The story so far: Published earlier this week, the Financial Stability Board (FSB)’s latest report on crypto-asset intermediaries sought measures to enhance cross-border cooperation and information sharing among local authorities. The is to effectively regulate and address gaps in multi-function crypto-asset intermediaries (MCIs) operating globally. Specifically referring to the FTX collapse in November 2022, it highlights potential risks associated with MCIs that combine different activities within the platform. This subjects them to structural vulnerabilities, amplified by “lack of effective controls and operational transparency, poor or no disclosures, and conflicts of interest.”
How does the report define MCIs?
The report defines MCIs as individual firms, or groups of affiliated firms that offer a range of crypto-based services, products and functions which primarily revolve around operating of the trading platform. Examples include Binance, Bitfinex and Coinbase. In the traditional financial landscape, the functions are provided by separate entities, instead of the same entity. This prevents potential conflict of interest and promotes market integrity, investor protection and financial stability.
The primary source of revenue for these platforms are the transaction fees generated from trading-related activities, the traded security here being self-issued crypto assets. Trades from alternative platforms may also indirectly drive additional demand for other services offered by the platform. These may include prepaid debit cards and lending, among other services. Both Binance and Coinbase issue debit cards that convert crypto-assets in individual wallets to fiat currency for ATM withdrawals and retail purchases. This shows that the aspirations of MCIs extend beyond just trading to becoming a “one-stop shop” for crypto-based services. The overall mechanism thrives on both economies of scale (higher cost advantage with increase in quantity ) and economies of scope (higher cost advantage when diversity of goods increase).
However, as reported by business news publication Bloomberg, payment cards operator Visa had stopped issuing new co-branded cards with Binance in Europe as of July this year. Mastercard too stepped away from its partnership. This was Tafter regulators globally raised concerns about their way of operating. U.S. Securities and Exchange Commission (SEC) Chair Gary Gensler accused Binance and its CEO Changpeng Zhao of an “extensive web of deception, conflict of interest, lack of disclosure, and calculated evasion of the law.”
These MCIs may also derive revenue from operating a blockchain infrastructure for which they may collect transaction validation fees. Another source of revenue could be proprietary trading (trading with their own individual capital rather than that of clients, with aim of acquiring profits).
FSB’s report observes that the magnitude of these revenue sources is unclear because of the limited publicly disclosed information. The revenue essentially depends on the extent of trading activity on the platform and more importantly, the demand for the assets.
What does it say about transparency and governance?
The report observes that most MCIs are generally not transparent about their corporate structure. Further, they are privately held. Even if they disclose information, the report observes, it is typically for a small part of their business, specific to a jurisdiction. Much of the available information has surfaced through press coverage, court filings and regulatory actions and not public disclosures.
The watchdog observed that MCIs failed to create a “meaningful separation” between potentially conflicting business lines, and provide clear account of transactions and activities or audit practices, among other things. The report suggests this could be intentional, to limit understanding of their vulnerabilities, economic models and activities — thus, to also evade regulatory oversight. Overall, this also translates to lowered or non-existent oversight parameters for management of risk and governance frameworks.
The FTX collapse is a case in point. In December last year after FTX had filed for bankruptcy, the U.S. SEC charged FTX for defrauding customers and observed that co-founder and CEO Samuel Bankman-Fried had concealed information from its investors. “We allege that Sam Bankman-Fried built a house of cards on a foundation of deception while telling investors that it was one of the safest buildings in crypto,” said SEC Chair Gary Gensler. The charges related to an undisclosed diversion of the exchange’s funds into Bankman-Fried’s privately-held hedge fund, Alameda Research LLC. The regulator also observed that Alameda was provided special treatment on the platform, including an unlimited line of credit funded by the platform users, along with exemption from certain key FTX risk mitigation measures. Lastly, FTX was charged with not disclosing the risk from its exposure from Alameda’s “significant holdings of overvalued, illiquid assets such as FTX-affiliated tokens.”
However, poor risk management, the report says, “may make it easier for insiders to engage in misconduct that magnifies MCI vulnerabilities.” Illiquidity and concentrated holdings combined with opaque information about supply and circulation could allow prices of self-issued crypto assets to be inflated. Other than this, lack of transparency could mean that risks from lack of effective governance and risk management or lack of profitability of the business model would be hidden until the negative shocks fully materialise.
n fact, in June this year, the U.S. SEC alleged that Binance misled investors about their risk controls and inflated trading volumes by utilising CEO Zhao’s self-owned entity. Additionally, they were alleged to be “actively concealing” who was operating the platform, besides “manipulative trading” of its affiliated market marker, and the place where the investor funds and crypto-assets were custodied.
What does the report say about concentration risk?
The report also lists market dominance and concentration among potential vulnerabilities. It argues that one or more MCIs could become the major source of liquidity in crypto-asset markets. This would not be ideal for realising the correct price as per market dynamics and existing conditions. High concentration alongside hosting a multitude of services could also facilitate anti-competitive behaviour, further amplifying the ecosystem’s vulnerabilities. For example, MCIs may raise entry barriers and increase costs for users to switch to a competitor.
What about spillovers into the traditional financial system?
The report observes that, based on available evidence, the threat to global financial stability and to the real economy from the failure of an MCI is presently “limited.” However, recent experience about failure or closure of “crypto-asset-friendly” banks (such as Silvergate Capital after the FTX collapse) reveal the prevalence of concentrated deposit exposures to firms whose business models rely in some form of crypto assets. However, as the report states, “stress events in crypto-asset markets caused significant losses to investors and shook confidence in these markets.” I
In March this year, Silvergate Bank had to wind down its operations and voluntarily liquidate. This was after the FTX collapse and an ensuing loss of confidence (in crypto-assets) that resulted in a ‘run-off’ (investors moving away from riskier to safer assets). The bank also revealed a “significant outflow of deposits,” necessitating measures for maintaining cash liquidity in its fourth quarter financial statement last year (right after the FTX collapse). The winding down was announced days after it had to discontinue the flagship Silvergate Exchange Network, which provided quicker and round-the-clock transfers between investors and exchanges (from cypto-currency to US Dollars).
Broadly, vulnerabilities emerged on two fronts, relating to leverage and liquidity mismatch (discrepancy between assets and liabilities when assets cannot be liquidated at market value to meet their short-term obligations).
MCIs depend on formal banks and payment service providers for ‘on-ramp’ and ‘off-ramp’ transaction services (that is, conversion of crypto currencies to fiat currencies and vice versa), among other things. Counterparty risks may also emerge should the trading venue stop operating, or if the bank fails to provide real-time operations. Credit risk also awaits the latter should they provide loans and credit lines to MCIs, especially when backed by crypto-based collaterals infused with the probability of a decline in value in the future.