Cryptocurrency exchanges act like banks, but not for the lawyers

When is a bank not a bank? When it's a cryptocurrency exchange.
13 June 2018 | 1513 Shares

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Another day, another currency exchange hack.

This time the victim was Coinrail, and around US$40 million of cryptocurrency assets are believed to have been stolen.

Although many of the tokens involved in this latest incident have been frozen, the proceeds will still be significant for those behind the hack, and the losses no less felt by the owners due to their lost assets being electronic “virtual” currencies rather than fiat money.

Bitcoin and cryptocurrencies are very big business, with the total energy consumed by mining activities now greater than that of some first world countries.

Additionally, European police estimate that 3 to 4 percent of proceeds from European crime is currently laundered through cryptocurrency exchanges.

And those figures are of course what law enforcement positively knows about — the real sums are bound to be much, much higher.

But while public interest appears to have waned in electronic currency (values of most coins are depressed, currently), there have been concerns raised recently about the rise of what is effectively a shadow banking system.

A paper, released by Cambridge University Computer Laboratory last month raises several issues, of which one of the most notable is the fact that many cryptocurrency exchanges today are operating effectively as banks, but are not subject to the same banking regulations as their fiat forebears.

Some countries’ governance is stricter than others, with Japanese authorities, for instance, turning down applications from more would-be exchanges that it accepts.

South Korea’s stipulations are even more strict, presumably attempting to protect the country’s population from its wild enthusiasm for all things cryptocurrency.

But despite government regulation in whatever form, exchanges continue to be hacked, and the protection extended to traditional banking customers does not, in most cases, extend to cryptocurrency exchanges even though these institutions are acting in much the same manner as banks.

The issue arises from the exchanges using their own private ledgers to conduct transactions between two customers, both of which hold their assets at the same exchange:

When two customers wishing to move Bitcoin (for instance) from one account to the other’s, many exchanges merely adjust an internal ledger, much in the same way a traditional bank might – rather than put the transaction out into the public domain to be mined.

This process is known as off-chain transacting. The notion of off-chain transactions was first mooted by Hal Finney, one of the originators of Bitcoin technology. He said:

“Bitcoin itself cannot scale to have every single financial transaction in the world be broadcast to everyone and included in the block chain […] Most Bitcoin transactions will occur between banks, to settle net transfers. Bitcoin transactions by private individuals will be as rare as… well, as Bitcoin-based purchases are today.”

According to the report, it is difficult to determine quite how much currency is exchanged off-chain in this manner, although it cites another report which quotes US$80 million per day.

And while this internal transfer process appears to at least have its roots in congestion problems caused by the difficulty of mining certain currencies, the overall effect is one that is moving the whole cryptocurrency concept away from its ideal.

A secondary effect is one of the local consolidation, where particular exchanges tend to be favored by local populations for instance.

For instance, Bitcoins traders in the US and the UK use Coinbase, Japanese users favor bitFlyer, and Chinese speakers are more likely to use Binance.

The safest way for any individual or institution to make its bitcoin assets safe (or at least safer) from hackers is by using a private wallet and transferring all exchanged funds immediately off the exchange onto private facilities.

Taking this action neatly sidesteps a further issue with cryptocurrencies which is the debate about the nature of ownership when funds are in the control of an exchange.

The original Mt. Gox exchange terms and conditions of 2012 quote: “It [Mt. Gox] will hold all monetary sums and all Bitcoins deposited by each Member in its Account, in that Member’s name as registered in their Account details, and on such Member’s behalf.” [our italics]

For victims of cybercrime against cryptocurrency assets to pursue cases successfully, ownership needs to be proven.

And in some cases, where the exchange itself holds the wallet, it is difficult to trace ownership back to the person who bought the original tokens — and in some cases, the nature of the token itself deliberately makes this even more difficult & complex to unravel.

Regulating cryptocurrency exchanges will always be difficult, due at least in part to the quasi-secretive nature of many of the exchanges. Part of some exchanges’ credo is to disruptively move outside the traditional banking system.

Therefore they are often stationed outside jurisdictions of governments seen inamicable to the whole cryptocurrency concept.

But even those exchanges which happily trade within a country’s jurisdiction may be carefully formed legally to appear as a different entity from a traditional bank and therefore not subject to the same regulations.

While every investment represents a risk, cryptocurrency speculators also have to realize that the bodies with which they are dealing often deliberately operate outside of legislative control — that’s part of their lifeblood. Caveat Emptor.