Mastercard, Bank of New York Mellon, and Tesla all entered the cryptocurrency market this week. Tesla’s 1.5 billion USD investment in Bitcoin in particular caused the digital asset to rise as much as 8.1% to 48,663 USD.
Bitcoin and other cryptocurrency accounts can be created by anyone, without charge and without any centralized vetting procedure — and even without the requirement to provide a real name. Thus, it promises a transaction system that is more flexible, anonymous, and, most importantly, not reliant on traditional financial intermediaries. While these benefits have attracted the attention of many investors, rapid appreciation of cryptocurrency in recent years has also highlighted important limitations.
In theory, the decentralized core technology of cryptocurrencies avoids concentrations of power that could allow a single person or organization take control. In reality, however, significant economic forces arising from the market structure push towards de facto centralization among a small number of intermediaries which are not subject to the traditional standards required of securities and derivative market intermediaries. At present, many trades in bitcoin are accompanied by one or even two conversions from or to conventional currencies, making currency exchanges that allow users to trade cryptocurrencies for traditional currencies essential for the market. Currently, about 99% of all cryptocurrency transactions go through centralized exchanges and the largest exchange, Binance, has a daily volume of 27 billion USD.
Many of these firms are not simply trading platforms; they also perform a variety of other functions that would never be allowed for traditional intermediaries. For example, many of these firms hold crypto-assets, saving users the effort of finding out how to store and transfer crypto-assets on one’s phone. This is especially important for every-day users, as phone users who lose their private key lose their crypto assets. In order to prevent hacking, exchanges often store these assets in an offline ledger and transactions are not booked on the blockchain. Without a recorded transaction history, customers have no guarantee they will get their deposits back. They must rely on the centralized intermediary – the very practice cryptocurrencies aim to prevent. These custody problems reached new levels in 2019 with the failure of QuadrigaCX, a Canadian crypto exchange. The founder and the only person who knew the details of assets stored offline died suddenly—no one has been able to access the 190 million USD worth of crypto and fiat currency stored for customers since.
The absence of a regulatory framework for these unconventional intermediaries poses problems beyond how exchanges hold assets. There are no rules on how quickly a trade must be executed or whether customers are entitled to get the best price. Without regulations designed to safeguard customer assets, such as customer funds from proprietary funds, exchanges can engage in proprietary trading and take advantage of their customers’ trades. Crypto platforms can also engage in wash trading, where the same party trades with itself in order to create the appearance of greater liquidity or to manipulate price. While the NYSE and NASDAQ have no economic interest in the stocks they list, the crypto platform could be the issuer of the asset or could have a significant interest in the asset’s success, and may issue more currencies in advance of a customer’s trade. Even if the platform itself does not engage in these activities, there are no rules prohibiting such activities by others nor are trading platforms required to scrutinise and prevent such activity. There are no equivalents to departments like the Securities and Exchange Commission (SEC) which are dedicated to the integrity of securities markets.
The question is not whether cryptocurrency should be regulated but how it should be done. The SEC has jurisdiction over crypto-assets deemed securities, but many crypto-assets—including Bitcoin—are deemed commodities by the Commodity Futures Trading Commission (CFTC). CFTC has the power to regulate derivatives on cryptocurrencies such as futures and swaps but not on the buying and selling of cryptocurrencies. Indeed, the chairmen of the SEC and CFTC have acknowledged this gap in legal framework. Congress should address this by creating regulatory oversight of the cash market for crypto-assets, the trading platforms and other intermediaries that operate in that market.
By Matthew Xiao
Sector Head: Jackson Philips