By Itai Avneri, Deputy CEO of INX
Progress is never made in a straight line. We take wrong turns and big dips before we arrive at our ultimate destination. If I’ve learned anything in the decades I’ve spent on the innovation highway – a journey that witnessed the birth of biotechnology, genomics, personal computing, the Internet, the smartphone and commercial space travel – it’s that the road to successful economic dominance must include disruption and then evolution, winners and losers, pain and joy along the way. Google would not exist without companies like Netscape and AOL; the iPhone without Nokia and Blackberry; Amazon without Sears.
As we continue our journey into the Web3 era and the fourth Industrial Revolution, we are at a pivotal moment. The facts are clear. Cryptocurrencies, and especially the tokenisation of securities, are a natural continuation of society’s transition from physical to digital, from the days of stock and bond certificates to electronic delivery, global settlement, Digital bond and CBDC. The Blockchain, and all that comes with it, represents a seismic shift in markets that will drive down transaction costs and create a tidal wave of innovation in finance. These innovations will benefit issuers and investors in the US and globally. The potential of the tokenised assets industry, as shown in the latest BCG report, will grow 50X and worth $16 trillion (£13.5tn) by 2030. However, to secure those benefits, we must minimise the potential for accidents along the way and weed out illegitimate industry players that only hurt progress instead of promoting it.
Darwinism in the Digital Economy
We’re already seeing patterns of growing pains and attrition with most of the early cryptocurrency companies under scrutiny for skirting regulation and displaying reckless disregard for laws designed to safeguard the public. The early mistakes and shortcuts some digital asset exchanges have made are coming home to roost. Recently, there have been high-profile cases of insider trading at cryptocurrency exchanges, listing of security token on a regular crypto exchange and operators halting customers withdrawals and going bankrupt almost overnight. In fact, the CFTC’s annual enforcement results revealed that more than a fifth of enforcement actions taken by the federal regulator in 2022 involved crypto.
However, nothing has shaken the industry to its core like the downfall of FTX, the second largest crypto exchange in the world. After mishandling the funds of millions of its investors, the company (and its infamous leader) has now vanished into thin air. Some in the industry have compared the FTX bankruptcy to and “Enron” or “Lehman” moment, but the unfortunate truth is that because of its irresponsible (at best) or illegal (at worst) activities, combined with a lack of regulatory guardrails in place to protect investors from such activities, the company’s reckless disregard for its investors’ wellbeing will have devastating implications for some time. The ripple effect from this event is yet to be completely unveiled and understood. There are likely more companies and startups that will collapse and go into distress mode, thousands of people may lose their jobs - even the luxury housing market could drop in some areas.
Survival of the Fittest: Must-Haves for Investing in Digital Assets
As the media coverage continues to focus on crypto’s “bad eggs,” the companies and exchanges that decided to go about things differently - the right way - are well-positioned to survive and thrive. So much is at stake when it comes to protecting personal wealth and the health and long-term vitality of the digital economy. Transparency, regulation and security are non-negotiables for today’s digital asset exchanges. Without these three critical “must-haves,” investors should not only think twice, but run the other way:
#1 Proper and comprehensive regulation
Many crypto exchanges and participants have played hide and seek with regulators under the guise of “decentralisation.” During the crypto upswing, these crypto companies raised bundles of cash by taking short cuts and making false promises when no one was watching. In the meantime, a small but forward-thinking few chose to put in the hard work alongside regulators - securing transfer agent, broker-dealer and ATS licenses under the SEC and FINRA. I would be remiss if I didn’t highlight the work INX put in to become the first digital asset exchange that’s fully regulated by the SEC.
Not only has this work paid off with clear regulation to help protect the investors, it provides clear “rules of engagement” for the exchanges themselves. That’s because in order to obtain these licenses, an exchange must meet a number of requirements - and that’s a good thing for everyone.
For example, exchanges worth their salt must have adequate security measures in place to prevent fraud and protect investors. They must also have a fair and transparent process for listing new coins or tokens. Obtaining these licenses is no easy feat, but it's essential for any exchange that wants to operate in the US. By having these licenses, an exchange can provide its users with peace of mind knowing that it is following all applicable laws and regulations.
#2 – Full transparency of financials and proof of cash reserve funds
One of the most important factors that contributes to the survival, and ultimately the success, of a crypto exchange is whether or not it’s transparent about its financials - especially its financial obligations. Without adequate liquidity, an exchange is at risk of insolvency and loss of trust from customers. Maintaining a strong liquidity position is critical for any crypto exchange. A healthy balance sheet that matches customers' investments 1:1 in each and every currency gives the exchange a cushion against volatility and enhances confidence among customers and counterparties - customer balances should match the total amount invested by each customer - period.
If the value of assets on the exchange falls sharply, the reserve fund can be used to cover losses for a number of reasons as a backup plan in extraordinary circumstances. Secondly, it enhances trust in the exchange. Institutions and retail customers are more likely to do business with an exchange that they believe has a strong liquidity position. Finally, investors must make sure that the exchange’s cash fund is completely segregated from all other aspects of its operations, including risky investments. Guaranteeing that those cash reserves aren’t used as collateral, will not be leveraged, rehypothecated or re-invested are some of the differences between INX and others.
#3 – Security guarantees with reinforced technology infrastructure and ironclad KYC and customer privacy policies
Today, data privacy and security are top concerns for businesses and individuals alike. In the wake of high-profile data breaches, many people are reluctant to share their personal information online. For crypto exchanges, this can pose a problem. In order to comply with anti-money laundering regulations, exchanges must collect certain identifying information from their customers. However, if this information falls into the wrong hands, it could be used to commit fraud or identity theft. As such, it is critical for exchanges to have strong KYC and customer privacy policies in place. By ensuring that customer data is properly protected, exchanges can help build trust and confidence in the crypto industry as a whole.
The Forest Must Burn for the Regrowth to Occur
We’re in the midst of an industry-wide fire that is burning down the most compromised and vulnerable parts of the ecosystem - making way for the regrowth of market participants that are resilient, innovative and regulated. Regulations must be respected and embraced, and there's no room for wishful thinking or a head-in-the-sand mentality. Too many have already been hurt, and our financial future is on the line.
The regrowth will be beautiful and the survivors will be transparent, regulated and secure, as all of them today should have been. The next evolution of digital assets and the digital economy will be worth the wait - we just need the regulators to understand their role in managing that process and providing the needed clarity the market has so desperately been calling for.
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