First, let me say there are far more than three cryptocurrency market reforms we need.  These are simply the top three that come to mind in the wake of the FTX and Sam Bankman-Fried disaster.  

These proposed reforms are not groundbreaking or Earth-shattering either.  At least, they shouldn’t be.  They exist, after all, in some way, shape, or form in traditional finance. 

And they exist for a reason.

Before the crypto true believers go on a rampage about how we cannot turn the crypto markets into traditional finance markets, please look at the current cryptocurrency market structure.  So long as large exchanges like Binance, DeepCoin, and (previously) FTX play an intermediary role between investors and crypto liquidity, guess what?

Many of the same risks found in traditional finance exist in crypto.  

If the crypto market was truly decentralized, meaning no exchanges or third party intermediaries whatsoever, then my position would be completely different.  But so long as those players interface between buyers and sellers, and particularly in the service of retail investors, there are high inherent risks to the crypto market structure. 

Here are the three best ways, in my humble opinion, to mitigate those risks.  Let me know in the comments what you think.

Industry code of conduct

First and foremost, global regulators need to develop an industry code of conduct in collaboration with market participants.  The United States in particular needs to be less hostile (particularly Gary Gensler’s SEC) and more collaborative to the industry.  This will not only enhance the safety for investors putting money into this market, but will also give the industry clearer guidelines and rules of the road.  

Industry codes are common in many other areas of finance.  Foreign exchange has one, and it’s probably the closest corollary to cryptocurrency.  The U.S. Treasury market also has guidelines to inform market participants on best practices.

Would this code of conduct be enforceable?  Not necessarily.  So you might ask, “Well, why even do it?”

We need common principles for the market to adhere to.  That’s what foreign exchange realized about a decade ago when the largely unregulated global FX market was hit with one scandal after the next.  All of the industry players literally got in a room and hashed it out so it wouldn’t happen again.

Crypto influencers like CZ of Binance, Brian Armstrong of Coinbase, and Michael Saylor of MicroStrategy need to come together with smaller market participants and propose baseline rules of the road to a consortium of global regulators.  Regulators should provide feedback and ultimately, agreement on a standard code of conduct that could be incorporated into local regulations.  As in the foreign exchange market, it should be comprehensive, covering everything from how exchanges should behave to ICOs and crypto lending practices. 

It should also address issues like market conduct.  For example, CZ’s tweet that sent the price of FTT (the FTX native coin) plummeting should be viewed as reckless and prohibited conduct.  

As part of Binance’s exit from FTX equity last year, Binance received roughly $2.1 billion USD equivalent in cash (BUSD and FTT). Due to recent revelations that have came to light, we have decided to liquidate any remaining FTT on our books. 1/4

— CZ 🔶 Binance (@cz_binance) November 6, 2022

It’s one thing to offload your entire position in an asset.  Quite another to signal to the entire market on Twitter the imminent offloading of a materially sized position.  He could have sold it in pieces over time and then announced to the market what he did.  Instead, he took the reckless path and signaled what it was going to do.  It understandably incited what was effectively a bank run on FTT, and thereby FTX.

Market conduct like this demands an industry code.  If the crypto market wants to continue attracting more participants, if it wants to continue to grow and innovate, it must act in unison and agree on globally consistent standards of behavior.  This would give the crypto market a framework where it could thrive, while enhancing market integrity for investors.      

Prohibit exchanges and market makers from the same beneficial ownership

A key element of an industry code should be the prohibition on exchanges and market makers having the same beneficial ownership.  So the next Sam Bankman-Fried would be barred from owning Alameda Research (market maker) while simultaneously owning FTX (exchange).  Unless Alameda never traded on FTX, this structure is ripe with conflicts of interest.  It gives a market maker unfair advantages over other market participants.

The first big concern with this structure is information sharing.  Exchanges like FTX have visibility into every quote, order, and trade on the platform.  Unless there are significant controls in place to block this information from a market maker owned by the same person, it gives the market maker a significant and unfair advantage.  They could trade ahead of customer orders and take advantage of anticipated movements, and they could adjust their pricing to undercut competition (among other strategies).  

The same beneficial ownership also creates bad incentives for risky lending, particularly in the form of extending margin.  Although we still do not know the full details, it sounds like Alameda borrowed (or stole) money from FTX.  If Alameda was struggling or otherwise wanted to put on a large position it didn’t have liquidity for, FTX was incentivized to prop up its sister company.  Even if FTX didn’t have the liquidity to do so.   

The other main reason to prohibit this type of relationship is due to other forms of preferential treatment, especially as it relates to execution.  An exchange would be incentivized to give better execution to its own market maker given the common ownership than it would any other market maker trading on the platform.  Why anyone would even want to trade on an exchange that also owned a market maker always baffled me.  

It’s like a casino not only owning the slot machines, but also removing a few of your chips before you have the chance to cash out.  

Implement Customer Protection Rules

These are standard in the world of traditional finance.  All U.S. broker dealers must comply with them.  The rules are twofold:

1. Net Capital Rule: basically, broker dealers must have adequate liquid assets to pay liquidation expenses.
2. Safeguarding Assets: generally referred to as the Customer Protection Rule, broker dealers must safeguard the investment assets of their customers.  

I’ve heard multiple people say that fraud and embezzlement rules already exist and therefore, the cryptocurrency industry doesn’t need specific industry rules.  

The problem with that statement is that most jurisdictions define crimes like fraud and embezzlement very broadly with words like intent to deceive.  What does that mean in the context of cryptocurrency?  What does that mean in the context of FTX and Alameda?  It gives too much room for the Sam Bankman-Frieds of the world to debate and dance around with colorful rhetoric as they attempt to convince you of their innocence.

With specific rules focused on customer protection that put an onus on exchanges and anyone else custodying crypto assets, there are specific requirements that give customers greater confidence in the system.  The traditional finance world is certainly not perfect, but on the day-to-day it functions pretty miraculously if you consider the trillions of dollars worth of assets that exchange hands without issue.

Cryptocurrency market reforms could make for an even better financial system

Crypto could be an even better financial system than the current one, with improved technology and greater efficiency, but it needs to evolve.  It cannot rely on generic old world statutes and regulations.  It cannot exist in worlds where regulators don’t know or disagree on who regulates what.  There needs to be more certainty and confidence in the system.

With an industry code of conduct, prohibitions on certain trading relationships (e.g., exchanges and market makers), and stronger customer protection rules, the cryptocurrency markets would not only stabilize, but encourage more market participants to enter the arena.  

Nobody can do this alone, however.  Not Binance.  Not Coinbase.  Not El Salvador.  It requires participation from everyone.  Sure, some countries like China may be slower to get onboard, but a critical mass of market participants and regulators is all that is needed to improve the system.

And then maybe some will be convinced that limited and reasonable regulation can actually promote greater innovation instead of stifling it.