Europe Fintech

Crypto Trading and the Need for Regulated Exchanges

Hedge funds and retail investors are entering the crypto space with high expectations –  but not everyone can manage the risks of crypto trading. Yuval Reisman, CEO and cofounder, YRD Capital believes that regulating exchanges will help to support transparency and protect investors while offering greater legitimacy to a new asset class. 

Yuval Reisman

Cryptocurrency is a digital asset class that has been around for over a decade, but for most people, its purpose is still something they find difficult to conceptualise – and even more challenging to accept as a viable investment opportunity with potentially attractive returns.

Reservations surrounding this digital asset are justifiable, and much of the problem lies in the lack of regulation around the crypto trade exchanges.  This exposes retail investors to high levels of risk, with very little protection – and in many cases, they don’t even realise the full extent of their vulnerability.

There’s talk about the industry self-regulating exchanges, but that would be a mistake since there’s so much variation in the way in which exchanges manage their activities and very little common ground to start from.

Some exchanges have hidden dangers and carry a much higher risk of being scammed or hacked than other rivals or even conventional financial markets. How the exchanges address the challenges of the risks also varies – as well the response.

Some behave honourably during crises, such as the case involving Binance, one of the world biggest Spot exchange, which was hacked on May 2019, leading to 40 million USD value assets stolen. In response, Binance gave a full refund, an action that not only acknowledged accountability and responsibility but also created a lot of trust among investors and the community. Yet, perhaps with with regulation in place, perhaps the regulator could have monitored  the level of cyber security Binance uses and prevent the hack.

Another interesting response is the example of Deribit, the world biggest Options exchange on March 12th this year, now known as Black Thursday. This is the day when the value of Bitcoin crashed by 50%, and the exchange nearly lost its Insurance Fund. To avoid its demise, Deribit decided to inject 500 BTC from its investors to maintain it. They were fully transparent in their actions and the market responded well to this approach. However, perhaps with regulation in place, Deribit Insurance would have been more solid, and such a dramatic involvement by the exchange’s investors would not have been required.

Yet for every Binance and Deribit, there are many other exchanges that don’t follow these relatively high standards and fail to mitigate risk, and losses or lack of trust effectively. This sets our industry back unnecessarily and makes it harder to win confidence amongst the retail investors that ultimately bear the brunt of the risk.

A good example is BitMEX and its lack of transparency around its Insurance Fund.  During Black Thursday,  BitMEX suffered a massive distributed denial-of-service (DDoS) cyber attack – which rendered its exchange unavailable. Instead of being upfront of what had happened the blame was initially placed on a hardware issue. During the attack, trades on the platform wereimpossible—and panic and anger ensued. Being upfront would have instilled greater trust in the firm that they understood the problem and had acted swiftly to address it.  BitMEX is one of the world leading Deriviatives Exchanges, with billions of dollars of daily volume.

But these actions happen too often to ignore, and regulators should be given greater authority to reign in the exchanges.

In the UK, they currently have to register with the Financial Conduct Authority (FCA), and must comply with the Money Laundering, Terrorist Financing and Transfer of Funds (Information on the Payer) Regulations 2017 (MLRs). However, the FCA doesn’t consider cryptocurrencies themselves regulated assets, which, exposes investors to a lot of risk.

The UK economic secretary to the Treasury & City Minister, John Glen, recently urged for more protections around the promotion of crypto assets, “while continuing to ensure people have access to a wide range of products on the market.” Giving the FCA the mandate to regulate digital assets, this would be the most efficient way of offering an acceptable degree of protection for ordinary investors.

HM Treasury agrees. The lack of regulation around cryptocurrencies and relevant financial products are leaving investors exposed to many risks without any of the protections usually afforded to retail investors, such as access to compensation.

All of this is true, but trading can’t just come to a halt.

Digital assets are here to stay, and people will still want to invest, so until regulation is put in place,  the industry should do more to educate people about the opportunities that are possible in this space, especially with a product that can reduce  risk, while allowing exposure to these appealing returns, like a fund of funds (FoF) approach, where professional investors with expertise in the asset class chose the best-of-breed funds. This is a pooled investment fund that invests in different types of crypto funds bycreating a diversified pool which mitigates the risk associated.  This is a high returns, yet, high risk environment.

A  growing number of hedge funds are exploring the potential of digital assets through this type of investment vehicle, and some are outperforming conventional capital market hedge funds. According to a report published by KPMG, during 2019 AuM of digital assets funds doubled in growth.

The new digital asset class has created a once in a decade opportunity for young hedge fund managers to set up their own quantitative funds for digital assets, which the new money transfer recipients and family offices can invest in. As the return on investment can be immense from early on, it would help these new fund manager to overcome the heavy ongoing costs related to setting up a structure fund. These costs kept the hedge fund industry as a close club over the last decades. But with potentially high returns early on, the fund can overcome this barrier. And so, we see a flow of top talent, leaving the leading proprietary shops of the world. With teams made out of PhD graduates, leaving funds like Jane Street, Jump Trading or Braven Howard, to set their own sops.

This is worth taking a look at, but the risks will still remain high unless regulation is put in place.  Hopefully, this will come soon – and more investors will have the chance to enjoy the opportunity that digital currencies can bring.

Author

  • Gina is a FinTech journalist (BA, MA) who works across broadcast and print. She has written for most national newspapers and started her career in BBC local radio.

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