Revisiting Quadriga and the Case for Crypto Regulations
OSC released the final report on Quadriga almost one year ago. The final report is worth a second look because it reveals a level-headed approach to crypto markets. Quadriga collapsed in 2018. It owed over 76,000 clients more than $215 million in assets. Around 40 percent of these clients were from Ontario, 95 percent from Canada, and 5 percent from the rest of the world. In the aftermath of the bankruptcy process, the clients lost money and crypto assets worth at least $169 million. Given the scale of the fraud, it would have been a popular move to overregulate this highly innovative market. Fortunately, Ontario Securities Commission (OSC) recognized the potential of the cryptocurrency markets to be the next big financial revolution. The regulatory takeaway is that regulations are needed to ensure transparency in the exchange businesses.
How Quadriga Represented itself
25-year-old entrepreneur Gerald Cotten and his friend Omar Dhanani found Quadriga in December 2013. At this time, Bitcoin was in the middle of its first bull run, with the price of Bitcoin going over $1000 from under $100 at the start of the year. Just like the bull-cycle we are in, consumer interest in Bitcoin was at an all-time high. Canadian consumers demanded an easier way to invest in crypto, and Cotten gave them a platform where retail investors could buy Bitcoin with Canadian Dollars and trade fiat and crypto assets with other Quadriga clients. Quadriga’s business model was to charge transaction fees on its clients, and all seemed good.
Behind the Scenes Quadriga was not Honest
Beyond the business model, Quadriga had serious leadership problems from its inception. Omar was convicted in the US of conspiracy to transfer identification documents and online money-laundering in 2005 and left Quadriga in 2016. From its beginning until its collapse, Cotten was the sole director and decision maker for all practical manners. It is unclear whether the duo ever intended to run a trustworthy platform. Still, it is not so surprising that Cotten used Quadriga to fund his highly speculative and often unsuccessful trades worth approximately $143 million. Of this amount, $115 million was attributable to fraudulent transactions Cotten made with fictitious currency and crypto-asset balances under pseudonyms with unsuspecting user Quadriga clients. Cotten funded his pseudonyms fake fiat, Bitcoin, and Ethereum totaling over a hundred million dollars to trade with his clients. In effect, these fraudulent trades exposed the clients to naked long positions in Bitcoin and Ethereum. When the crypto prices crashed following the 2017 bull run, the value of Quadrega’s crypto assets evaporated. Cotten lost the remaining $28 million of the client’s money-making unprofitable trades on other crypto asset trading platforms without authorization from, or disclosure to, clients. He also spent lavishly in his extravagant lifestyle. Before going bankrupt, the platform had turned into a complete Ponzi scheme, with new clients’ deposits immediately re-routed to fund other clients’ withdrawals.
Quadriga was Dishonest about its Crypto Custody Strategy
On the surface level, Quadriga’s advertised crypto custody and security strategies are similar to that of centralized exchanges that exist today. Online, Quadriga claimed that it stored 99% of clients’ crypto in cold wallets. As with many other crypto asset trading platforms, trades within Quadriga were not recorded on the blockchain unless it was a trade with Quadriga to fund or withdraw crypto assets using an account. The platform held custody of the client’s crypto assets. This setup is familiar to those of us who invest in crypto assets. Centralized exchanges like Binance, Kraken, or Coinbase are the most convenient way of onboarding your fiat into most blockchains. Until the client withdraws their crypto or fiat, all they have is a claim against the platform. Clients rely on transparency and honesty of the exchange. Cotten lied to its clients about how Quadriga stored the client’s assets. In reality, Cotten regularly moved the client’s crypto to his personal wallets on other crypto trading platforms to trade for his benefit.
The OSC’s takeaway from the Quadriga saga is that whenever there is a novel business with a developing regulatory framework, the existence of bad actors willing to take advantage of the circumstances to defraud investors is not surprising. The report reports many times that Quadriga is not indicative of the general state of the cryptocurrency exchange industry or a fundamental flaw within cryptocurrencies. OSC correctly identified Cotten ran a traditional Ponzi scheme and took advantage of the bottlenecks in accessing the emerging crypto money markets. OSC tempered their response in recognition that financial innovation is vital for creating future wealth. Major technological innovations in programmable cryptocurrencies are producing brand new financial products and affirm the importance of not overregulating cryptocurrency markets. It would significantly hurt Canadians if regulations locked us out of being a part of the revolution in crypto markets. The regulatory response is proportional, in my opinion, to the risks and benefits that exist in cryptomarkets.
The report identifies the regulatory measures that will protect Canadians against schemes like Quadriga. OSC asserts that securities laws apply in full force if a platform holds custody of the client’s cryptocurrencies. They also maintain that platforms should adopt internal systems to control and manage key personnel and business continuity risks. Finally, OSC states that disclosing key information is necessary to ensure a safe and honest financial environment for the cryptocurrency markets to continue to innovate.
Regardless of one’s ideological groundings, OSC is correct that the lack of regulations in the cryptocurrency markets makes it vulnerable to fraudsters. Bad faith actors have a much more significant impact on the public psyche than the technological breakthroughs that are difficult to explain to the ordinary person. In the long term, it is as much in the interest of the libertarian cryptocurrencies ideologues and their more conservative counterparts to embrace a responsible regulatory scheme. Securities regulations are a great place to address the vulnerabilities that make crypto innovations open to abuse without smothering innovation.