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A s the crypto economy was gradually recovering from the Luna and Terra crashes that took place a few months ago, another crisis hit already-troubled markets last week. The failed FTX-Binance deal and Friday’s bankruptcy filing by FTX in the US marked the collapse of one of the world’s largest cryptocurrency exchanges, raising concerns and uncertainty about the future of cryptocurrency markets and their contagion effect.

With news of a possible crash of FTX, crypto markets took a hit. Estimates indicate a wipeout of around $180 billion in investor wealth from crypto markets last week. This incident again brings under the spotlight the burning question of crypto-asset regulation that many policymakers seem to be sidestepping.

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Last week, Binance Holdings Ltd, which operates the world’s largest cryptocurrency exchange, was set to acquire its rival FTX, which was facing a liquidity crunch. Before this news could sink in, Binance abandoned the deal, citing concerns about the business practices of FTX (including mishandled consumer funds) that have since led to probes by US financial-sector regulators.

Troubles started surfacing for FTX with a news report showing Alameda Research, a hedge fund run by FTX’s founder Sam Bankman-Fried, holding a large amount of FTT tokens (the native crypto token of FTX). While FTX and Alameda were supposed to be separate businesses, the report indicated close financial ties between the two, raising concerns of corporate governance practices, valuation standards and the financial health of FTX.

Soon, this was followed by an announcement by Binance that it would be liquidating its FTT tokens, heightening concerns about the solvency situation of FTX. This led to large withdrawals of funds by investors, which in turn impacted the value of the FTT token. With impending bankruptcy proceedings, consumer funds remain at risk, as FTX has highlighted the challenges it faces in returning money without an infusion of external funds.

The collapse of FTX, which was considered to be a credible player in the crypto market, has highlighted the vulnerability of the crypto economy. That an apparently financially sound company, valued at $32 billion not very long ago, could also collapse this way exposes the fault lines of loosely regulated crypto markets.

This episode, therefore, has raised several important questions. How does a retail investor interact with such exchanges in such situations? How are asset values determined? What are the liquidity requirements of such exchanges? Who is responsible for protecting investor money in the event of an exchange turning insolvent? And last, but not least, is there a redressal route for aggrieved cryptocurrency investors?

If anything, the FTX collapse should be a wake-up call for policymakers who have either adopted a wait-and-watch approach or resorted to half-baked measures to regulate the crypto market. There is an urgent need for regulatory intervention to clarify the legal status of crypto assets under applicable laws and bring exchanges and other intermediaries in the market within the regulatory ambit.

If legal status is determined in crypto’s favour, then the law must clearly lay down the authorization requirements and eligibility criteria for such players to operate in the market. It must also spell out capital and liquidity requirements, and corporate governance norms, including requirements for management structures. Also, how interactions with group companies would be held, apart from valuation norms, permissible use cases, provisions for protecting consumer funds, an insolvency framework, risk management strategies, and a set of consumer protection and market integrity provisions.

Other than the EU, which is currently in the process of finalizing a comprehensive legislative framework (its Markets in Crypto Assets regulation), most countries have focused on regulating certain aspects of cryptocurrency assets; i.e., through either money laundering laws or securities laws. In India, while the government has decided to tax crypto assets, it has so far not taken a clear stand on their legal status.

Given the unique nature of crypto assets, it is often difficult to pigeonhole them under a specific category of traditional asset classes. This calls for a bespoke legal framework to regulate crypto assets. This framework must further be supplemented by efforts at creating global principles for crypto asset regulation to aid cross-border standardization, which is important given the global reach of this market.

While designing regulation is one aspect, most policymakers seem more concerned about the enforcement of regulations in the context of the extra-territorial and pseudo-anonymous nature of such assets. Effective enforcement would require policymakers to envisage leveraging technological advancements for better supervision and integrating international cooperation frameworks for information sharing.

As India assumes the G20 presidency, the government should take the lead in forging a consensus on designing global standards and principles for cryptocurrency regulation, and also perhaps lead by example, by bringing the sector under the country’s regulatory ambit.

These are the author’s personal views.

Shehnaz Ahmed is fintech lead at the Vidhi Centre for Legal Policy.

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