The FTX effect and the actions that mitigate (and improve) the world of digital assets
If 2021 was a prosperous year for the digital asset market, the same cannot be said for 2022. The collapse of what was once considered the second-largest crypto asset exchange in the world, FTX, revealed the fragility of an unregulated and easily disguised system. However, the exchange’s downfall shed new light on the need for greater oversight, particularly regarding solvency and the ability of cryptocurrency exchanges to meet customer demands in the event of a bank run - a sudden, massive request for fund withdrawals by clients.
In these cases, Proof of Reserve (PoR) becomes essential, a mechanism often used to demonstrate that there is a match between the assets issued/allocated in the market and the liquidity within the company itself to cover mass liquidations. PoR activities are typically carried out by third parties who objectively and impartially confirm an exchange’s ability to repay amounts held by customers in digital assets. From a technical perspective, Proof of Reserve activities leverage the concept of a Merkle Tree, which aggregates customer balances without exposing any private information, but proving that the total value is fully reconciled.
Following the collapse of FTX, the Financial Stability Board (FSB), a global financial authority, proposed a regulatory framework similar to that applied to traditional finance.
Specifically, the emergence of custody services—where users open an account with a third party that stores assets on their behalf, eliminating the need for them to hold their own keys—has shifted attention towards greater asset security. This avoids the need for self-custody solutions—where the user solely owns the private keys and has direct access to their assets, as in the case of solutions like Metamask or Phantom. This has also led to the use of specialized technologies such as MCP-CMP (to be discussed in a dedicated article).
The framework, introduced in 2023, aims to regulate more rigorously the activities of Stablecoins and Crypto Assets Service Providers (CASP), focusing on several key aspects:
• Regarding stablecoins, it is recognized that global stablecoins are at risk of becoming "systemically important" for global financial markets, which is why the FSB aims to improve governance, transparency, and risk management systems. Additionally, stablecoins must comply with clear principles such as convertibility, transparency regarding the underlying reserves, and clear risk management practices.
• As for CASPs, the framework calls for increased oversight by regulatory bodies, subjecting them to more stringent rules similar to those applied to traditional financial services. These providers must follow standards related to asset custody, cybersecurity, and investor protection, akin to those in traditional finance.
• In the European market, we are witnessing the impact that will unfold in the coming months with the introduction of MiCA (Markets in Crypto Assets Regulation). Officially approved by the European Parliament in April 2023, MiCA represents a crucial step towards regulating cryptocurrency markets, with the goal of providing greater security, transparency, and protection for investors.
Specifically, MiCA is based on four fundamental elements:
1. Investor and consumer protection, ensuring that users who purchase or hold crypto-assets are adequately informed of the risks, while service providers comply with transparency and consumer protection rules.
2. Financial stability, by reducing the risks that crypto-assets and stablecoins pose to the financial stability of the EU, particularly if they become widely adopted.
3. Promotion of innovation, providing a clear regulatory framework for companies operating in the crypto-asset sector and fostering innovation without compromising user protection.
4. Prevention of money laundering and terrorist financing, aiming to reduce the use of cryptocurrencies for illicit purposes such as money laundering and terrorism financing.
While there is still a long way to go, the regulations defined so far are helping shape a better and more suitable landscape for users who want to engage with the world of digital assets.