Cobo: Cryptocurrency regulators should pursue technological innovation to safeguard user funds
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Cobo: Cryptocurrency regulators should pursue technological innovation to safeguard user funds
Now is a good time for regulators to step in and encourage, or even mandate, the use of technology to separate transactions from funds.
Navigating Web3 tides with focused insightsAuthor: Changhao Jiang, Co-founder and CTO of Cobo
Editor's note: Today, the South China Morning Post published an article by Changhao Jiang, co-founder and CTO of Cobo, exploring how centralized exchanges and their trading clients can address current trust challenges, and how Cobo plans to leverage technological innovation to help rebuild trust between exchanges and users.
This article is translated from English for reference only. Click “Read More” at the bottom of the page to access the original English version.
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As investor confidence was shaken by the FTX scandal, Hong Kong is legalizing retail participation in cryptocurrency trading, highlighting the urgent need for industry regulation.
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One essential measure is the separation of trading and custody of funds—a space where technology can help centralized exchanges create transparency and restore trust.
Recently, Hong Kong has adopted a more favorable stance toward cryptocurrency regulation, going so far as to legalize retail trading of digital assets. This move has reignited enthusiasm among market participants. However, as the crypto industry continues to grapple with the aftermath of FTX’s collapse, establishing robust regulatory oversight over cryptocurrency exchanges has become an immediate challenge.
Strengthening licensing requirements for exchanges and enforcing compliance and supervision is clearly a top priority. Beyond this, due to the unique characteristics of blockchain and digital assets, technology can play a critical role in regulating trading platforms.
The dramatic downfall of FTX is widely regarded as the "Lehman Brothers moment" for the crypto industry. Indeed, the collapse of what was once a model exchange has had far-reaching consequences. More importantly, market confidence in centralized exchanges has been severely undermined and may take years to rebuild. According to on-chain analytics firm CryptoQuant, investors withdrew over $8 billion from centralized exchanges within seven days following the FTX incident.
Nevertheless, since centralized exchanges still account for approximately 99% of total cryptocurrency trading volume, their dominant position is unlikely to weaken significantly in the short term.
The crypto world continues to struggle with the fallout from FTX’s collapse, and discussions about the industry’s path forward have centered around three possibilities.
1. Top-down licensing systems enforced by regulators. Many advocate that crypto exchanges should be regulated to the same standards as traditional financial exchanges. This call appears reasonable and aligns with current policies of Hong Kong regulators. However, developing and implementing strict yet practical regulatory frameworks takes time—especially when regulators are dealing with a completely new industry.
2. Transitioning to decentralized exchanges (DEXs). DEXs do offer strong advantages in reducing internal moral hazards at exchanges. However, DEXs are still in their early stages and face numerous challenges in efficiency and user experience. While DEX trading volumes did increase after the FTX collapse, this does not indicate an imminent structural shift. Although we remain optimistic that DEXs will capture greater market share over time, given the ease of use and high liquidity offered by centralized exchanges, the latter are likely to maintain dominance in the foreseeable future.
3. Separation of trading and custody. A more realistic and feasible approach is redefining the roles of different actors within the trading ecosystem through technological innovation to achieve separation between trading and fund custody.
The biggest issue exposed by FTX’s failure was that customer funds were held directly on the exchange, making them vulnerable to misuse due to minimal oversight.
Separating trading, clearing, and settlement functions is a long-standing practice in traditional finance. This model helps eliminate or minimize conflicts of interest, fosters trust among market participants, and contributes to the overall integrity of the financial system.
In contrast, in the cryptocurrency industry, these functions have historically been bundled together within centralized exchanges. Many market participants have now recognized the associated risks and are calling for independent intermediaries—particularly third-party custodians and prime brokers outside the exchange—to become involved.
Although such calls have existed for years, no intermediary has successfully challenged the power of exchanges—until now. With increasing market pressure, exchanges are becoming more willing to embrace this new model.
Technically, exchanges could self-enforce the separation of trading and custody by allowing customers to keep funds in isolated wallets while trading on their platforms. However, because custody functions would still ultimately be controlled by the exchange, this approach cannot fundamentally prevent the risk of misappropriation of customer funds.
A better solution is to have a neutral third party hold customer funds and facilitate transactions, thereby reducing counterparty risk for both sides. This role can be fulfilled by traditional financial institutions or specialized crypto custody providers, ensuring a true separation of duties—functions that should never have been combined in the first place.
Now is the ideal time for regulators to step in, encouraging—or even mandating—the use of technology to separate trading and custody. In fact, technological innovation in this area began as early as 2019, such as Cobo’s off-exchange custody and settlement network SuperLoop (formerly known as Loop), which enables trading teams to trade while keeping their funds under independent custody.
For example, a trading team can utilize an MPC-based custody solution to jointly manage their funds with an independent custody platform and trade those funds on cryptocurrency exchanges integrated with the custody platform’s settlement network. First, the trading team deposits funds into the custody platform; next, the platform locks these funds (only releasing them during trades) and maps them 1:1 onto the exchange; then, the trading team can trade as usual, with final settlement executed through the custody platform after trading concludes.
FTX’s collapse has raised serious concerns about the security of cryptocurrency trading and offers a valuable learning opportunity for all industry participants. Regulators should seize this moment to establish sound regulatory frameworks, embrace technological innovation, promote high transparency, rebuild trust, and ensure the healthy development of the cryptocurrency ecosystem.
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