Cryptoassets trading – a brief status

It is now over 15 years since the modest launch of Bitcoin in January 2009. Since then, the value of Bitcoin has risen significantly, although in fits and starts. The interest in Bitcoin and other digital assets based on blockchains has largely been linked to the enormous increase in value.

Only a few of the different alternative digital currencies based on blockchain technology have managed to achieve critical mass in terms of audience interest and actual turnover. Various exchanges and trading systems for cryptoassets have emerged despite a number of unresolved legal issues and inadequate regulations. This has resulted in substantial underlying exposure for clients trading through such exchanges. One scandal has superseded another, emphasizing the need for legal regulation of trading venues of this type.

Below, we'll take a closer look at one recent case, the so-called FTX scandal. Thereafter we will present the current status of legal regulation of the trading of crypto assets.

Sam Bankman-Fried and Gary Wang started the crypto exchange FTX (short for Futures Exchange) in 2019. Already in 2021, FTX, with over a million registered customers, had established itself as the third-largest global cryptoassets exchange. Alameda Research, which traded in digital currency, was at times the client with the highest trading volume at FTX. This eventually raised concerns from several external players, as Alameda Research was created by the same Bankman-Fried in 2019. Eventually it became clear that FTX and Alameda inflated numbers and volumes in each other, among other things by buying up and leveraging digital certificates (tokens) issued by FTX.

FTX and Alameda Research subsequently proved to be interdependent through several hidden transactions and agreements. Among other things, FTX issued a separate FTT token that gave the holder a discount on fees on trades on the FTX exchange, a separate referral commission, and a separate regime for bonus points. According to FTX itself, the value of such FTT was to be maintained by FTX having a program to buy back FTT tokens which were then destroyed.

In an article dated 2 November 2022, online newspaper Coindesk pointed to several links between Alameda and FTX and that they were unusually close given the huge underlying values in question. Coindesk noted that Alameda had a total of $14.6 billion in assets, of which $3.66 billion consisted of "unlocked FTT" and an additional item equivalent to $2.16 billion referred to as "FTT collateral." On the debt side, more than NOK 8 billion were listed in loans, of which NOK 292 million related to "Locked FTT". It wasn't just a lack of diversification in the portfolios of the two businesses, the interdependence apparently rested on fictitious values and a gaping hole of over $8 billion in Alameda's balance sheet. FTX, on the other hand, was a private company that was not subject to the strict accounting and reporting requirements of other financial institutions. In other words, there was no real control over the numbers and underlying exposure at FTX.

Competitor Binance, another major digital currency trading platform, had expressed interest in acquiring FTX immediately after the article, which it quickly withdrew. Changpeng Zhao, head of Binance, cited ongoing investigations by US regulators as well as figures showing widespread embezzlement of client funds at FTX. During this period, a number of clients attempted to withdraw their funds from FTX at the same time as the value of FTT plummeted. It wouldn't take more than a week after the Coindesk article before FTX was forced to file for bankruptcy.

Attorney John J. Ray III was quickly placed as trustee and new head of FTX. Ray had already seen a lot of strange things in his career where he specializes in fund recovery from failed companies. Among other things, he held the chief role at Enron Creditors Recovery Corporation, which worked to track down and recover funds from Enron's bankruptcy estate. A statement in his statement to the Delaware bankruptcy court sums up Ray's views on the business model of FTX: "Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here."

The problems with FTX were due not only to a lack of control mechanisms, but to the fact that it deliberately played on the conflation between FTX and Alameda to increase trading volumes and generate revenue. In the subsequent criminal case against Bank-Friedman, his former partner Gary Wang explained that in the summer of 2019, FTX incorporated new code instructions into its systems. The seemingly simple phrase "allow_negative" had major implications for the relationship between FTX and Alameda. The line of code in the FTX database allowed Alameda to have a negative trade balance at FTX without any repercussions. In practice, this allowed for an unlimited line of credit, meaning that Alameda could trade on the FTX exchange without paying for the transactions. Wang later explained that Alameda effectively had a credit of $65 billion without this being reported or disclosed in the accounts.

The FTX scandal occurred during a period of great turmoil related to other digital currency trading venues as well. Even large and established currencies such as Bitcoin and Ether had plummeted in value throughout 2022, and distrust and turmoil associated with several of the trading platforms was a major factor in this development. It is estimated that the overall market fell from a value level of about $3 trillion in 2021 to an estimated level of $796 billion in the period immediately following the FTX scandal.

As of today, several of these currencies have climbed upwards and recovered much of their value, but as the example of FTX above shows, there is obviously a need to tighten and regulate the trading platforms. In many countries, so-called "crypto exchanges" have been subject to general local anti-money laundering and terrorist financing laws, but without the strict regulation of traditional financial undertakings. This is now about to change, as the global financial market has matured and largely started the process of absorbing blockchain as a concept.

In January 2024, the U.S. Securities and Exchange Commission (SEC) allowed the Grayscale Bitcoin Trust to be converted into an ETF. This fund sits on about $29 billion in Bitcoin and opened the door to similar permits for other players in the market. ETF stands for Exchange Traded Fund and means that a fund can be bought and sold at a known price on an exchange just like a stock. Such an ETF will essentially fall under an existing and known set of rules that can be assumed to be favourable for providing a safer framework for trading in this type of securities. It is also a way of "taming" Bitcoin and other similar currencies by transferring the trade from the blockchain and prying into conventional trading systems. In this way, one also distances oneself from the central concept of the blockchain: Direct trade between buyer and seller without an intermediary.

In the EU, the Markets in Crypto Assets Regulation (MiCA/Crypto Assets Regulation) came into force in June 2023 with effect from 30 December 2024. The regulation will be incorporated pursuant to Article 7 of the EEA Agreement "be made part of the contracting parties' internal legal order", which in practice means by law or regulation. An important purpose of the regulation is to create financial stability and confidence in the markets for so-called crypto-assets, while protecting both professional players and consumers from risk. National authorities are to be able to regulate, control and process products and services in the market, as well as suppliers of related services.

MiCA must be seen in conjunction with, among other things, the EU DORA regulation (Digital Operational Resilience Act), which sets requirements for financial sector actors to take measures against cyber attacks and other risk factors, as well as the regulation of certain crypto transactions in anti-money laundering regulations and other regulatory requirements that have emerged in recent years.

MiCA uses the term "crypto asset", defined as a digital representation of a right or value that can be transferred and stored electronically using distributed register technology or equivalent solutions. Three main categories of crypto assets are regulated:

1. E-Money Tokens (EMT/E-Money Token): Crypto assets that constitute a form of e-money by stating a stable value related to one official currency
2. Asset Reference Tokens (ART/Asset-based token): Asset-based cryptoassets with a stable value linked to other rights or values, possibly combinations of, for example, official currencies and different types of investment objects
   
3. Utility Tokens: Other crypto assets with use value, such as Ether, Bitcoin and the like.
   

For crypto assets that fall outside the first two categories, there are requirements for the provider, the person applying for the cryptoasset to be offered on a trading platform, as well as trading platforms that on their own initiative take up the cryptoassets for trading. In all these cases, a separate document must be prepared to provide potential investors with information on the characteristics, functions and risks of the crypto assets in question.

The legal framework applies not only to issuers and providers of tokens, but also to crypto asset service providers (CASP). This group comprises both natural and legal persons offering various services related to crypto-assets, including operation of the trading platform, purchase or exchange, and advisory or portfolio management. To reduce the risk of new FTX-like cases, governance requirements are introduced, and client funds must be segregated from other company funds, so that the funds are secured even in the event of bankruptcy.

MiCA is not intended to replace the current regulatory framework for financial instruments. MiCA can be regarded as a supplement that complements the current financial regulatory framework. Ordinary digital currencies that fall outside the concept of crypto asset will thus fall outside MiCA. The same applies to other types of digital assets that are already classified as financial instruments under the current regulations.

Here, challenges may arise when deciding in practice whether, for example, an NFT (Non-Fungible Token) falls within MiCA. Information about ownership of an NFT will be stored in encrypted format on the blockchain while linking it to a specific and specified asset. This asset can be digital or physical. Such NFTs have several functions, and can be used, among other things, as digital certificates to document authenticity and notoriety for digital artworks and other digital goods. Paragraph 10 of the preamble states that assets with value based on distinct and distinctive characteristics and a low degree of "fungibility" fall outside the scope of the Regulation. However, paragraph 11 states that the division of such an asset into several individual elements or a larger collection of assets may be an indication of fungibility. Hence it can be stated that in practice NFTs are not completely exempt from MiCA and that a concrete assessment must be made in each individual case. It goes without saying that that assessment won't always be as simple.