Crypto’s dream of decentralization is dying
It’s been a tough few months, legally speaking, for the world’s biggest crypto exchanges. FTX founder Sam Bankman-Fried has been indicted on multiple charges, including fraud, after his exchange imploded last November, taking billions in customer assets with it.
In February, the Securities and Exchange Commission sued Kraken for failing to register its so-called staking-as-a-service program. The exchange quickly agreed to stop offering the service and paid a $30 million fine to settle the charges.
In early March, Coinbase (which had just finished settling a lawsuit from New York regulators for $100 million) said that the SEC had sent it a Wells Notice, which is essentially a letter stating that an enforcement action may soon be coming down the pike.
And then on Monday, the Commodity Futures Trading Commission filed a massive lawsuit against the industry’s largest exchange, Binance, alleging a wide range of violations of U.S. commodity regulations.
The 74-page CFTC complaint paints a portrait of Binance as a company committed to evading regulation whenever possible. It alleges that Binance refuses to say where it’s headquartered in order to make it harder for regulators to claim it’s subject to their jurisdiction, and that Binance executives carried on some business communications via Signal in order to make it harder for those communications to be tracked.
More substantively, the CFTC alleges that Binance violated know-your-customer and money-laundering regulations, solicited American customers to trade on its platform even though it’s never registered in the U.S. as an exchange, and traded on its own platform via hundreds of accounts controlled by the company’s CEO, Changpeng Zhao. (In response, Binance called the complaint “disappointing,” and said it was based on an “incomplete recitation of facts.” It also said no employees actively trade on the platform.)
You might think that all of this news would be very bad for business. But the really striking thing is that it doesn’t seem to have made much of a difference.
To be sure, FTX’s blowup led to billions of dollars being pulled off the big exchanges. But since then, crypto prices have recovered and money has flowed back to those exchanges. And while the CFTC’s lawsuit against Binance in particular seems like a very big deal, its impact has been small: According to blockchain data tracker Nansen, the exchange has seen outflows of around $1.6 billion, which is less than 2% of assets.
What all of this showcases is the fundamental paradox of the crypto economy, namely that even though crypto was created as a tool for decentralized commerce and finance, almost all crypto trading takes place on big, centralized exchanges in which crypto investors place a surprising amount of blind faith.
The whole point of cryptocurrencies, supposedly, was that they worked without the need of an intermediary, allowing people to trade without the interference of governments or financial institutions. (That’s why crypto was often described as enabling “trustless commerce,” meaning that it allowed you to do transactions without trusting the other person.)
As an editorial from CoinDesk recently put it, crypto was designed with “the goal of empowering individuals to control their own fates in the digital era, separately from government and corporate structures.” And yet the vast majority of crypto transactions now take place on centralized exchanges like Binance, which are very much corporate structures.
In fact, crypto exchanges are more centralized than traditional financial institutions. After all, if you’re an investor who buys and sells stocks, you have a brokerage account at a place like Charles Schwab, which holds your assets and places your trades. But it doesn’t typically make markets in stocks or bonds, or run the exchange where the trades are made.
By contrast, centralized crypto exchanges are the custodians of your assets. They place your trades. They run the exchange where the trades take place. And, if you believe the CFTC (or look at what happened at FTX), in some cases they may even be on the other side of the trade you’re making. Calling these companies “exchanges” is, in fact, a misnomer. At the very least, they’re broker-dealer-exchanges all rolled into one.
This isn’t because of necessity. Crypto is set up so that you can hold your own digital currency yourself in a digital wallet, and make peer-to-peer trades with other users directly on what’s called a decentralized exchange, with trades recorded to the blockchain. This method offers more privacy (you don’t have to register your identity), lower transaction costs, and doesn’t require you to trust an exchange with your assets, since they’re always in your possession.
Yet far from embracing these decentralized systems, most crypto investors and traders have gravitated toward centralized exchanges. It’s easy to understand why. Centralized exchanges are much easier to use for crypto novices. They’re the only places where you can reliably exchange crypto for fiat currencies like dollars. And because they have so many more customers, it’s much easier to find a buyer or seller and get a reliable price.
The consequence of all this, though, is that if you’re a crypto investor, you have to put a tremendous amount of faith in these exchanges, assuming that they’re executing your trades at the best price, keeping your assets segregated from the company’s, and maintaining enough capital on hand—all despite being only lightly regulated. And as we saw with FTX, if it turns out they’re not doing those things, or if it simply turns out they’re bad at business and they end up going bankrupt, you have little recourse. Which, as we also saw with FTX, comes as a surprise to many customers.
What we’ve ended up with, then, is a peculiar status quo in crypto in which, just as in the traditional financial world, most investors have entrusted their assets to large corporate entities, but with a lot less regulation and ongoing supervision. Of course, Binance and its peers all insist that they’re doing business on the up and up and that they religiously protect customer assets. And that may very well be the case. But for the most part, you have to take their word for it.
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