Following the collapse of fabled cryptocurrency exchange FTX, and subsequent arrest of its founder and former CEO Sam Bankman-Fried, shockwaves continue to echo through the crypto industry as the true extent of what has been described as ‘one of the biggest financial frauds in US history’ continues to unfurl.
In the cold light of day, warning signs of the exchange’s demise could have easily been identified as the convergence of an over-hyped product, with little to no due diligence, started trading in ‘assets’ with no underlying fundamental value on a pseudo-regulated exchange. In the analysis that followed, aside from the negative impact on cryptocurrency investor confidence, a sheer lack of regulation within the sector emerged as a stark reminder as to why shortcutting oversight, due diligence, and a general lack of understanding of investment products will never amount to anything good.
No matter how hyped or attractive.
As accurately summarised by the ‘Financial Times’, “Technology that not many understand can also allow for obfuscation, for style over substance, and for a fear of missing out to grip even seasoned investors (including Rupert Murdoch and Larry Ellison). Combined with an era of low interest rates and easy money — now well and truly over — it is the ideal habitat for swindlers.”
DGCX’s rock-solid track-record
This month, I contrast the establishment and development of the Dubai Gold & Commodities Exchange (DGCX) with FTX’s meteoric rise and fall and discuss the future of financial exchanges and how investor confidence in crypto can be restored.
Established in November 2005, DGCX launched under the Dubai Multi Commodities Centre (DMCC) as the MENA region’s first electronic, regulated derivatives exchange. Establishing a new pricing benchmark for gold in the UAE - namely through the one kilobar gold futures contract - the exchange followed up with the world’s first offshore Indian Rupee Futures contract, a product that has grown from strength-to-strength to become its top performer in terms of volume.
Unlike FTX’s products, DGCX aimed at meeting investor demand through practical, proven products that were relevant to the region’s market and growth – a formula which became the basis for its future products such as the MENA region’s first Copper Futures contract in 2012, and the region’s first WTI and Brent Oil Futures contracts thereafter.
Additionally, DGCX’s strategic location and trading hours of 07:00am – 11:55pm (GMT+4) provide a vital position in the global derivatives landscape, connecting Asia and Europe with US trading hours.
Expanding gold-linked products
Working in tandem with the UAE’s national agenda, DGCX also innovated new products based on the socio-economic conditions of the market, perhaps most notably through the launch of its Israeli Shekel Futures on June 17, 2022. Not only a top performing emerging markets currency since the impact of the pandemic, the product also supported the enhanced cooperation and business between Israel and the UAE, forged through the signing of the Abraham Accords in 2020.
Further products to launch in the past six months include new physical gold futures and spot gold contracts, which will provide traders and financial institutions the option to use physical gold as collateral to access affordable sources of short-term lending, while its partnerships with Sam Precious Metals and FinMet will again provide bourse members with access to an ever growing range of high-quality products.
FTX’s non-business model
Conversely, FTX’s business and product development remained heavily weighted in the unregulated waters of crypto, NFTs, and allegedly unregistered securities; resulting in a highly volatile portfolio, where even the bookkeeping was managed by small-business accounting tool QuickBooks, despite its one-time $32 billion valuation.
And this all before SBF’s alleged use of customer money to make philanthropic donations, property investments and prop up FTX’s partner firms, Alameda Research’s trading activity.
While technically correct, to call FTX an exchange is really a misnomer. Unlike bourses such as DGCX, NYSE or NASDAQ, cryptocurrency exchanges, particularly those in offshore jurisdictions are not required to adhere to the same levels of regulation as their long-standing counterparts.
As stated by Joe Rennison in the New York Times, “The implosion of FTX shows just how different crypto exchanges are from their more well-known, and highly regulated, counterparts. They don’t have to disclose how customer money is handled, either to investors or to a regulatory body. Internal financial controls can be scant.
“The absence of oversight contributed to what prosecutors said was a years-long, widespread fraud at FTX, once the crypto world’s second largest exchange. By contrast, LedgerX, a crypto derivatives exchange owned by FTX, was based in the United States, and was more strictly regulated. It is still standing.”
Commenting on how customer funds are afforded greater protections on a regulated exchange, Michael Blaugrund, COO of the NYSE summarised, “Investor protections, such as the segregation of roles between trading venues, market makers and asset custodians, are a hallmark of regulated exchanges like the NYSE.”
Clear regulatory controls
Regulated by the Securities and Commodities Authority (UAE) of the UAE, a member of the International Organization of Securities Commissions (IOSCO), DGCX is not only a highly regulated exchange, but further enhanced by its wholly owned clearing house, the Dubai Commodities Clearing Corporation (DCCC), which recently received its renewed recognition as a Third Country CCP (TC-CCP) by the European Securities and Markets Authority (ESMA).
Not only a reflection of DCCC’s commitment to international regulatory standards, and alignment with stringent risk management and governance frameworks, the facility also enables all European banks to clear trades settled through DCCC without incurring additional capital requirements as imposed by EU regulations.
While many have seen the collapse of FTX as a significant setback to the crypto and blockchain movement, I believe it should serve as a reminder that regulation and oversight are necessary constants in any financial ecosystem. The truth is that FTX was just a centralised, unregulated entity that traded primarily in cryptocurrencies under a highly inexperienced, poorly administered management.
Whether their motives were naïvely rooted in effective altruism, of which an estimated $40 million was pumped into ‘campaign committees and other groups, mostly aligned with Democrats’, or as part of a carefully calculated fraud, the failure of the system should only encourage exchanges to carefully evaluate their decisions to move towards regulated, decentralised models.
In the same way that centralised power has already shown its signs of misuse and abuse, particularly through the censorship leveraged by the big tech giants in either influencing the flow of information or closing the accounts of people who don’t share their social or political narratives, the same has also been exhibited in a financial context.
Overreach on controls?
When governments are unable to adequately regulate or protect their national currencies from failure, often to the detriment of their population, as seen in countries ranging from Argentina to Zimbabwe, through to gross overreaches of power, such as Justin Trudeau’s government freezing ‘accounts connected to people whom police say have been involved in illegal protests’, the risk posed by centralised control is ultimately systemic and cannot be ignored.
While carefully regulated, centralised exchanges have shown to be effective under the right governance, the only true route to independent, financial freedom is to ensure a community-led approach that hedges against the risk of malevolent leadership and or authoritarianism.
Dennis Jarvis, CEO at Bitcoin.com commented, “I don’t think it’s productive for me to make predictions about the regulatory approach the US will ultimately take – whether it will be heavy-handed, or passive, or what it will be. But what I do think happens is that centralized crypto exchanges like FTX, BlockFi, and Celsius will be regulated differently from decentralized networks like Bitcoin or decentralized applications like Uniswap or Aave.
“A lot of regulation is about forcing disclosures and getting transparency for investors — and that’s a good thing. The transparency that’s baked into decentralized protocols makes them inherently less in need of regulation. On top of that, I think government agencies will eventually realize that it’s not actually possible to regulate decentralized protocols in the same way as centralized entities.
“If this summer’s LUNA coin/Celsius contagion didn’t already convince investors, then the FTX implosion should make it clear to everyone in crypto now that centralized entities need to be regulated. Everything that’s happening outside of crypto makes me certain about the long-term prospects for Bitcoin, DeFi, and crypto assets that embody crypto’s value propositions.”
Blockchain as enabler
Certainly, the idea of utilising blockchain technology to facilitate trust-less delivery versus payment settlement without any intermediary isn’t a new one. Acknowledged as a more efficient way to manage settlements by decreasing the associated transaction costs and involved risks, it wasn’t until August 2022 that the main clearinghouse for the US stock market switched on a settlement system built on blockchain.
Known as ‘Project Ion’, the Depository Trust & Clearing Corp said that its ‘platform is now processing around 100,000 bilateral equity transactions a day in parallel with its existing settlement systems, which remain the authoritative record. At peak level, the platform can reach about 10 per cent of the bilateral equity volumes handled by the firm’s classic settlement systems’.
While no formal timeline has been stated, it is expected that the Project Ion platform will eventually replace the current system, however, the decision will depend on its performance, client feedback and regulatory approval.
Where DGCX is concerned, it will continue to carefully research and evaluate new products and partnerships that add value to its members and the markets while remaining as risk averse as possible. In partnering with Nasdaq Technology AB, it will soon benefit from a full suite of integrated marketplace solutions, including multi-asset trading and real-time clearing capability, pre-trade risk management, as well as market intelligence, market surveillance and quality assurance applications required to safeguard the integrity of the market.
A Nasdaq alliance
While still pending regulatory approval, the planned migration will be to Nasdaq’s NFF system and take place in Q2-2023.
Beyond this, the exchange achieved 16 per cent y-o-y growth in 2022, with 8.2 million lots traded amounting to $162 billion in notational dollar value.
Ultimately, it’s important to remember that the role of an exchange is to facilitate trade safely and securely and while the temptation to move quickly in line with the pace of technology to make a quick buck will only likely increase.
All the more reason for exchanges and regulators to double down on evaluating and understanding new products and systems until such a time when we are better able to regulate our exchanges as a decentralized community.