How do you monitor a crypto exchange?

The author is a former financial supervisory officer

regulate or burn crypto? While the debate in the USA (and over the pixels of the Financial Times) is raging, it is already over in the EU - and will soon be in Great Britain.

The Financial Services and Markets Bill meanders through the parliament. It now contains a broad definition of crypto-assets that are subject to regulation. A consultation of the British Ministry of Finance will fill out the details shortly. And in the EU, the markets in Crypto Assets Regulation (Mica) were decided this summer, which will come into force by 2024.

With the aftershock of the collapse of the crypto exchange FTX, a new question focuses on: How do you monitor a crypto exchange?

mica admires strict standards for crypto-asset service providers that cover the stock exchanges. Exchange now needs a license from a country to get a passport in order to be able to do business throughout the EU. Two big changes are imminent.

first, corporate structure. The service providers must have a solid corporate management and control, a legal person in the EU and above all a corporate structure with legal systems that do not conflict with effective supervision. Failing FTX underlines the importance of these standards. But it is difficult to give the other stock exchanges good grades. The biggest, Binance, for example, will not yet say where he has its headquarters.

As Jon Cunliffe explains from the Bank of England, part of the problem is that it is not really "stock exchanges", but rather several bundled services that are separated in traditional finance for reasons of the conflict of interest, supervision and consumer protection.

mica seems to be unable to give such a bundling of several services in a single legal person. Some guidelines are required in detailed rules that are determined in advance of the implementation.

Secondly, Mica will impose rules to protect customer assets. The alleged use of customer assets by FTX to finance his trade arm means that the creditors are waiting to find out how much money they have lost. It is believed that these creditors could count at least 100,000 and be more than 1 million.

This has caused other stock exchanges to prove the validity of their reserve certificate, the assets that support customer positions, whereby Binance commissioned a report by the Mazars accounting company. However, the scope of the report is limited to the crypto assets he covered, it is not convincing how customer liabilities are calculated, and there are no comments on the effectiveness of internal controls. Mazars announced at the end of last week that it fully set the proof of reserve reports and that previous reports meticulously qualified as no assurance exercise.

The separation of customer assets was a big non-crypto problem when failing Lehman Brothers and the broker dealer MF Global. This led to a hard passage in Great Britain and elsewhere, with high fines, detailed new regulatory requirements and increased personal liability of managers. Strict rules that are tailored to crypto must quickly be developed and adopted.

The supervisory authorities will have to make some difficult decisions about the issuing of licenses if the stock exchanges are not ready for the new EU and British regulations in good time.

The stock exchanges will clearly have to make major changes to their business models before they submit their license applications. Mica has a number of other demanding requirements that must also be sorted quickly.

The stock exchanges must check the suitability of each crypto asset for customer trade based on the "reliability of the solutions used" used and the possible connection with financial crime. You also have to disclose the adverse environmental and climate-related effects of the mining that is required for every crypto asset. Liability for losses from the chopping of customer walls will occur. And stricter risk of crypto investments will come into force in both the EU and Great Britain.

The supervisory authorities themselves have tight deadlines to make license decisions under Mica. The risk is that the race for the crypto center of Europe will influence decisions-as well as the new British commandments for supervisory authorities, to take competitiveness into account.

Binance, by far the largest stock exchange, is the most important test case. The French supervisory authority, the authorité of the Marché Financier, raised the eyebrows by registering Binance according to the pre-mica rules, although Binance was occupied by Dutch supervisory authorities and the British Financial Conduct Authority with a fine, which said that it could not be supervised. What happens in the (new) licensing process?

Supervisory authorities need resources and political cover to refuse licenses until the problems of the corporate structure and customer assets are solved. The best way to monitor crypto exchanges? Start not licensing you until you have teamed up.