Original Author: Jiang Changhao, Co-Founder and CTO of Cobo
Editor’s note: The South China Morning Post website today published an article by Jiang Changhao, co-founder and CTO of Cobo, discussing how the current centralized exchanges and trading customers can resolve the current trust challenges, and how Cobo plans to use technological innovation to help exchanges and trading Customers rebuild trust.
Hong Kong is legalizing retail participation in cryptocurrency trading at a time when the FTX scandal has shaken investor confidence, underscoring the need for industry regulation.
One of the steps that needs to be taken is to segregate funds and transactions, and this is where technology can help centralized exchanges create transparency and rebuild trust.
Recently, Hong Kong’s cryptocurrency regulatory system has turned friendly, even good enough to legalize retail trading of encrypted assets. The move reignited enthusiasm among market participants. However, with the crypto industry still reeling from the FTX debacle, how to implement strong regulation of cryptocurrency exchanges has become an urgent challenge to be resolved.
Strengthening licensing requirements for exchanges, implementing compliance and regulation, is clearly a top priority. Beyond that, 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 to be a disaster for the crypto industry"Lehman Brothers"time. Indeed, the collapse of FTX, which was once a model in the encryption industry, also had a profound impact. Whats more, the markets confidence in centralized exchanges has been severely shaken and may take years to rebuild. Investors withdrew more than $8 billion from centralized exchanges in the seven days following the FTX incident, according to on-chain analytics firm CryptoQuant.
Even so, since centralized exchanges still account for about 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 debacle, with discussions centered on three possibilities for how the industry can move forward.
1. Implement the licensing system from top to bottom, with regulatory agencies implementing compliance and supervision.Many advocate that cryptocurrency exchanges should be regulated to the same standards as other traditional exchanges. Such calls seem reasonable and consistent with the current policy of Hong Kong regulators. However, developing and implementing a rigorous and practical regulatory framework will take time, especially since cryptocurrencies are a completely new industry for regulators.
Two, switch to using a decentralized exchange (DEX).DEX does have a strong advantage in reducing the moral hazard within the exchange, 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 has indeed shown an upward trend, but this by no means means that there will be structural changes in the short term. While we are optimistic that DEXs will take a larger share in the long run, given their ease of use and high liquidity, centralized exchanges may still hold the upper hand for the foreseeable future.
3. Transactions and funds are separated.A more realistic and feasible approach is to redefine the roles of different actors in the transaction ecosystem, and achieve the isolation of transactions and funds through technological innovation.
The biggest problem exposed by the collapse of FTX is that customers’ funds are stored in the exchange, and due to the weak supervision, the funds may be misappropriated by the exchange at will.
The separation of trading, clearing and settlement functions is a longstanding pattern in traditional finance. This model eliminates or minimizes conflicts of interest, helps build trust among market participants, and contributes to the overall integrity of the financial system.
However, in the cryptocurrency industry, these functions have been integrated by centralized exchanges from the beginning. Many market participants are aware of the associated risks and have called for the involvement of independent intermediaries, particularly third-party custodians and prime brokers outside exchanges.
While such calls have long been made, no middleman has been successful in undermining exchanges. This is about to change. With increasing market pressure, exchanges are now more willing to accept this new model.
Technically, the separation of trades and funds could be self-enforced by the centralized exchanges themselves. Exchanges can allow customers to hold funds in segregated wallets while trading on the platform. However, since the custody function is ultimately still controlled by the exchange, it is impossible to fundamentally eliminate the risk of customer funds being misappropriated.
A better approach would be for a neutral third party to hold client funds and facilitate transactions, which would mitigate counterparty risk for both parties. This role could be assumed by a traditional financial institution or a cryptocurrency custody provider to ensure a true separation of responsibilities that should never have been mixed in the first place.
Now is a good time for regulators to step in and encourage, or even enforce, technology to separate transactions from money. In fact, technological innovations in this field began to appear as early as 2019, such asCobos off-exchange custody and settlement network SuperLoop(formerly Loop),Allows trading teams to trade while maintaining independent custody of funds.
For example, trading teams can leverage MPC custody solutions to co-manage their funds with an independent custody platform and trade those funds on cryptocurrency exchanges integrated with the settlement network operated by the custody platform. First, the trading team deposits funds into the escrow platform; next, the escrow platform locks these funds (executed only before the transaction) and maps the funds to the exchange at a ratio of 1:1; then, the trading team can proceed as usual Transaction, after the transaction is completed, it will be settled through the escrow platform.
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