Time for Crypto to Make Nice With Regulators

If you still think cryptocurrency can thrive best within the ambiguous, ill-defined, geographically varied and relatively lax regulatory system, you haven’t been paying attention.

With the spectacular failures of TerraForm Labs’ LUNA/UST and Celsius, the systemic fallout from the liquidity challenges at Three Arrows Capital and the erasure of almost $2 trillion in value from crypto markets, it should now be clear to all that this industry needs better, clearer and consistent rules.

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Whatever comes next must be good for the industry as a whole – the developers, the businesses and most importantly, the users. We need regulation that makes the entire ecosystem more stable and secure, yet which also enables innovators to develop projects that realize the true benefits of decentralization and that give users greater autonomy and sovereignty.

The good news is that, despite the understandable alarm that recent events have sowed among some policymakers, a growing cadre of regulators recognizes the positive potential of cryptocurrencies, digital assets and blockchain technology and genuinely wants to be constructive.

We heard that sentiment at CoinDesk’s Consensus 2022 festival this month. It came from the likes of Commodity Futures Trading Commission Chair Rustin Benham, Deputy Treasury Secretary Wally Adeyemo, White House Director of Cybersecurity and Secure Digital Innovation Carol House and Federal Reserve Chief Innovation Officer Sunaya Tuteja, as well as from the three senators and one congressman who joined a bipartisan panel of lawmakers.

Also, last week, the Bretton Woods Committee, a nonprofit organization comprising many former regulators and current leaders of the Wall Street and business establishment, unveiled a surprisingly constructive report that we highlighted on our “Money Reimagined” podcast. It was encouraging to find the committee recognizing the benefits of privacy, financial inclusion and international efficiency that permissionless, decentralized and token-based protocols have to offer.

This might be hard to accept for many in the crypto community who’ve seen the government as the enemy, but hearing these people’s open-minded perspectives has put them in a far more positive light than various crypto leaders whose dubious behavior has caused great pain for so many over the past few months.

No knee-jerking, please

Those positive signals notwithstanding, there is real hostility toward this industry in some government quarters. If these skeptics gain the upper hand – especially if public opinion gets behind them – there’s a real risk of a knee-jerk policy response to the latest fallout. One unwelcome upshot might be that regulators end up forcing more centralization on an industry when the best way forward is to build workable decentralized systems that can’t be exploited by self-interested players.

Read more: How Crypto Lender Celsius Overheated

Too much centralization in crypto is, in some respects, the core problem right now. (Consider Celsius’ freeze on withdrawals – it would simply not be possible if, under a more decentralized model, the provider did not have custody of its users’ assets.)

But regulators, working off the old pre-crypto playbook for keeping financial entities in line, instinctively want someone or some entity to be held accountable. That means they can end up favoring the formation of centralized, trusted third parties, the very source of risk, corruption, cost and dependency that cryptocurrency developers have historically sought to replace. If that happens, it would set the industry up for the same “too big to fail” problems that led to the Wall Street collapse of 2008.

Yet crypto users really do need greater protection from businesses and developers who, with their information asymmetry advantages, are in a position to exploit their customers. Regulation should lean into solving that problem in a way that brings transparency and trust to decentralized models and which limits the ability of centralized parties to take outsized risks with their clients’ funds.

Many financial laws are simply incompatible with an entirely new, open-design system

Centralized entities such as Celsius could be required, as brokerages often are, to create segregated accounts that ring-fence clients’ assets – especially crypto collateral posted for loans – from risks taken on by the firm. That will, of course, tie these firms’ hands, giving them less leverage with which to take big bets, which will result in lower yields on clients’ investments. But such is the trade-off for the safer conditions that come from regulation.

This could also mean yield-maximizing opportunities shift to noncustodial decentralized finance (DeFi) models in which users retain control over their private keys.

Yet, after the Terra debacle and a host of hacks and “rug pulls” by founders, users also need protection from flawed projects in DeFi. Here, the way forward may lie in a decentralized version of industry-based self-regulatory organizations (SROs). Token holders with governance voting rights could forge these bodies, preferably with an interoperable purview across different platforms, to agree on software and security standards and, most importantly, on frequent audits of the code.

A DeFi SRO could also borrow from a tool the Federal Reserve applied to banks in the aftermath of the 2008 financial crisis: stress tests. Simulations of stressful market conditions and of different types of speculative and technical attacks might have revealed the flaws in the Terra ecosystem before it was too late.

Lean into blockchain transparency

Whether these rules and transparency standards are administered by government agencies or by token-holder bodies, they should be taking advantage of a hugely underutilized aspect of blockchain technology: its capacity to enhance transparency around reporting.

In a tweet this week, investor and commentator Maya Zehavi suggested the industry needed its own “on-chain Dodd-Frank or Mifid2,” a reference to the seminal postcrisis financial legislation that was introduced in the U.S. and Europe, respectively, to boost transparency around financial systems.

Her idea is that to reduce the systemic risk exposed by failures such as Three Arrows Capital, users could have access to reliable, blockchain-based data on outstanding trading positions so as to “gauge the overall leverage in [the] centralized platforms” that interact with those blockchains.

The bottom line is that while crypto needs regulation, it must be designed in ways that leverage the strengths of the technology and which are consistent with its core design principles. Whether it’s the 89-year-old U.S. securities law that can’t be reconciled with the commodity-like features of blockchain tokens, or the 51-year-old Bank Secrecy Act, which gave rise to draconian anti-money laundering and know-your-customer rules, many financial laws are simply incompatible with an entirely new, open-design system of finance that crypto proposes.

Let’s stop trying to jam square pegs into round holes.