Specialized crypto bourses like FTX burst forth through this conceptual hole. They helped create spectacular wealth, as evidenced by Bankman-Fried’s now-eviscerated $26 billion fortune. But although they chose to go by the name ‘exchange’, they weren’t satisfied taking fees from customers. The real prize was in becoming shadow banks. Globally, regulators let them get away with it. There was a reason for indifference. Before the contagion set off by the Terra-Luna crash this spring, authorities’ main preoccupation was with preventing a new conduit for financing terror and laundering money.
The Financial Action Task Force said in 2019 that it wanted crypto bourses to follow the “travel rule" and identify originators and beneficiaries in transactions above a threshold. When Singapore introduced a law that year to recognize crypto exchanges as payment service providers, it bolted on the travel rule to its licensing requirement. This has been the global norm so far. The focus of the regulators worldwide is “generally on anti-money laundering and due diligence measures, not trading," blockchain scholars Martin C.W. Walker and Winnie Mosioma noted in their survey last year of 16 major crypto exchanges. They found only four to be regulated significantly when it came to trading.
Clearly, the scope of scrutiny needs to expand. Singapore, in the eye of the storm because of the city’s links with the now-defunct Three Arrows Capital hedge fund, the Terra-Luna project and collapsed crypto platforms Hodlnaut and Zipmex, has already adopted a more cautious stance on consumer protection. In a consultation paper last month, its monetary authority asked the public if digital-token payment services should be “required to appoint an independent custodian to hold customers’ assets." After the most recent meltdown, in which FTX reportedly lent billions of dollars of clients’ funds to Alameda Research, a connected trading firm, the answer is obvious. Another important lesson from the Bankman-Fried saga may be that a licence seeker may offer one of its doors for inspection, while it conducts business with the city’s wealthy via another. According to a Straits Times article, FTX had a Singapore entity Quoine, which had the central bank’s permission to take on local customers pending a review of its licence application. Yet Singaporean investors who have lost money were clients of FTX.com; there was no attempt to migrate them.
In conventional finance, the 2008 subprime crisis was a cautionary tale. Entities with liquid liabilities, illiquid assets and no access to central bank emergency lines were in fine shape as long as the housing market only went up. Crypto bros simply replaced homes with even riskier digital assets and replicated the same dangerous shadow-banking model. Yet authorities weren’t in a hurry to prescribe risk-based capital or liquidity requirements for them. That’s because only a thin channel connected the small pond of digital-asset trading with the vast ocean of traditional finance: According to one survey, major banks’ crypto exposure was less than $200 million in 2020.
But low institutional entanglement doesn’t mean that the industry can be left lightly supervised. The stakes will only rise as decentralized finance (DeFi) attempts to re-create banking, investment and insurance on blockchains. The focus of Western regulators even here will be on how algorithms are used to launder money. The US Office of Foreign Assets Control opened a fresh can of worms this summer when it placed sanctions on a set of ‘smart contracts’ that reduce the traceability of some virtual assets. A sledgehammer may be the right tool in some instances, but not all. To make DeFi safer, one option suggested by Bank of Italy economist Claudia Biancotti is to require developers to embed certain controls in protocols before they assume a life of their own.
Singapore has an opportunity to lead the world by coming up with a comprehensive licensing regime for digital-asset intermediaries as well as code. To not allow crypto advertising around the tracks during the city’s annual Formula One night race or to prevent people from buying tokens with credit cards is the weak-tea version of consumer protection. After this year’s string of debacles, filling the gap that Satoshi left unaddressed should go right on top of the regulatory agenda.
Andy Mukherjee is a Bloomberg Opinion columnist covering industrial companies and financial services in Asia.
