Changpeng Zhao, CEO of Binance, the world’s largest cryptocurrency exchange, has called for increased regulation clarity following a tumultuous week in the crypto market and the estimated loss of a staggering USD 2 trillion (GBP 1.7 trillion) by investors in the last year.
“We do need to increase the clarity of regulations and the sophistication of regulations in the crypto space,” Zhao addressed a gathering of G20 leaders at a summit in Bali. He emphasized that it is not only regulators that have the responsibility of protecting people, but the industry should also explore new models that can help.
The downfall of FTX, which was appraised at a value of US$32 billion earlier this year but has since sought bankruptcy protection in the US, has had a considerable impact on the cryptocurrency sector. This event has even caused the most prominent digital currency, Bitcoin, to plummet to its lowest point in two years.
Cryptocurrencies allow traders and investors to purchase and sell assets without the need to involve banks or brokerages. Thanks to blockchain technology, peer-to-peer cryptocurrency transactions can occur on exchanges such as FTX and Binance, eliminating the need for these intermediaries.
A group of validators authenticates transactions, often referred to as miners. They solve intricate mathematical problems, known as the proof of work system, used by Bitcoin and other cryptocurrencies.
But when it comes to managing transactions, Binance and other exchanges employ the same “limit order book” model as traditional exchanges such as the New York Stock Exchange. This model has a centralized structure that connects buyers and sellers, with market makers providing liquidity and collecting fees from traders.
This type of setup has added to the recent issues in the crypto world to a certain degree. FTX’s centralized approach enabled it to provide loans to struggling crypto businesses earlier this year. It also used exchange-issued tokens (FTT) to balance its sister company’s financials. This increases the possibility of getting impacted by a market crash.
Cryptocurrencies have been known to be associated with certain risks. Still, a decentralized exchange model is emerging that can address these issues. These exchanges allow investors to buy and sell tokens at prices determined by algorithms rather than relying on professional market makers. This automation gives individual investors the opportunity to provide liquidity and earn a share of the trading fees.
A novel crypto trading approach
Like many decentralized exchanges, Uniswap, launched in 2018, has a governance token called UNI, which allows the users of the exchange to control their own funds. It is estimated that up to 49,000 Ethereum addresses possess UNI tokens, with 60% of these tokens held by investors.
Centralized exchanges, such as FTX, have the ability to suspend withdrawals of cryptocurrency from investors. This has caused problems for many people who have been unable to access their money, which was used for trading on the exchange.
In comparison, decentralized exchanges do not have this ability. So individual investors have full access to their crypto wallet balances. They can withdraw, deposit liquidity, or stop trading at any time without the risk of their assets being frozen.
A downside of decentralized exchanges compared to centralized models such as FTX and Binance is that they do not allow traders to exchange fiat currency for crypto; traders can only exchange different cryptocurrencies.
In addition, the size of any trade depends on the size of the liquidity pool, which can sometimes make it challenging to complete the desired transaction.
Crypto trading’s future depends on many variables, including which exchange will be the most powerful. Recently, Binance has seen an influx of traders leaving its rival FTX, increasing its market share and liquidity. These factors make Binance more competitive, allowing it to offer lower transaction costs and stay the dominant force in crypto trading.
However, when exchanges hold more activity, customers are more susceptible to the risk of a single crypto provider or large trader failing. Moreover, this risk is only increasing after recent market failures, as a higher concentration leads to a greater risk of contagion.
And over time, decentralized exchanges can become more competitive and reduce their transaction costs due to the development of “scaling solutions” – protocols or sets of rules that increase activity and transaction speeds without compromising decentralization. This will also help to lower the amount investors need to pay to validate their transactions on the blockchain, making trading more affordable.
New guidelines
Cryptocurrency markets are largely unregulated, but this is likely to change due to recent issues with FTX and other events this year.
It has become increasingly evident that more official structures need to be implemented. Regulators have already begun examining FTX’s lending products and customer fund management in light of its downfall. But what other measures can they take?
Closer Scrutiny of Cryptocurrency Assets
To prevent a recurrence of the FTX incident, Binance’s CEO recently suggested on Twitter that crypto exchanges should monitor their assets in real-time rather than relying on inaccurate annual reports.
The good thing is this is achievable. A third party can provide “proof of reserves”, an audit report that tracks the money coming in and out of investors’ exchange wallets. This will help identify any potential systemic failures, such as using exchange reserves to make loans to crypto firms, as seen with FTX.
Making Crypto Risk Assessments More Effective
Financial regulators must develop an appropriate risk assessment framework for cryptocurrencies that involves independent audits and stress-testing on-chain data.
Regulations should be imposed to limit the use of exchange tokens to make loans to crypto firms and to provide more customer protection to prevent exchanges from suspending withdrawals, thus allowing traders to access their money stored in an exchange that is in trouble.
Although the current situation in the crypto market is not ideal, it is not all doom and gloom. With the proper regulations and new models, the industry can recover and become stronger, encouraging further adoption of decentralized finance in mainstream financial markets.
