Cobo: Cryptocurrency regulators should seek technological innovation to protect user funds

Written by: Jiang Changhao, Cobo Co-founder and CTO

Editor’s Note: The South China Morning Post published an article today by Jiang Changhao, Co-founder and CTO of Cobo, discussing how centralized exchanges and trading clients can address the current trust challenges they face, and how Cobo plans to leverage technological innovation to help rebuild trust for exchanges and trading clients.

• As the FTX scandal shakes investor confidence, Hong Kong is legalizing retail participation in cryptocurrency trading, highlighting the need for industry regulation.
• One of the measures that need to be taken is the segregation of funds and trading, which is where technology can help centralized exchanges create transparency and rebuild trust.

Recently, Hong Kong's cryptocurrency regulatory framework has shifted to a more friendly stance, even going so far as to legalize retail trading of crypto assets. This move has reignited enthusiasm among market participants. However, as the crypto industry is still reeling from the impact of the FTX collapse, how to implement robust regulation on cryptocurrency exchanges has become an urgent challenge.

Strengthening licensing requirements for exchanges and enforcing compliance and regulation is clearly a priority. In addition, due to the unique characteristics of blockchain and digital assets, technology can play an important role in regulating trading platforms.

The dramatic collapse of FTX is considered the "Lehman Brothers" moment for the crypto industry. Indeed, the downfall of FTX, once a paragon of the crypto industry, has far-reaching implications. More importantly, market confidence in centralized exchanges has been severely shaken, and it may take years to rebuild. Data from on-chain analytics firm CryptoQuant shows that investors withdrew over $8 billion from centralized exchanges within seven days following the FTX incident.

Even so, as centralized exchanges still account for about 99% of all cryptocurrency trading volume, their dominance is unlikely to wane in the short term.

The cryptocurrency world continues to struggle with the aftermath of the FTX collapse, and discussions on how the industry should move forward focus on three possibilities.

1. Implement a top-down licensing system enforced by regulatory agencies for compliance and regulation. Many advocate for the same regulatory standards for cryptocurrency exchanges as those applied to traditional exchanges. This call seems reasonable and aligns with the current policies of Hong Kong regulators. However, developing and implementing a strict and practical regulatory framework takes time, especially since cryptocurrency is a completely new industry for regulators.

2. Shift towards decentralized exchanges (DEX). DEX indeed has significant advantages in reducing moral hazards within exchanges; however, DEX is still in its infancy and faces many issues regarding efficiency and user experience. Following the FTX incident, trading volume on DEX has shown an upward trend, but this does not mean a structural change will occur in the short term. While we optimistically believe that DEX will capture a larger share in the long run, given the ease of use and high liquidity of centralized exchanges, they may still hold an advantageous position in the foreseeable future.

3. Segregation of trading and funds. A more practical approach is to redefine the roles of different actors in the trading ecosystem and achieve the segregation of trading and funds through technological innovation.

The biggest issue exposed by the collapse of FTX is that customer funds are held at the exchange, and due to minimal regulation, these funds can be misappropriated by the exchange at will.

The separation of trading, clearing, and settlement functions has been a long-standing model in traditional finance. This model can eliminate or minimize conflicts of interest and help establish trust among market participants, contributing to the overall integrity of the financial system.

However, in the cryptocurrency industry, these functions have been integrated by centralized exchanges from the very beginning. Many market participants have recognized the associated risks and are calling for independent intermediaries to be involved, particularly third-party custodians and prime brokers outside of the exchanges.

Although there have been calls for this for a long time, no intermediary has successfully diminished the power of exchanges. This situation is about to change. With increasing market pressure, exchanges are now more willing to accept this new model.

Technically, the segregation of trading and funds can be self-enforced by the centralized exchanges themselves. Exchanges can allow customers to store funds in segregated wallets while trading on the platform. However, since the custody function is ultimately still controlled by the exchange, it cannot fundamentally eliminate the risk of customer funds being misappropriated.

A better approach is to have a neutral third party hold customer funds and facilitate trades, thereby alleviating counterparty risk for both sides. This role can be fulfilled by traditional financial institutions or cryptocurrency custody providers to ensure true separation of duties, which should not be mixed.

Now is the right time for regulators to intervene, encouraging or even mandating the use of technology to separate trading and funds. In fact, technological innovations in this area began to emerge as early as 2019, such as Cobo's over-the-counter custody and settlement network SuperLoop (formerly Loop), which allows trading teams to trade while keeping their funds independently custodied.

For example, trading teams can utilize MPC custody solutions to jointly manage their funds with an independent custody platform and trade those funds on a cryptocurrency exchange integrated with the custody platform's settlement network. First, the trading team deposits funds into the custody platform; next, the custody platform locks these funds (executed only before trading) and maps the funds to the exchange on a 1:1 basis; then, the trading team can trade as usual, settling through the custody platform after the trade is completed.

The collapse of FTX has raised serious concerns about the security of cryptocurrency trading and has provided a valuable learning opportunity for all practitioners. Regulators should seize this opportunity to establish a reasonable regulatory framework, embrace technological innovation, create high transparency, and rebuild trust to ensure the healthy development of the cryptocurrency ecosystem.