When crypto exchanges decentralise

© Bloomberg

Earlier this month, the Department of Justice brought criminal charges against the founders of the Seychelles-based crypto exchange BitMEX.

The Commodity Futures Trading Commission also brought civil charges against the founders and five other entities behind BitMEX for failing to register with the agency and for not implementing AML procedures. The founders were also accused of running an internal trading desk on a conflicted basis.

Readers may recall BitMEX’s chief executive Arthur Hayes had engaged in a fiery debate with economist Nouriel Roubini. Dubbed “the tangle in Taipei”, the conversation saw Roubini throw a slew of contentious accusations at the company, among them that the exchange openly targeted “degenerate gamblers” and brazenly disrespected accredited investor rules and KYC/AML by operating out of the light-touch jurisdiction of the Seychelles.

Representatives from HDR Global Trading Limited, a BitMEX-related company, have responded that the company plans to vigorously defend itself, describing the charges as heavy-handed.

Nonetheless, for now at least, it looks like Roubini’s perspective has the edge over the BitMEX one.

As the case continues another important aspect of the story may come into play: how the case bares on the evolution of decentralised crypto exchanges.

BitMEX stood out as one of the last major exchanges (at least with any significant liquidity) where traders could engage in trading almost entirely anonymously. Even as recently as the beginning of this year, all a user needed to open a BitMEX account was an email and 2-factor verification instrument.

In theory, that meant anyone submitting trades into and out of BitMEX from jurisdictions where KYC and AML rules applied was being serviced illegally by BitMEX.

Sources close to BitMEX told FT Alphaville last year that the company believed that as long as they blocked users with IPs from contentious jurisdictions, especially America, they would remain compliant.

But as FT Alphaville understands it, the authorities believe contentious markets remained a major source of revenues, especially in terms of fees, and that the company hinted strongly to users that the use of VPNs would get around its own systems.

The latest US actions (which can be read in full here and here), thus apply a death knell for the crypto exchange model that services clients anonymously in KYC/AML-obliging jurisdictions (ie most of the world).

This is important, because it means customer-facing crypto services in places like the United States are entirely pulled into the regulatory net of the core system, ensuring there is very little advantage in using crypto over traditional financial services

Never ready to give up, however, this has shifted the crypto community’s focus to the creation and propagation of so-called decentralised exchanges instead. The problem is that the industry is still unwilling to acknowledge the fact that a decentralised exchange is a contradiction in terms and is thus no substitute for operations like BitMEX.

That doesn’t mean, however, that they’re not going to try.

In industry eyes, matching-software that can be downloaded and used to bring counterparties together constitutes a tool rather than a service. Accordingly, the same requirements about financial disclosure, KYC and AML do not apply, not least because there is no central body governing or intermediating the sums of cash that pass through a system.

Undeniably, there are some advantages of using such software relative to trusting in conventional off-grid exchanges. Chief among them is the elimination of the risk that a third party exchange, such as BitMEX, uses a proprietary trading desk — with superior information about customer flows — to trade against its own users.

As the CFTC complaint notes, this was a point of contention with respect to BitMEX:

BitMEX acts as the counterparty to certain transactions on its platform, such as through its internal “market-making” desk, or through the BitMEX “Liquidation Engine” that can assume a customer’s position under certain circumstances.


BitMEX has failed to establish rules to minimise conflicts of interest. This is apparent because Hayes, Delo, Reed, and numerous other BitMEX employees trade on the platform, and BitMEX’s own internal “market-making” desk has at times been one of the largest traders on the platform.

Such conflicts remain possible with all centralised exchanges, dark pools and market-making operations. Without proper oversight, there will always be a risk, if not a temptation, to trade against one’s own clients. As will the temptation to run conflicting market-making operations. The core financial system itself is not immune to this problem but the risk is all the greater if the exchange is also the manager and controller of any escrow funds, and operating offshore.

A decentralised system, in theory, eliminates that problem. But the flipside of that reality is that there is no guaranteed liquidity on any such system and no protection against flaking counterparties or worse. There are simply no guarantees at all. And while reputation scoring can help, over time it becomes an expense in its own right, since it becomes entirely impossible to verify all counterparties at any significant scale or pace independently. All of which knocks liquidity and increases the theoretical discount that needs to be applied to any cryptocurrency that cannot be cashed-out in the realms of the regulated system.

In the long run, customers (even fraudulent ones) will realise that all the structure really does is outsource the job of KYC and AML screening to users directly. If crypto users are smart, they will realise this will never be as cost efficient as institutions doing KYC on users’ behalf.

It’s at this point, all those involved would do well to look into why such things as pirate’s code and honour among thieves have always existed. Trust is not optional. If you want the benefits of a scaled system, you need institutional trust to intermediate it. That applies as much to black-market transactions as it does to cleared ones.

Copyright The Financial Times Limited 2020. All rights reserved. You may share using our article tools. Please don’t cut articles from FT.com and redistribute by email or post to the web.