Centralized exchanges in the US doomed?

The U.S. Securities and Exchange Commission (SEC) has launched a major attack on the cryptocurrency exchange industry by filing separate lawsuits against Binance and blockchain, the largest such companies in the world and the U.S., respectively.

The SEC, led by Chair Gary Gensler, has brought 13 serious securities violation charges against Binance, including the exchange’s failure to meaningfully differentiate its global and U.S.-based operations, putting customer funds at risk, and engaging in a “calculated effort to evade the law.”

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Perhaps the most serious allegation against Binance is that it has commingled billions of dollars in customer assets through a third-party called Merit Peak Limited, which is owned by CEO Changpeng Zhao, in a manner resembling the crooked dealings between Sam Bankman-Fried’s FTX crypto exchange and hedge fund Alameda Research.

The charges against blockchain, which has built a reputation as a crypto exchange willing until recently to work within the bounds of the law, are nearly as devastating.

But neither of these civil suits comes as a surprise. In March, the Commodities and Futures Trading Commission (CFTC) filed a lengthy suit against Binance, including many complaints that are repeated in the SEC court documents. And earlier this year, the SEC sent a “Wells notice” to blockchain, which usually indicates that the agency is building a case and intends to file charges.

The question now appears to be whether Binance or blockchain will be subject to even more serious criminal charges brought by the U.S. Department of Justice (DOJ). In Binance’s case, it has long been rumored (and reported) that the DOJ is considering a case, although according to Reuters, it appears to be internally divided on the way forward.

Furthermore, there appear to be several dissenters within the SEC who argue that the organization should have done more to provide a pathway for firms to “come into compliance” with the law. Most notably, Hester Peirce, one of five SEC commissioners, has said that, even if Gensler and the SEC’s actions are motivated by a real desire to protect investors, what they’ve done is created uncertainty.

In a recent interview with CoinDesk TV, Peirce said that one way for her employer to “plant a flag” and establish dominance over the nascent crypto industry is to file enforcement actions. It’s become commonplace to suggest that U.S. authorities are “regulating by enforcement” and are also caught up in turf wars with other agencies, but the claims do have a ring of truth.

It’s not unheard of for the SEC and CFTC to target the same entity, but it does seem like a waste of resources for agencies that are chronically underfunded. And trying to determine which watchdog, securities or commodities, should take the lead has been a legislative nightmare and, frankly, a national embarrassment.

See also: U.S. House Republicans Push for Crypto Oversight With Bill to Make SEC Play Ball

Essentially, the SEC’s function is to establish standards for companies to follow, including disclosure rules and protocols to prevent the criminal misuse of money (such as laundering ill-gotten funds and financing terrorists). The agency is not necessarily tasked with rooting out bad actors, contrary to what many crypto activists mistakenly believe.

But by filing suit, the SEC and CFTC do have a remarkable ability to signal what type of businesses or practices are less-than-desirable in a functioning economy. And by going after the two biggest fish in crypto, it’s becoming clear that all exchanges are at risk. Scratch any financial firm, and you’ll find that it has committed financial infractions, especially in an industry as rough-and-tumble as crypto.

What regulators want

However, the idea that exchanges, as they currently operate, are not exactly welcome in the U.S. is not a new risk, even though the SEC’s recent cases are a reality check.

Gensler has been saying for years that existing financial rules apply to crypto service providers, that cryptocurrencies resemble securities unless issued under very specific conditions (in fact, labeling at least 61 specific tokens as securities in its various lawsuits), and that exchange operators have a responsibility to “come in and register” with the SEC.

Many reports suggest that crypto companies have opened a dialogue with the SEC only to have those meetings fall apart (and a few counter-examples). But the real fundamental change the SEC wants is for crypto companies to offer up more insight into who is using these platforms and how.

See also: U.S. Court Orders SEC to Respond to blockchain’s Allegations

Simply put, the crypto industry is now subject to standard surveillance and information disclosure rules that are commonly seen in financial markets and have been codified into law for crypto companies that want to do business in the European Union under the recently passed MiCA regulations.

“Blockchain’s alleged failures deprive investors of critical protections, including rulebooks that prevent fraud and manipulation, proper disclosure, safeguards against conflicts of interest, and routine inspection,” said Gensler in a tweet.

Why the rule may not work

However, there are serious reasons why such reporting rules are culturally anathema in the crypto industry (which tends to value financial privacy and sovereignty quite highly), and why at a technological level, they either introduce risks for crypto users or are legitimately unnecessary. Any disclosure on a blockchain is total disclosure, opening up a user’s entire history of transactions to view by nature of how blockchains work.

More importantly, there is also a fair argument that cryptocurrency networks have built-in systems for customer protection, or at the very least, are optimizing for a different understanding of “safety” compared to financial regulators.

For crypto, what is truly important is to offer equal access to all potential users while also ensuring that these new forms of money are non-confiscatable and their transactions are irreversible. The open-ledger design also provides a complete view for authorities to track down bad actors when necessary, which is now standard practice.

That blockchains accomplish all this does not eliminate the need for regulations. And it would clearly be better if founders and companies knew in advance how to operate within the bounds of the law. But crypto’s very real neutrality and technical achievements does put it in conflict with some regulatory aims, as argued in a recent “Consensus @ Consensus” report titled Should DeFi [decentralized finance] Defy Regulators?

This includes the “commodity-money” aspects of many tokens that probably have use in a decentralized system and utility beyond mere speculation. It also includes the programmatic circuit-breakers in DeFi lending markets, the pre-established rules that all necessarily follow when they engage with a smart contract.

When is it worth defying?

What is true for pure decentralized systems does not necessarily apply to centralized companies like blockchain and Binance, however. It is difficult to predict the results of these recent lawsuits – and they are likely to play out for years – but the scope of the allegations does suggest the SEC is looking to totally, irrevocably reshape how crypto functions. Liquidity is already being drained out of Binance, which, even before the lawsuit, was seeing multi-year low transaction volumes.

Some predict such a hostile move will bottom out the domestic U.S. crypto industry. Others think it may usher in an age of truly decentralized finance and decentralized exchanges. It is worth noting that allegations are not facts, and some degree of skepticism is warranted given Gensler’s clear bias. In the past, the SEC’s enforcement actions have led to slaps on the wrist.

What is certain is that exchanges – if they want to benefit from the efficiencies and protections of operating as “centralized” companies – will need to start acting a lot more like fintech firms and banks. That means more KYC, more disclosures, and more interactions with regulators. It is why some think the real future of crypto exchanges isn’t DeFi, but FTX 2.0, a bankrupt exchange that has every incentive to play by the rules.

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