How should Nigeria regulate crypto-exchanges?

As we've established before, the first step in regulating cryptocurrency is understanding how it can be defined. Historically, we’ve seen that cryptocurrencies are mostly speculative assets, sometimes intended to be currencies. That is, the creators of the currencies issue the tokens or coins out with the intention of it being used as a medium of exchange. However, this new invention also has a use case as a speculative asset. This distinction is critical because it informs who is responsible for controlling it. 

In many cases, crypto is both a currency and a regulation. If we accept crypto as both a currency and a security, then it would make sense that both the central bank and the securities and exchange regulator would care about how the space develops. 

But even after defining what cryptocurrency is, we need to think of what aspect of cryptocurrency should be regulated. Should we regulate the platforms people trade on, or how people use it as a medium of exchange? 

Given the decentralised nature of cryptocurrency, and the anonymity of transactions on the distributed ledger; one way regulators might attempt to protect investors in crypto is by regulating semi-anonymous channels for trading crypto such as exchanges. For example, when the Central Bank of Nigeria (CBN) prohibited banks from allowing crypto transactions, the main crypto player that was affected was exchanges. 

In simple terms, regulations will need to provide a clear stance on how such platforms can interact with investors such that the risks of trading through such platforms are significantly reduced. This does not necessarily reduce the volatility of crypto, but it reduces exchange-related risks and increases the information given to the investors such that they protect themselves. 

Although many countries have crypto regulations, enforcement (especially for large incumbents) has not been straightforward. For instance, the UK's FCA attempted to take on one of the big crypto exchanges, Binance. Yet, after asking a series of questions—like where the Binance headquarters is incorporated, the FCA admitted that it couldn't regulate the body and censored Binance in the UK. Now, given that the FCA regulates one of the largest financial markets in the world, it is one of the largest and most powerful regulators in the world. If the FCA is struggling to enforce its regulation, smaller regulators like the Nigerian SEC—which control smaller financial markets or oversee fewer investors, might not be able to. 

However, what does regulation (and regulatory enforcement) look like for exchanges?

To go into the business of regulating exchanges, one way to start is to look at its operations:

Omni-functional crypto exchanges

My first interaction with crypto was through an exchange and no doubt this is applicable for many of us. Through this exchange, I deposited fiat currency and bought some Bitcoin utilising the simplicity of a peer-to-peer system. Taking into consideration the truth that many of us are indeed limited in our crypto knowledge, making use of a random 100- digit alpha numeric key that comes with trading directly on the blockchain seems impractical at first instance. 

Cryptocurrency exchanges perform multiple functions: they act as custodians, brokers and exchanges. They also facilitate initial coin offerings and sometimes issue their tokens or coins. 

Let's take these functions one after the other. 

The first role of the crypto exchange is, as the name implies, to exchange one currency for another. Someone wants Bitcoin but has Naira; the exchange swaps it for them.

Another role of crypto exchanges is as custodians. As the name implies, custodians keep assets in their custody on behalf of the owners. In traditional finance, when institutional partners like pension funds, hedge funds and family offices invest in significant investments, they hand them over to a custodian for safekeeping. 

The custodian then stores these assets electronically or physically and charges the investor a fee for safekeeping. Likewise, the custodians safeguard wallet keys and other sensitive information for investors. They became relevant when institutional investors became more interested in cryptocurrencies. 

But custodians don't only store assets; they also harness their market expertise to minimise the risk of fraud, theft or loss of those assets. Although custodians help the people with settlement in traditional finance, there's no need to do this with crypto because the distributed ledger technology does this itself. 

Crypto exchanges act as custodians in that they help people, like me, who are prone to losing their wallet keys to keep our assets. One of the advantages of storing your assets on exchanges is that the transaction cost for storing the assets is low because several other people are doing the same thing. So investors (like you and me) end up paying just a tiny fraction of the value of our assets as transaction fees. However, there are three risks that investors might face using exchanges as their custodians: theft, commingling and counterparty risk. 

When crypto exchanges act as custodians, their primary responsibility is to safeguard the investors' assets. There's a problem when the assets in the exchange's custody are still stolen or hacked. Crypto hacks have become a little too familiar. In 2021 alone, about $14 billion worth of crypto was stolen by scammers, which makes us wonder if they are indeed equipped to safeguard investor funds. 

With traditional investments, custodians are equipped to store their investor money and employ insurance solutions. Some crypto exchanges insure the first $250,000 of each investor's money, just like banks, but that may not cover a significant portion of the investor's funds. This explains why institutional investors would rather store their crypto investments with third-party consultants than on exchanges. The value of cryptocurrencies stored in third-party custodians increased by $300 billion from 2020 to 2021. 

With crypto exchanges, an investor is given an IOU—an informal issuance of debt in exchange for their funds put in the crypto exchange, so if the exchange folds up and people lose money, nothing can be done to recover the investor's funds.

For instance, although Binance touted TerraUSD as a safe asset after the collapse led to investors on the platform losing over a billion, there was no repercussion for Binance. 

Another risk that investors might face is when an investment fund or custodian merges several investor funds to invest in one asset. Now, commingling is good for investors because it reduces the cost of trading, and they enjoy the benefits of trading together as one large block.

However, commingling can also be illegal, especially when the investment advisors do not inform the investor that their funds are being commingled. This sometimes happens on crypto exchanges where all investors' funds are put together and used to invest. When investors give crypto exchanges their funds, they're usually placed in a large pool or shared account used to trade in crypto. This typically exposes all investors (regardless of their risk appetite) to the volatility of whatever crypto is being invested in. If the investment does not yield desired results, they may lose their money. 

Also, some exchanges sometimes misuse people's funds in ponzi schemes. For example, BitConnect claimed to lend people money but only ended up being a ponzi scheme. Then there's counterparty risk, where one party may not hold up its end of the agreement for different reasons if an exchange claims it's using investor funds to trade in crypto when it is, in fact, not doing that.

Some crypto exchanges also act as brokers, trading on behalf of their investors. That is, they help people buy and sell securities. A broker holds your existing securities as collateral while buying other securities on your behalf. So allows you to benefit from the fluctuations of another asset without necessarily losing yours. 

Although many exchanges stick to just storing or trading assets on behalf of their investors, others go as far as brokering. 

Crypto exchanges also issue coins through a process known as the Initial Exchange Offering (IEO). The IEO, which is similar to an IPO, is when companies raise funds for a project or launch a token through an exchange. It is different from an initial coin offering (ICO) in that ICOs are usually conducted by the companies attempting to fundraise.   

There are also situations where crypto exchanges launch their token or cryptocurrency. For example, Binance launched its coin, the BNB, in 2017, in which it raised $15 million in bitcoin and ethereum. The BNB raise was used to upgrade the Binance network and conduct branding and marketing. 

Crypto exchanges currently perform several functions that are separated in traditional finance. They act as custodians, brokers, exchanges and issuing new coins, which is quite ironic because there seems to be a centralisation of decentralised finance functions or activities. This is bound to give them a bit too much power and information, at the detriment of the investors—which is one of the reasons why regulation is needed. 

With regulation in place, crypto exchanges are bound by law to ensure that custodians have enough ammunition to safeguard people’s investments. This involves conducting thorough background checks on the kinds of crypto assets they publish on their platforms to reduce the risk of fraud and losses. It also ensures that they have enough protection for their investors when acting as custodians. 

Standing on existing protocol

Now that we know how cryptocurrency exchanges work. One way to decide how they may be regulated is by comparing the crypto exchange functions with traditional investment functions and applying the same kind of regulation to them. 

Due to the complexity of the different roles, several countries' Security and Exchange commissions tend to regulate them separately. That is, breaking down the functions of the exchanges and setting up regulation for each of these functions.  The custodians, brokers and markets (or exchanges) in traditional finance all have different regulations through which they're controlled. 

So, regulating crypto exchanges through this lens means that the regulators would use existing rules. For example, in the UK, the Financial Conduct Authority (FCA) states that custodians must put in an adequate arrangement to prevent investors from losing their funds, even if the custodian becomes insolvent. With regulations like these, it is expected that the FCA would ensure that the custodians indeed have the required security to safeguard investors' funds and investors' funds are safe when custodians become insolvent. Therefore, the custodians may be subject to regular checks and audits. In the US, the Securities and Exchange Commission (SEC) requires that custodians maintain a separate bank account for their investors and seek permission before using their funds for anything other than the intended purpose of the investor. Again, to enforce this, the SEC would have to undergo several checks and audits to ensure they stick to the rules. 

Similarly, if crypto exchanges were to be regulated using existing custodian regulations, they would be subjected to regulatory audits to ensure they're using investor funds as required. If they're not, they would be penalised. This is precisely the US SEC's stance on crypto exchanges. In a statement by the former chairman of the SEC, Jay Clayton, he said,"I also caution those who operate systems and platforms that effect or facilitate transactions in these products that they may be operating unregistered exchanges or broker-dealers that are in violation of the Securities Exchange Act of 1934." 

Apart from the regulations for crypto exchange as a security trader-custodian-exchange-broker, another traditional law that countries have adopted is the regulation governing banks and financial institutions that deal with money. 

Remember we had said that the jury is still out on whether crypto is a currency or security. If it's a security, then the functions above apply; if it's a currency, however, exchanges then have to incorporate laws on the use of money like anti-money laundering laws (AML). Some countries have made provisions for this in their regulatory toolbox. For example, in the US, crypto exchanges are governed by the Bank Secrecy Act (BSA), which prevents financial organisations from using money laundering vehicles. The BSA Act ensures that financial institutions enforce anti-money laundering laws (AML) and prevent it from happening. If these exchanges fail to comply with the regulation, they could face financial penalties. 

Many other countries like Australia, Japan and the UK have also gone the AML regulation route. In some cases, regulators don't only stop at the AML route but take it a step further, ensuring that exchanges verify the identity of their customers and share the customer information with the regulators. This form of regulation doesn't just guarantee that investors' monies are safe but that the anonymity that comes with trading crypto is not detrimental to the country. This is a genuine concern for governments because it is reported that over $8 billion was laundered in 2021 through cryptocurrency. Therefore, requesting that exchanges comply with AML laws would be used to prevent or reduce the occurrence of money laundering through crypto. 

Doesn't this defeat the purpose of the anonymity that comes with crypto? Yes, it does, and as I highlighted earlier, regulators have struggled with compliance in the past. On the one hand, it isn't easy to regulate something that is not precisely domiciled in a physical place and can be moved easily across borders, so countries would have to create regulations that provide these complexities.

Some countries have attempted to create entirely new policies—still very similar to existing traditional policies, to govern the crypto space, especially for exchanges. Like in Nigeria, the SEC's guidelines on digital assets highlight the requirement for registration, unlike other licences for traditional investment players. 

Although many crypto stakeholders have been calling for regulation, they need to understand that it's not enough to regulate cryptocurrency but to enforce the registration. For exchanges, crypto regulation might look like unbundling their existing processes and applying the rules to existing investment stakeholders will protect investors and make the sector less volatile.