Exchanges Need Oversight and Regulations Are Coming

The recent QuadrigaFX fiasco has highlighted the need for crypto exchange oversight. When investors lost their shirts and looked to regulators for help in recovering their assets, the primary securities regulator, B.C. Securities Commission, declined to get involved, reasoning that there were no “securities” transacted on the exchange. This was a big deal, since investors would have been able to access up to CAD$1,000,000 in insurance — more than likely enough for virtually all of the exchange’s investors who lost money.

Beyond access to insurance for an exchange’s failure, if crypto exchanges were regulated like securities exchanges, they would need to have appropriate business practices expected of financial institutions who safeguard investors’ assets. While state money transmission regulations provide some protection, these rules are often different between states and may have differences in coverage between state residents and non-state residents. Instead, there needs to be a comprehensive federal system that applies to all exchanges, whether they trade crypto deemed to be securities or not.

Exchanges not operating as FINRA-licensed broker-dealers may not have qualified Chief Compliance Officers (CCOs), rules against self-dealing and front-running, fulsome disclosure of fees and spreads charged to investors, segregation and custody of assets, and minimum net capital requirements to give regulators and investors an “early warning” for an exchange’s possible failure, among other things.

A critical component of an effective regulatory system would be the requirement to have a qualified CCO oversee all compliance operations of an exchange. The CCO would be the primary responsible individual for implementing, testing, and reporting to the Board of Directors of an exchange the effectiveness of a compliance program designed to ensure that the exchange acts as a fiduciary to its customers.

Regulations, as they exist today, have a serious gap that allows exchanges, if they so choose, to skirt fiduciary obligations to their customers. As an example, an exchange’s employees are able to essentially front-run a new crypto listing before that news is announced to the public. That internal knowledge may allow an internal employee to make a substantial profit based on that material non-public information. Yet, there isn’t anything illegal from a securities standpoint if the crypto isn’t a security since front-running rules only apply to securities.

Another example is the application of rules against insider-trading knowledge or, more accurately, the lack thereof. Every crypto project worth investing in is traded on an exchange. Some of these exchanges have a lot of volume while others do not. Yet, none of these projects are considered to be publicly-traded securities so the insider trading rules that have been developed over decades of jurisprudence don’t apply or fit neatly. This is what allows insiders and others (e.g., “tippees” of insiders) asymmetric informational advantages to trading ahead of publicly-disseminated news. And, from a legal standpoint, this is generally OK even though it doesn’t feel like it should be legal.

Here’s my prediction: regulatory oversight is coming and it should be welcome news for everyone who wants this industry to succeed. It means we won’t end up with some people profiting at the expense of the vast majority of others.