Moral hazard is a concept that describes the increased likelihood of risky behavior when individuals or entities are shielded from the negative consequences of their actions. In the cryptocurrency industry, the lack of clarity regarding the ownership of cryptocurrency held on exchanges creates a significant moral hazard. This ambiguity can lead to exchanges engaging in risky behavior, and if an exchange becomes insolvent, customers may face challenges in recovering their assets.
One of the critical issues is the absence of clear regulatory frameworks and legal precedents surrounding cryptocurrency. Unlike traditional assets, many jurisdictions often do not recognize cryptocurrencies as legal tender or property. Consequently, the protections afforded to traditional assets may not extend to crypto assets. In the event of exchange insolvency, customers who hold cryptocurrency assets on the platform may be considered unsecured creditors. As unsecured creditors, they do not have a specific claim on any particular asset or property of the exchange, and there is no guarantee that they will recover their total assets.
Bankruptcy lawyer A.J. Levitin highlighted this issue in the journal article “Not your keys, not your coins: Unpriced credit risk in cryptocurrency.” Levitin emphasized that cryptocurrency exchange investments create a debtor-creditor relationship between the custodian and the customer, allowing exchanges to behave more frivolously with consumer funds than traditional finance due to the lack of precise regulation.
A recent example that illustrates the moral hazard in the cryptocurrency industry is the collapse of FTX, a company with various divisions, including venture capital, a hedge fund, and two exchanges. The group’s hedge fund made risky loans and bets with customer assets. While custodial holdings of securities or cash deposits by securities or commodities brokers or banks receive substantial legal protection under US law, no such protections exist for custodial holdings of cryptocurrencies.
To address these concerns, the Securities and Exchange Commission (SEC) proposed new rules on February 13th, 2023, requiring advisors to properly segregate investors’ assets, including crypto assets, into separate accounts. This proposal aims to prevent fraudulent activities such as Ponzi schemes by ensuring that assets are not recycled to deceive investors. By imposing stricter regulations and requiring audits and record-keeping, the SEC seeks to enhance clarity and guidance for companies issuing cryptocurrencies in compliance with the law.
The SEC’s proposed action is a significant step towards resolving one of the prominent issues in the crypto industry related to the ownership and usage of customer funds. As the regulatory body takes action against cryptocurrency issuers violating securities laws, it brings greater accountability and transparency to the industry. Establishing clear frameworks and protections is crucial for mitigating the moral hazards associated with the ownership of cryptocurrency assets by exchanges.
In conclusion, the lack of clarity surrounding the ownership of cryptocurrency held on exchanges creates a moral hazard in the industry. This ambiguity can lead to risky behavior by exchanges, and customers may face difficulties in recovering their assets if an exchange becomes insolvent. Clear regulations, accountability, and guidance from government regulators are essential to protect customer interests and ensure the long-term viability and stability of the cryptocurrency industry. As the market continues to evolve, efforts should be made to establish comprehensive frameworks and safeguards to address the moral hazards inherent in the ownership of cryptocurrency assets by exchanges.