Author: Jiang Changhao Co-founder and CTO of Cobo
This is the 21st article of Cobo Global
Editor's Note: The South China Morning Post website published an article today by Cobo co-founder and CTO Jiang Changhao, which discussed how centralized exchanges and trading clients can resolve the trust challenges they currently face, and how Cobo plans to use technological innovation to help exchanges and trading clients rebuild trust.
This article is translated from English for reference only. Click on the original text button at the bottom of the article to read the original English text.
Hong Kong is legalizing retail cryptocurrency trading at a time when the FTX scandal has shaken investor confidence, highlighting the need for industry regulation.
One of the measures that needs to be taken is to isolate funds and transactions, which is where technology can help centralized exchanges create transparency and rebuild trust.
Hong Kong’s recent cryptocurrency regulatory regime has turned friendly, even to the point of legalizing retail trading of crypto assets. This move has reignited the enthusiasm of market participants. However, as the crypto industry is still reeling from the fallout from FTX’s collapse, how to enforce strong regulation on cryptocurrency exchanges has become a challenge that needs to be addressed.
Strengthening licensing requirements for exchanges and implementing compliance and supervision are clearly urgent priorities. In addition, due to the unique characteristics of blockchain and digital assets, technology can play an important role in regulating trading platforms.
The dramatic demise of FTX is considered the "Lehman Brothers" moment of the crypto industry. Indeed, the collapse of FTX, once a model for the crypto industry, has also had far-reaching consequences. More importantly, market confidence in centralized exchanges has been severely shaken and may take years to rebuild. Data from on-chain analysis firm CryptoQuant shows that within seven days of the FTX incident, investors withdrew more than $8 billion from centralized exchanges.
Even so, with centralized exchanges still accounting for approximately 99% of all cryptocurrency trading volume, their dominance is unlikely to loosen anytime soon.
The cryptocurrency world is still reeling from the aftermath of the FTX collapse, with discussion centering on three possibilities as to how the industry can move forward.
1. Implement a top-down licensing system, with compliance and supervision enforced by regulators. Many people have advocated that cryptocurrency exchanges should be regulated to the same standards as other traditional exchanges. This call seems reasonable and consistent with the current policies of Hong Kong regulators. However, it takes time to develop and implement a strict and practical regulatory framework, especially since cryptocurrency is a brand new industry for regulators.
2. Turn to decentralized exchanges (DEX). DEX does have a strong advantage in reducing moral hazard within exchanges, but DEX is still in its infancy and there are still many problems in terms of efficiency and user experience. After the FTX incident, the trading volume of DEX did show an upward trend, but this does not mean that there will be a structural change in the short term. Although we are optimistic that DEX will occupy a larger share in the long run, given the ease of use and high liquidity of centralized exchanges, centralized exchanges may still have an advantage in the foreseeable future.
3. Isolation of transactions and funds: A more realistic and feasible approach is to redefine the roles of different actors in the transaction ecosystem and achieve isolation of transactions and funds through technological innovation.
The biggest problem exposed by the collapse of FTX is that customers’ funds are deposited in the exchange, and due to the lack of supervision, the funds may be misappropriated by the exchange at will.
The separation of trading, clearing and settlement functions is a long-standing model in traditional finance. This model can eliminate or minimize conflicts of interest, help build trust among market participants, and contribute to the overall integrity of the financial system.
However, in the cryptocurrency industry, these functions have been integrated into centralized exchanges since the beginning. Many market participants have realized the risks involved and require the involvement of independent intermediaries, especially third-party custodians and prime brokers outside the exchange.
While there have long been calls for this, no middleman has been able to successfully undermine the power of exchanges. This is about to change. As market pressures mount, exchanges are now more willing to accept this new model.
Technically, the separation of transactions and funds can be self-enforced by the centralized exchange itself. The exchange can allow customers to keep their funds in isolated wallets while trading on the platform. However, since the custody function is ultimately controlled by the exchange, the risk of customer funds being misappropriated cannot be fundamentally eliminated.
A better approach would be for a neutral third party to hold the client’s funds and facilitate the transaction, thus mitigating counterparty risk on both sides. This role could be taken by a traditional financial institution or a cryptocurrency custody provider to ensure true separation of duties that were never meant to be mixed.
Now is a good time for regulators to step in and encourage or even force the separation of trading and funds through technology. In fact, technological innovation in this area began to appear as early as 2019, such as Cobo's exchange over-the-counter custody and settlement network SuperLoop (formerly Loop), which allows trading teams to trade while maintaining independent custody of funds.
For example, a trading team can use the MPC custody solution to manage its funds with an independent custody platform and trade these funds on a cryptocurrency exchange that is integrated with the settlement network operated by the custody platform. First, the trading team deposits funds into the custody platform; next, the custody platform locks these funds (only before the transaction is executed) and maps the funds to the exchange at a 1:1 ratio; then, the trading team can trade as usual, and the transaction is settled through the custody platform after completion.
The collapse of FTX has raised serious concerns about the security of cryptocurrency transactions and provided a valuable learning opportunity for all practitioners. Regulators should take this opportunity to establish a reasonable regulatory system, embrace technological innovation, create high transparency, and rebuild trust to ensure the healthy development of the cryptocurrency ecosystem.
Cobo is a leading global digital asset custody and blockchain technology provider headquartered in Singapore. As a technology-driven innovative company, Cobo focuses on building scalable infrastructure to promote the development of Web 3.0.
Since its establishment in 2017, Cobo has been committed to building a professional, one-stop, secure digital financial technology service platform, serving more than 500 institutional clients worldwide (including: well-known family offices, listed companies, top hedge funds, exchanges, etc.), and has gained their continued trust. At present, the products and services provided by Cobo include: Cobo SuperLoop (exchange over-the-counter custody and settlement network), Cobo MPC WaaS (co-management solution based on multi-party secure computing threshold signature technology), Cobo Argus (on-chain smart contract multi-signature solution suitable for teams to conduct DeFi) and Cobo Custody (centralized secure custody solution). At the same time, Cobo has launched WaaS (wallet service) and NaaS (NFT custody service) for specific institutions and tracks to meet the full range of institutional needs for asset custody.
In terms of compliance, Cobo has obtained SOC 2 Type I certification, an in-principle approval letter from the Dubai Virtual Asset Regulatory Authority (VARA), and holds licenses in the United States, Hong Kong, and Lithuania.