The digital-assets landscape often feels like a cowboy movie, with gunslinging brogrammers creating ways to transact magic-money tokens without the burdens of compliance. Freedom!
There’s a sheriff in Cryptotown, though.
On Thursday, October 1, two U.S. regulators filed joint charges against Hong Kong-based, Seychelles-domiciled bitcoin derivatives exchange BitMEX and its three founders.
This is a serious action with potential jailtime. It will reverberate throughout the digital-asset space, with winners and losers.
The most likely winners are those firms that have been taking the route towards regulation to service institutional investors.
This includes companies like BC Group, which has won a Type 7 license from the Hong Kong Securities and Futures Commission to operate a digital exchange for accredited investors; Diginex, a digital-assets financial services company that has just listed on Nasdaq in the U.S.; and derivatives exchanges like CME that provide bitcoin futures to institutions.
The charges against BitMEX also coincide with the U.S. Securities and Exchange Commission hinting it may loosen its opposition to a bitcoin ETF, which has long been seen by many in the crypto community as an important stamp of approval.
On October 3, SEC chair Jay Clayton was reported as having told a seminar that he was open to a tokenized ETF, that is, a tokenized stock representing an index.
U.S. regulators have struggled to encourage innovation in decentralized finance (DeFi) within the framework of existing legislation. The BitMEX charges could be interpreted as housecleaning in anticipation of the U.S. finding a way to accommodate DeFi without compromising principles of consumer protection and fighting money laundering and terrorist financing.
Or they could simply be a heavy crackdown with no greater motivation beyond upholding the law.
This will impact how the BitMEX affair ultimately impacts innovation and the possibility of DeFi. This is something that mainstream bankers should care about, because the opportunity to grow massive volumes in digital assets is at stake. Mainstream financial institutions will benefit from an explosion in assets to originate, structure and trade, but the innovation is not coming from banks. It’s coming from the cowboys.
BitMEX, for example, was an innovative company. Set up by Arthur Hayes, Ben Delo and Samuel Reed in 2014, it was the first bitcoin exchange to offer perpetual futures with massive leverage. Hayes, the CEO, told DigFin back in March 2017 that the company’s success came from online advertizing 100x leverage on bitcoin futures.
In that interview, he also said BitMEX avoided U.S. customers. The Commodities and Futures Trading Commission and the Department of Justice allege otherwise.
Fight for futures
Today other crypto derivative exchanges enjoy greater volumes, led by Binance Futures with $2.9 billion worth of turnover over 24 hours, according to data provider Skew. Huobi and OKEx also trade about $2.4 billion each, with BitMEX at $1.7 billion. CME, with a far less risky framework, has 24-hour turnover of under $700 million.
The diversification of the industry means if BitMEX goes down, there are plenty of alternatives – although the regulatory action surely means all of these exchanges operating without regulation are expelling customers with U.S. passports, if they have any.
BitMEX has said in a statement that “We strongly disagree with the U.S. government’s heavy-handed decision to bring these charges, and intend to defend the allegations vigorously.”
It has continued to trade and its team is trying to maintain a business-as-usual stance – but as of October 3 it had reportedly suffered an exodus of over BTC45,000 ($476 million), as investors sought to move their money elsewhere. Before the exodus it was believed to have about BTC190,000 under custody plus BTC36,000 in an insurance fund.
Also, its CTO is co-founder Samuel Reed, and he has been arrested in the U.S., which raises uncertainties if the platform hits any technical glitches during this sensitive time. Hayes, an American, and Delo, a Brit, remain at large. A fourth co-owner has also been charged, Greg Dwyer, the firm’s head of business development, marketing and sales.
The allegations against BitMEX are sobering. The CFTC’s focus is on consumer protection. It is unhappy that BitMEX has allegedly served U.S. clients without being registered to do so. The DoJ is accusing BitMEX of breaking the Banking Secrecy Act, which is designed to stop money laundering by the likes of drug lords, human traffickers, and terrorists. If found guilty, BitMEX’s principals could face time in a federal prison.
Set aside the hypocrisy of the U.S. government targeting crypto financiers with jail time when it has let mainstream global banks’ executives off the hook for the same alleged crimes. DoJ may yet agree to a financial settlement with BitMEX, similar to U.S. government deals with banks.
The crypto world is trying to build the rails of a new financial world. If it wants to win mainstream acceptance, the onus is on the crypto community to earn trust. This is the playbook for those firms seeking to handle institutional money.
This flies in the face of the DeFi movement, however, which is all about being “trustless”, that is, enabling the software to make decisions so no central company or agency can or should moderate transactions. There’s no need to trust a counterparty.
DeFi: heart of innovation
The cutting edge of innovation in digital assets today is with the DeFi world.
The biggest example is Uniswap, an open-source set of computer programs built on the Ethereum blockchain. It lets anyone with an Ethereum wallet to trade tokens, with no centralized organization involved. Traders can exchange Ethereum tokens and anyone can lend their tokens to the reserves that back these trustless exchanges (called liquidity pools).
These trustless protocols are also called Decentralized Exchanges, or DEXs, in contrast to the centralized exchanges that have dominated crypto, including BitMEX, Binance Futures, and Coinbase Pro (for spot). DEXs are coming into their own.
On October 1, just as the U.S. government was announcing its inditement against BitMEX, Uniswap recorded $398 million in 24-hour volumes, making it bigger than Coinbase. Uniswap and the other dozen largest DEXs together notched $24 billion in swaps over the past 30 days, according to Dune Analytics.
There is clearly growing interest among all kinds of people to trade on DEXs. The legitimate desire for privacy, however, is also being tainted by money laundering. It is not cool to help the Sinoloa cartel or child labor traffickers clean their money.
And it’s not good enough for DeFi adherents to simply say they’re a platform that isn’t responsible for worrying about such matters – if not from an ethical point of view, then from a legal one. Every DEX needs people to write software and manage the protocol, and every DEX generates profits from the trading.
If other unregulated exchanges simply take the view that BitMEX’s mistake was to be caught with U.S. customers, they are deluding themselves. The U.S., through its influence over ICANN, which issues website domain names, can block a site. Huobi is domiciled in Singapore, Binance and OKEx in Malta (a member of the European Union). These are places that might cooperate with a U.S. investigation.
Perhaps BitMEX thought domiciling itself in the Seychelles made it immune to the long arm of the U.S. law. But according to the DoJ, BitMEX was too cavalier in this regard: its indictment alleges Hayes chose the Seychelles because he could bribe its authorities for “just a coconut”.
L’affaire BitMEX shows that the creativity in the DeFi community needs to find a way to enable privacy without abetting money laundering. The U.S. government needs to reform its outdated laws and regulatory regime to give DeFi some breathing space – not because the world needs untrammelled DEXs but because the innovation in this industry is already shaping the future of finance.