Crypto exchange’s jurisdiction-shopping: a regulatory problem that requires a global response

By: William Chao; Staff Editor

The jurisdiction-shopping behavior of crypto exchanges is raising some serious regulatory questions, especially considering the recent collapse of FTX, Sam Bankman-Fried’s crypto exchange based in the Bahamas. These exchanges, such as FTX and Binance, have a notorious history of moving to jurisdictions with a less stringent or poorly-enforced crypto regulatory framework to secure and maximize their profits. It is worth evaluating how exactly the United States can protect its retail investors and consumers from the misconduct of a foreign crypto exchange, given the highly interconnected crypto market and the contagious nature of the global crypto market.

A brief recap of crypto exchanges’ jurisdiction-shopping

The collapse of Sam Bankman-Fried’s Bahamas-based FTX trading has revealed many troubling aspects of the crypto industry that, for a significant period of time, has been operating with almost no regulation worldwide. The question remains as to how the United States can protect its retail investors and consumers from a crypto exchange headquartered in the Bahamas. The FTX debacle has raised questions regarding the jurisdiction-shopping behavior of centralized crypto exchanges.[1] To take advantage of the lax regulatory environment of jurisdictions such as Bahamas, Malta, and Virgin Islands, centralized crypto exchanges often relocate to jurisdictions with less stringent crypto regulatory framework to secure and maximize their profits, possibly as the expense of consumer protection. For FTX, its jurisdiction-shopping actions are well-documented.

Following the passage of 2020’s Digital Assets and Registered Exchanges (DARE) Act, and the Financial and Corporate Service Providers Act in the Bahamas, crypto entrepreneurs relocated their exchanges to the Caribbean nation after other jurisdictions tightened their restrictions on cryptocurrency. In the case of SBF, he left Hong Kong after China’s crackdown on crypto trading and mining.[2] Other crypto exchanges, such as OKX, have also registered as Digital Asset Businesses in the Bahamas under the DARE act. The DARE act regulates the issuance and sale of digital tokens and the conduct of those issuing digital tokens and those providing related intermediary services. The act chooses not to answer whether a digital asset is a security. Instead, it provides a framework to address digital assets holistically. In the case of FTX, (un)surprisingly, the local securities commission only had jurisdiction over one local entity, FTX Digital Markets Ltd., and was blind to the extent of FTX’s financial problems without access to dozens of other related units, including FTX Trading Ltd., the parent of FTX Digital Markets.[3] It also does not oversee SBF’s hedge fund, Alameda Research. The regulator was left in the dark, even if the DARE act required FTX to have “effective arrangements in place to protect client assets and money.”[4]

Bahamas’ theoretically holistic yet poorly-enforced crypto regulatory framework stands in direct contrast to the U.S. crypto regulatory landscape, where there is no specific legislation targeting digital tokens. At the same time, while SEC Chair Gary Gensler has repeatedly conveyed his belief that the vast majority of crypto tokens constitute securities, the determination is still hotly contested as a legal issue, especially considering the ongoing SEC v. Ripple case.[5] If a digital token is no security, it would then fall under the Commodity Exchange Act (CEA) as commodities and be subject to the jurisdiction of the Commodity Futures Trading Commission (CFTC). If crypto-assets are considered securities, the SEC would then have both enforcement authorities and regulatory authorities over centralized crypto exchanges.[6]

The U.S. regulatory uncertainty related to the status of crypto tokens has undoubtedly prompted many crypto exchanges to steer away from the U.S. The now-fallen FTX is not alone in jurisdiction shopping. Binance, the largest centralized crypto exchange, has a notorious history of jurisdiction shopping. Initially founded in China in 2017, Binance announced its move to Malta after it faced crackdowns in China and Japan in 2018. The same year, the company signed a memorandum of understanding with the government of Bermuda. A similar memorandum was later entered between Malta and Binance as well. However, the location of Binance’s headquarter remains murky. Malta’s Financial Services Authority (MFSA) announced in 2020 that Binance was “not authorized by the MFSA to operate in the cryptocurrency sphere and is therefore not subject to regulatory oversight by the MFSA.”[7] Reports later seemed to confirm that the firm was registered in the Cayman Islands. The firm’s chief growth officer described Malta as the firm’s “spiritual headquarter,” while its founder, CZ, famously answered the question regarding the whereabouts of the firm’s headquarters by saying that the firm’s office is “like where’s the Bitcoin office because Bitcoin doesn’t have an office.”[8] “Wherever I sit, is going to be the Binance office.”[9]

It is worth noticing that Binance, the largest crypto exchange in the world, was banned in the U.S. for regulatory reasons in 2019. Its investors opened Binacne.US, a separate exchange still banned in six states, including New York and Texas. However, reports have suggested that American users can still bypass measures that seek to block them from trading risky crypto derivatives outside the U.S. with technologies such as virtual private networks.[10] Crypto derivatives allow traders to place leveraged bets on the rise and fall of digital tokens. In the U.S., they would be subject to the regulation of the CFTC. Because centralized crypto exchanges like Binance operate outside of the U.S. and allegedly do not serve clients in the U.S., it avoids CFTC rules, such as the investor-protection requirements and safeguards against money laundering and market manipulation.[11]

Seriously, what exactly can the U.S. government do?

Crypto companies like Celsius and Voyager, both of which are located in the U.S. and previously filed for bankruptcy, are naturally subject to U.S. regulatory jurisdiction and U.S. bankruptcy proceedings. What would happen if the largest centralized crypto exchange, with its spiritual headquarters in Malta and supposed registration in the Cayman Islands, went bankrupt is unimaginable. However, such an event is not entirely inconceivable. Binance’s auditing firm, Mazars, paused its activity relating to the provision of Proof of Reserves Reports last December for entities in the cryptocurrency sector,[12] while the four big accounting firms found themselves unwilling to audit Binance despite their experience with Coinbase.[13] The highly contagious nature of the crypto market and the volatile nature of digital tokens further complicate this issue. When crypto investors struggled to assess FTX’s collapse and the potential bailout of FTX by Binance in November, bitcoin fell by 22% in less than a day.[14] When TerraUSD, an algorithmic stablecoin, destabilized, Three Arrow Capital, a Singapore crypto-focused hedge fund, suffered losses due to its exposure to TerraUSD, failed to meet a margin call from crypto lender BlockFi, defaulted on a more than $660 million loan from Voyager Digital, and filed for bankruptcy under Chapter 15 of the U.S. Bankruptcy Code.[15] Both BlockFi and Voyager Digital later filed for bankruptcy in the wake of FTX’s bankruptcy.[16] In the world of decentralized finance, these centralized crypto exchanges and lending facilities appear overly leveraged, poorly regulated, and highly interconnected.

The possibility that a centralized foreign crypto exchange or lending company beyond the reach of the American regulatory scheme would disrupt the U.S. crypto market overnight makes one wonder how exactly the U.S. government should proceed with the matter of crypto ex ante regulation, especially considering the mechanism of jurisdiction shopping and the race-to-the-bottom regulatory mentality of other jurisdictions (think about Bahamas’ attempt to establish itself as a crypto hub). In the case of FTX’s collapse, many have questioned how the SEC failed to stop FTX and whether the SEC was more interested in protecting its turf rather than protecting investors.[17] The SEC seemed almost always late to the game. Suppose it is the SEC’s view that the securities law provides the SEC with the legal authority to regulate crypto exchanges and to bring enforcement actions against them for fraud. It is puzzling why it has not been done so long before. As of now, there is still no systematic proposal to regulate crypto exchanges from the SEC.[18] The latest development in President Biden’s infrastructure bill regards crypto exchanges as brokers that must comply with the relevant anti-money laundering/combating the financing of terrorism (AML/CFT) requirement.[19] Congress is also expected to rethink CFTC and SEC’s jurisdiction over crypto tokens and explore alternative legislative arrangement. Maybe regulators should focus on making crypto-asset securities and crypto commodities regulatorily alike. Maybe the design of the crypto-asset regulation framework should align with the existing securities trading and investment regulation. Maybe Congress should appoint a primary regulator for crypto-asset markets.[20] The future remains unclear.

Still, in the decentralized crypto world where the office of a centralized crypto exchange could travel with its founder, the global problem of jurisdiction shopping would require a global crypto regulatory solution. An effective global crypto regulatory regime would need major crypto market participants such as the United States, Singapore, and Japan to adopt and apply more stringent regulatory rules and similar frameworks. Around the world, as regulators become aware of the interconnectedness of centralized crypto institutions and the contagious nature of the global crypto market, the myth of secure DeFi is going bust as nations increasingly learn about the risk of centralized crypto institutions and start looking at more stringent crypto regulation. A global regulatory framework that is coordinated, consistent, and comprehensive will bring order to the markets, help instill consumer confidence, and provide a safe space for useful innovation to continue.[21]

[1] https://www.foxbusiness.com/markets/regulatory-expert-ftx-jurisdiction-shopped-locate-lax-regulatory-environment.

[2] https://www.thestreet.com/crypto/news/bahamas-we-are-a-place-of-laws-stop-saying-we-lack-crypto-regulations-after-ftx.

[3] https://www.bloomberg.com/news/articles/2023-01-19/bahamas-financial-reputation-threatened-by-ftx-collapse.

[4] Id.

[5] https://www.investopedia.com/sec-vs-ripple-6743752.

[6] https://crsreports.congress.gov/product/pdf/IN/IN12052.

[7] https://www.cryptoglobe.com/latest/2020/02/binance-is-not-authorized-to-operate-in-malta-says-country-s-financial-watchdog/.

[8] https://www.coindesk.com/markets/2020/05/08/binance-doesnt-have-a-headquarters-because-bitcoin-doesnt-says-ceo/.

[9] Id.

[10] https://www.wsj.com/articles/u-s-crypto-traders-evade-offshore-exchange-bans-11627637401.

[11] Id.

[12] https://www.reuters.com/technology/auditing-firm-mazars-pauses-work-binance-other-crypto-clients-coindesk-2022-12-16/.