Should Cryptocurrency exchanges be regulated?

There have been consistent attempts to hack into cryptocurrency exchanges around the world. Mt. Gox has been the most infamous example to date, and its collapse both ended as well as defined an era of cryptocurrency trading. Following on from its example, should exchanges be regulated to create safer trading conditions for the protection of traders?

Mt. Gox’s example

It has been four years since Mt. Gox collapsed in a confused mess of hacks, lawsuits, and outages. The now-defunct exchange continues, however, to hold over $1.4 billion in Bitcoins in spite of demands from its former users that it return their cryptocurrencies.

The situation was described as unprecedented: whatever was left of Mt. Gox is entirely able to pay off its former users, but they will not accept it as Bitcoin has been valued at its 2014 price of $483.

As the Verge has noted, these users have found that valuation extremely unpalatable – especially after Bitcoin shot up to $20,000 in December last year. Many of them have continued to hold out in the hopes of getting a revaluation, but that seems more and more unlikely with each passing year.

As recently as April this year, nearly $141 million worth of Bitcoins were transferred out of Mt. Gox’s remaining wallets by its bankruptcy liquidator.

The collapse and its aftermath have been instructive. Indeed, Mt. Gox has now come to be a byword for many of the ills associated with unregulated cryptocurrency trading. At its peak, the exchange was the largest in the world and responsible for an estimated 70% to 80% of all Bitcoin transactions worldwide.

Its prominence made it an attractive target for hackers: first in 2011 when Bitcoin prices on the exchange were artificially set to $0.01, and 2,000 Bitcoins were transferred out, and then later that same year in what was reportedly a continuous, unnoticed effort that precipitated the collapse.

The aftermath

Aside from filing for bankruptcy and subsequently undergoing liquidation, not much else has been done to bring Mt. Gox to justice. Its CEO, Mark Karpeles, is still facing criminal proceedings in Japan for embezzlement, manipulation of electronic data, and breach of trust.

Such measures (or the conspicuous lack thereof) may have encouraged hackers for yet another attempt on a Tokyo exchange: earlier this year, Coincheck lost over $420 million worth of XEM – $80 million more than the amount lost in Mt. Gox’s second hack.

More is required to prevent as well as deter another Mt. Gox from occurring. This is especially pressing given that there are now many more exchanges and cryptocurrencies than when Mt. Gox collapsed in 2014. The hacking of exchanges has only become more prevalent since then, and there is also a noticeable dearth of solutions available to authorities to either prevent or follow up on such incidents.

The Coincheck hackers’ wallets could be traced and their transfers interdicted via exchanges, but the damage was already done – there was no getting the money back. In fact, compensation to affected customers was to be paid out of Coincheck’s pocket.

What are exchanges

The most straightforward definition of a cryptocurrency exchange is that it is a platform for trading cryptocurrencies. Much like a real-world stock or currency exchange, the cryptocurrency exchange allows prices on cryptocurrencies to be set through the volume traded for a specific period.

It is also somewhat localised in that exchanges tend to conduct trades primarily in the fiat currency where they are based. As a result, there is not one single, universal standard to which cryptocurrencies can be priced: one Bitcoin can be worth $17,000 in the United States and $18,000 elsewhere in the world at the same time.

More pertinently, many exchanges differ in their practices and processes. Among the most fundamental is the use of “hot” and “cold” wallets for clearing transactions. Hot wallets are online and therefore easily vulnerable to hacking attempts over the Internet; in fact, both Mt. Gox and Coincheck had their hot wallets drained in their hacks.

Unsurprisingly, experts have noted that holding large sums in hot wallets is akin to walking around with large amounts of cash on one’s person. In contrast, cold wallets are not connected to the Internet and often take the form of hardware devices such as the Ledger Nano S, the Trezor, and the KeepKey. These are usually stored in safes, and are not connected to the Internet unless necessary.

How should exchanges be regulated

The use of hot and cold wallets could provide a starting point for regulators to focus on. In the world of traditional finance, best practices and processes that have become industry standard are usually codified into law to ensure that customers are protected. These best practices and procedures have generally been derived over centuries through trial and error, and have more often than not been costly.

There is no reason whatsoever to the contrary for the cryptocurrency industry not to follow the example set by its forebears. Too much is at stake, and too much has been lost over the years through mistakes from which exchanges should have learned lessons from.

By guaranteeing a minimum standard of service and protection, exchanges would go a long way in increasing public confidence in cryptocurrencies worldwide – and thereby help to popularise the revolutionary concept of an alternative financial system that does away with the middleman.

Regulating exchanges would also go a long way towards clamping down on Initial Coin Offerings (ICOs) that have proven to be nothing but scams or Ponzi schemes.

Stock and currency exchanges have similar regulations set in place that protect traders from getting defrauded; it is inconceivable that millions of dollars could be lost on nothing more than a handful of documents amounting to just a white paper and promotional pamphlets.

Unfortunately, that has more often than not proven to be the case. The ICOs for over 1,600 altcoins have been revealed as opportunities for enterprising fraudsters to prey on the naivety and greed that plague the industry.

Perhaps that is what may make the case against regulating exchanges, as there is nothing more efficient than a Darwinian selection of the fittest, or smartest.

No amount of regulation can force a trader to conduct more detailed research, or suppress their greed – the traditional finance sector has ample proof of that.

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