This is a time of reckoning for digital assets. The markets have been rocked by the demise of several high-profile firms. Regulators are demonstrating unprecedented willingness to provide guidance and guardrails. Bank collapses have eliminated crucial on- and off-ramps, and venture investment is down, raising the stakes for the firms in this space. All the while, institutions are watching these developments and carefully weighing whether and how much to get involved in crypto.
In the not-too-distant future, we’ll look back on this period as one that kicked off a new, more stable and more institution-friendly era for crypto – but before we get to defining moments, we need to define our terms. In this relatively new market, the nomenclature and categorization of firms and entities can be inconsistent, confusing and even misleading for those who built their careers or investment portfolios in traditional assets.
If you want an example, look no further than the crypto “exchanges” that have been at the center of the recent market turmoil.
Exchanges vs. Brokers
Throughout finance, exchanges play a clearly defined role and are subject to specific requirements that come with specific licenses. They must provide market surveillance. They must maintain clearinghouses. They must disclose and uphold clear trade flow processes from origination to settlement. And above all, they must have members – brokers and market makers who provide capital to the clearinghouse and abide by various operational rules in order to trade on behalf of institutional and in some cases individual investors.
In crypto, most “exchanges” tend to contrast sharply with this model. These firms have no members – instead, they have customers. They are not matching engines – instead of connecting buyers and sellers at a mutually agreeable price, they hold their clients’ assets and trade on their behalf. To be blunt, these “exchanges” are not exchanges at all – they are brokers, with some custodial functions thrown in for good measure.
This isn’t just some quibble around dictionary definitions. It gets to the heart of where these firms sit in the market, who they serve and what we – as both an industry and a society – can or should do about it. As we regroup from the turmoil of 2022 and seek to define a new path for crypto market structure, it’s absolutely critical that everyone is speaking the same language, with common terms and a shared understanding of what each one actually refers to. This is one occasion when semantics really do matter.
Making Sense of Regulatory Priorities
Want proof? Let’s review a few of the top priorities among regulators and institutions in reforming the crypto markets. While this list is by no means exhaustive, and the specifics will vary by jurisdiction, most market structure initiatives in this space today revolve around at least one of these four themes:
- An End to Commingling – This is table stakes for a safe and stable crypto industry. Investors need to have the utmost confidence that their assets will be kept separate from operating capital and any proprietary trading.
- Staking Disclosures – Many crypto firms stake their clients’ digital assets, giving them access to opportunities for yield without actually making trades. Customers need to know when their tokens are being locked away in this manner. Compare it to the concept of rehypothecation in traditional finance – it’s allowed, but only with robust disclosures.
- Capital Adequacy – In traditional finance, maintaining a brokerage license means posting collateral, performing complex calculations to ensure solvency and scrupulously avoiding products that could lead to shortfalls. Currently, there are no such requirements in crypto.
- Curbing Conflicts of Interest – Many crypto firms play a wide variety of different roles in the market. This is particularly problematic when a firm fails to disclose that it has both a client-facing and a market-making business. The issue here goes beyond withholding information from clients – it also creates perverse incentives for employees, as we saw in the FTX debacle.
What’s the common thread? Beyond the overarching goals of investor protection and market stability, these are all brokerage regulations – yet the main reason they’re being so heavily discussed is the bad behavior of certain firms that refer to themselves as exchanges.
Real-Life Implications
This confusion has trickle-down effects that impact the entire industry. For regulations to be effective, there must be a clear understanding of who they apply to. In the Bahamas, for example, the DARE Act outlines various requirements for operating a crypto exchange – but the requirements themselves, most of them around staking and custody, clearly describe brokerage functions. A company that wants to employ a more traditional exchange model will have no idea how to comply.
The media has also fallen victim to this confusion – when FTX collapsed, the initial conversation revolved around the very survival of Bitcoin. It’s hard to imagine the collapse of a broker in any other asset class, no matter how prominent, triggering that kind of reaction. Above all, it adds complexity for anyone seeking to do business with the firms in question. From individual investors to venture capital firms, no one should have to do extra homework just to figure out what kind of entity they’re dealing with.
To be clear, we’re not advocating for one model over another. Some firms are brokers and some are exchanges; both are vital to a healthy market structure. But what absolutely cannot stand is the lack of clarity. As outlined above, this confused terminology has real-life implications. These issues, from the lack of effective regulation to the breathless media coverage, will not be solved until the fundamental problem is addressed.
This is an incredible opportunity to redefine crypto market structure, but it will require moving forward together as an industry. Speaking the same language would be a great place to start.
