Alessio Quaglini, CEO of Hex Trust speaks to Carolyn Wright about the role both regulators and crypto custodians play in keeping your digital assets safe.
What really happened with the failure of various crypto exchanges the past year? How did investors end up losing access to their digital assets?
The digital asset industry still lacks a clear regulatory framework to protect investors, and the market has really developed in its own way as a result. Centralized entities like crypto exchanges and lending platforms are really only by name – they actually operate as banks with fractional reserves. When investors deposit their assets to these platforms, they basically become unsecured creditors, and their assets are not held in custody in segregated and bankruptcy-remote accounts. This means these platforms can utilize customer depositors for whatever purpose, whether it be to earn additional return by lending them out, or through making investments (like what happened with Alameda). When the crypto market crashed, the value of these investments decreased, and the bankrun forced these platforms to sell these assets for a lower value – hence, the loss of value for investors on these platforms.
What is a crypto custodian and how does it compare to other digital asset safekeeping methods?
Custodians play an important role in both traditional finance and decentralized finance. Custodians safekeep client assets in segregated and bankruptcy-remote accounts, meaning if an intermediary goes down for whatever reason, the assets are segregated and clients are still able to withdraw the assets. In traditional finance, this function is usually performed by banks, but these banks are absent in the digital asset world. In place there are specialized companies – usually fully licensed, independent custodians like Hex Trust, that focus on compliance, risk management, regulation, governance, and client servicing. If clients want to ensure full protection of their assets, they should make sure that the intermediaries they interact with (exchanges, broker-dealers etc) are utilizing a licensed, independent custodian to keep client assets. This means even if the intermediary experiences issues or even bankruptcy, their assets would be safe.
→ Read more about the Foundational Principles of a Licensed Digital Asset Custodian
Are crypto custodians regulated similarly to the traditional financial world?
Unfortunately, the answer is no. The digital asset market is still in its infancy, and regulatory intervention is coming with a bit of delay. Many regulatory frameworks that should have been in place to avoid the turmoils of the past few months, but we’re not there yet. Some countries have been quicker than others but regulatory clarity is still limited and in certain jurisdictions, custodians still have to rely on custody rules that apply to traditional finance and not specifically for digital assets.
What is the regulatory development for digital assets in Hong Kong specifically?
Hong Kong regulators have been looking at the digital asset space for quite some time. The recent consultation proposal and new VASP framework revolves around the activities of virtual asset trading platforms – exchanges. This means the new framework will only revolve around virtual asset exchanges, and the activity of custody would not be separately licensed or regulated. It is definitely positive that Hong Kong is making strides to embrace digital assets in a safe way, and it’s already called back several companies back to the city. However, the new framework falls short for a number of reasons. The issue of lack of asset segregation is evident as the cause of what happened these past few months, and the fact that the proposed framework doesn’t require the segregation of custody activities with exchange activities, is a missed opportunity for the framework in properly protecting investors.
So should regulation be clamping down more on the custody sector?
It was very clear that something was missing in the case of FTX, and all the other centralized entities. These outcomes were a result of embezzlement, fraud, and misappropriation of clients’ funds. These events could have been prevented if the digital asset intermediaries (e.g. exchanges) were using licensed, independent custodians. This is a big gap that could be filled with today’s regulatory developments.
There’s a lot of speculation around Hong Kong’s new proposal in opening the market up to retail investors. How do you see the industry developing here as a result?
I think it’s very positive that the regulators are looking into what happened, and are stepping up to place guidelines and rules, but the new framework’s intent to include retail investors isn’t going to fundamentally change the market. Retail investors in Hong Kong already have access to global exchanges. If strict regulation is placed for exchanges operating in Hong Kong, and the wider public still has access to global exchanges that operate without strict guidelines, will investors choose to trade with these local exchanges? It will be interesting to see how the SFC will enforce the presence of international exchanges in the city.