this situation and emphasized that it could mean the introduction of stricter regulation in Ukraine. Mykhailo Romanenko, CVO and co-founder of the Kyrrex global fintech ecosystem, told Mind how to implement effective regulation of the crypto industry without harming its development, and how crypto exchanges should work in the general system of financial coordinates.

Reliability and decentralization are among the most important advantages of cryptocurrencies and crypto assets. Such freedom of action provides an opportunity to reduce the cost of using crypto by increasing the speed of transfers. However, when can freedom turn into arbitrariness? The case of the FTX exchange and its sudden bankruptcy cost traders and investors millions of dollars, highlighting the significant weakness of the regulatory framework in the industry. Although experts and participants have long pointed out these imperfections, regulatory institutions have continued to delay decisions. Solutions should appear soon, as most of the world's attention is focused on the problem. However, certain questions remain relevant.

Increase in the Level of Transparency in Asset Use

Transparency of financial reporting has long been an essential part of the modern business industry. The concept of "transparency" refers to the publication of quarterly and annual reports, including financial results with in-depth descriptions. At the same time, annual financial statements are being audited by independent companies. Auditors provide a conclusion on the correctness of the specified data and the quality of internal control over the company's financial reporting process. This approach significantly increases the level of trust in published data on the part of shareholders and investors. In addition, the process of review of reporting by government regulators is greatly facilitated through standardization.

Are these methods appropriate for the crypto industry? Undoubtedly, the practice of publishing financial statements will significantly increase the level of transparency for cryptocurrency exchanges and platforms. How exactly can this process be implemented? The individuals can rely on the experience of stock exchanges working as public companies with shares placed on their platforms. The public status of stock exchanges implies publishing financial statements with auditors' conclusions in accordance with current legislation. Thus, such exchanges as NYSE and NASDAQ provide the highest level of transparency by choosing public status.

An in-depth analysis shows that cryptocurrency exchanges lag behind stock exchanges regarding transparency. The case of the recent bankruptcy of FTX reveals significant gaps in financial reporting. It is necessary to say that FTX has had a mind-boggling $1.4 billion in cash at the moment of bankruptcy. For example, neither FTX nor Alameda Research, affiliated with Sam Bankman-Fried, had financial reporting departments. Such gaps cause potentially fraudulent actions, bankruptcies and financial losses for investors.

Strengthening Control Over the Largest Participants

The choice of public status by stock exchanges was entirely voluntary. Certain crypto exchanges operate as private companies with one or more owners, even now. In addition, these platforms are registered in offshore zones, complicating their regulation process. The relatively young status of the industry, the desire to avoid additional costs, and the preservation of full control over management decisions led to the emergence of this situation.

At the current stage of the industry's development, publicity has not yet been generally accepted by contradicting the norms of transparency. It requires a more advanced level of control. Public status involves the placement of shares on the stock exchange and an increase in the number of holders. The owners perceive their ability to influence the company's management as a potential threat. Furthermore, the preparation of public financial statements, as well as their audit, requires additional costs, providing mostly intangible benefits. The ability to recognize these advantages remains underestimated by owners of crypto exchanges. Many small platforms cannot afford getting public statuses with all related obligations.

Despite the above caveats, the crypto industry needs regulation. The negative case of FTX and its owner showed the painful consequences of insufficient regulation. In addition to significant losses of investors’ funds, the bankruptcy of one of the industry leaders significantly undermined confidence in crypto exchanges, cryptocurrencies, and crypto assets. Such well-known corporations as Goldman Sachs Group Inc., JPMorgan Chase & Co. and Wells Fargo & Co. became victims of FTX’s bankruptcy as the exchange’s creditors. Mistrust has long-term problems, especially for industries and companies in the development stage.

It is important to emphasize that the crypto industry is not unique regarding major crises. One can recall the bankruptcy of the Enron company and the termination of Arthur Andersen that was among the top five auditing companies in 2001. Likewise, the bankruptcy of one of the largest US banks, Lehman Brothers, in 2008 catalyzed the global economic crisis. Both bankruptcies led to the introduction of new regulatory instruments, namely the Sarbanes-Oxley Act in 2002 and the Dodd-Frank Act in 2010, respectively. Therefore, it is reasonable to expect that the bankruptcy of FTX will lead to increased regulatory control. The “crypto winter” has had irreversible consequences for the industry in 2023. The recent bankruptcy of Celsius is one more confirmation of the need for urgent changes.

Implementation of Requirements for Crypto Exchanges

Even at this stage, it is not clear what the regulatory framework for crypto exchanges will look like. Individual approaches to the issue in different countries complicate the process of control at the global level. The company's registration in the Bahamas, with its limited regulatory control and ability to oversee financial services companies, was one of the reasons for FTX's bankruptcy. This situation made it possible for the owner of FTX to conduct risky operations with signs of fraud.

Strengthening regulatory requirements for crypto exchanges is set to become a real solution to the problem. The first step should imply the creation of a registry of licenses recognized in all countries of the world, allowing transactions with cryptocurrencies. Thus, crypto exchanges can obtain licenses like the Malta VFA Class 4 License. Such a license confirms the sufficient level of security of the exchange for its clients. At the same time, it is necessary to limit the possibility of using exchange clients' funds in high-risk transactions. Control of such a restriction can take place in the form of periodic inspections of the stock exchanges for the use of funds. These steps will help restore and increase the level of trust in crypto exchanges and prevent large-scale bankruptcies, as happened in the case of FTX.