South Korea puts exchanges on the hook for losses

Events in South Korea suggest this could be set to change. Following a recommendation made last year by the country’s Fair Trade Commission, five leading South Korean cryptocurrency exchanges have updated their terms of service to make them liable for customer losses regardless of the cause. This includes hack events, system malfunctions, or just plain negligence.

The new terms and conditions, which reflect a trend of regulatory changes in the region, come after a period of increased scrutiny by regulators. An investigation by authorities in January found lax security at 14 of the 21 exchanges in the country, resulting in several orders for improvement to be completed before service was allowed to resume.

Bithumb, the country’s largest exchange, and one of the seven exchanges deemed sufficiently secure was hacked two months later.

Eastern lawmakers lead the way

Several neighboring Asian countries have also recently introduced new precautions to protect traders from losses, suggesting that regulatory authorities in the region are leading the way towards safer conditions for traders on local exchanges.

In April, Japan, following the hack of the Coincheck exchange, Japan’s largest exchange hack, the Financial Services Agency (FSA) ordered the 19 registered cryptocurrency exchanges in the country to review their cold storage security measures.

Since then, the agency has applied even more pressure; amending two cryptocurrency laws at the end of May which will come into effect in April 2020.

The Payment Services Act, originally introduced in April 2017, has been revised to introduce several new safeguards similar to the South Korean regulations. The amendments include a requirement that exchanges hold a separate fund of the equivalent amount of all funds kept in hot wallets. This effectively mandates the creation of an insurance fund to cover any potential loss of customer funds.

Similar requirements were imposed late last year by the Hong Kong Securities and Futures Commission, which demanded in November that all licensed local bitcoin exchanges provide full coverage for customer funds.

But while it might be easy for regulators to demand insurance, the reality of acquiring it can be more difficult.

The cost of security

With over $1 billion lost to crypto exchange hacks in 2018, and over $356 million stolen in 2019 already, insurers are understandably hesitant to offer coverage.

According to reports from two of the leading cryptocurrency insurance brokers Aon, and Marsh & McLennan, business in the crypto insurance industry is booming, but the total capacity can’t satisfy the demand.

“It’s a new technology, it’s evolving quickly,” said Marsh’s U.S. financial products placement leader to Insurance Journal. “There are security risks. That’s a big concern.”

The premiums that are available can be difficult for blockchain startups to afford, and Marsh & McLennan, which has formed a dedicated team to service the growing needs of startups in this area, says that policies can take months to be approved, with little history of losses for underwriters to model.

Leading US exchange, Gemini, one of the first exchanges to become insured, did so by forming a consortium of insurers, but still only offers coverage of funds held in hot wallets.

Coinbase, which has made significant headway with regulators and has implemented a successful institutional custody service, has also only insured the contents of its hot wallets, which generally contain up to five percent of an exchange’s entire holdings.

Taking an alternative approach, exchanges bound by law to ensure customer funds might follow the lead of Binance and devise a homegrown model. The SAFU fund, which takes 10 percent of all fees generated by trading activity to protect users from potential losses, was recently tested successfully for the first time after Binance hackers made off with 7,000 BTC.

Regardless of how it is achieved, increasing insurance coverage reflects a maturing industry, and would go some way to restoring the suspect reputation of cryptocurrency exchanges. Eventually, this should open the gates to further investment from mainstream asset managers in South Korea and beyond.