Panic at the Casino
The crypto industry should make a last ditch effort to self-regulate or be prepared to face a regulatory leviathan
2022 crypto markets were an embarrassment for everyone involved. The regulators, the regulated, customers, commentators, if the Bond Market from the famous James Carville quote “can intimidate everybody", then the crypto markets of 2022 could be said to embarrass everybody.
Multiple stablecoins de-pegged, tearing down the LUNA token in the process. That kicked off a slow moving domino sequence that seems to still -slowly- be playing out.
Along the way FTX collapsed and billions of depositor funds seem to have vanished.
In the aftermath we’ve heard increased calls for broad regulation of crypto markets and specifically the oversight of stablecoins, as well as increased scrutiny of the companies and platforms that use them.
Lost in these calls is the idea that crypto markets could do anything to regulate themselves. And perhaps at this point they can’t. But before we jettison the idea entirely let’s ask if -perhaps- they still can, and why they might want to try.
It certainly isn’t the first time that customers have been put into the awkward role of their own due diligence provider.
History chimes in
This situation isn’t new, it’s just been forgotten.
During the various periods of free banking, private banks were able to issue their own banknotes and conduct their own activities with minimal or without government regulation or oversight.
Along with a slew of problems, this created a more dynamic and competitive banking system, as banks competed with each other to attract deposits by offering higher interest rates and other incentives.
Depositors had to be attentive, as putting money in a bank, put the depositor in a position where they needed to manage deposits at multiple banks against the incentives and associated risks at each bank.
Without the government providing deposit insurance or acting as a lender of last resort, depositors needed to weigh their own due diligence on each bank against the interest rate offered by the given bank. Reputation. Solvency risks. Accessibility/availability of deposits. These were considered by each depositor.
Crypto depositors today face a similar situation. The lack of regulatory clarity or backstops in the space has put crypto purchasers into the position of carefully managing the risks of depositing their funds on each crypto exchange and platform they use.
Like with free banking, there is no centralized regulatory body that oversees or guarantees the safety of crypto assets. So crypto depositors need to perform their own due diligence on each exchange or platform and consider factors such as the reputation, security, and regulatory compliance of the platform, as well as the accessibility and availability of their assets.
The truth though, is that most don’t. Why?
Intimidating everybody
The challenge is that understanding crypto for most people is a big educational lift to begin with and quickly becomes a full time, ongoing effort as one learns more about the crypto market and how it relates back to existing asset classes.
For example, crypto staking and the buying of a traditional bond have some similarities. Both involve a commitment of funds with the expectation of receiving a return on investment over a specified period. In the case of bonds, the investor lends money to an issuer and receives interest payments over the life of the bond. With crypto staking, the investor holds a certain amount of a cryptocurrency to secure the network and receives rewards for doing so. Both investments also involve a degree of risk, with the potential for the issuer or network to default or fail, and both bonds and staking can provide a predictable income stream which might seem like an attractive option for investors seeking more stable returns.
But sometimes, goals within a cryptocurrency development community (who usually run the staking programs) can be more flexible than originally imagined, which can create confusion and risk for the stakers.
Unlike traditional bond investments, where the terms and conditions of the bond are clearly defined, staking relationships can be more complex and subject to interpretation. This can lead to extreme uncertainty around issues such as the duration of the staking commitment - as Ethereum stakers just learned last year (Cointelegraph: Ether staking withdrawal schedule removal faces harsh criticism) (more) (even more).
For the traditional regulators who encounter this, the reaction is understandable: SEC: Kraken [crypto exchange] to Discontinue Unregistered Offer and Sale of Crypto Asset Staking-As-A-Service Program and Pay $30 Million to Settle SEC Charges.
And despite SEC head Gary Gensler's personal experience and awareness of crypto, the Securities and Exchange Commission (SEC) more broadly has struggled to hire employees with expertise in the field, making the hiring of crypto talent a focus mid-year last year so as to bolster its crypto facing group: SEC Nearly Doubles Size of Enforcement’s Crypto Assets and Cyber Unit.
Moreover, while existing securities law requires lawyers and accountants that might be drawn from traditional places, finding qualified candidates with the necessary knowledge and experience in crypto is a bigger challenge.
The risk with this, is that missteps within the first few years of finally regulating crypto could echo through the next few decades of crypto regulation.
Native solutions
On the crypto side, the industry has been exploring and implementing its own solutions.
The primary solution that has gained traction in recent years is ‘Proof-of-Reserves’, which is a collection of methods that crypto exchanges use to prove that they hold enough reserves to cover all their customers' deposits - though the method they do this by can range from a traditional audit to a cryptographic on-chain process. The effort increases trust and security for customers while also promoting responsible behavior among exchanges.
So it’s no surprise that several exchanges have already implemented Proof-of-Reserves or similar methods to provide assurance to their customers, with even more exchanges finding Proof-of-Reserves religion in the aftermath of 2022: Top 10 Exchanges that have Released Proof of Reserves Audit
As more exchanges adopt Proof-of-Reserves and similar methods, it could become a standard for the industry. But again, the devil will be in the details of the industry’s choice of implementation (or lack thereof).
Ready. Set. Gone.
The relentless pace of crypto advancements, particularly the development of smart contracts, is the forcing function in all this. The increasing complexity of new tools like smart contracts will cause an even greater need for transparency, security, and understanding as they go into broad use and the expertise needed to assess them increases.
While government regulators like the SEC will provide some oversight, the industry should leverage private sector expertise and self-regulation to ensure the safety and integrity of the market and to have some contribution to the regulatory techniques that are developed in the aftermath of last year.
Tokenomics advising firms already exist to provide guidance and expertise to their customers on how to create smart contracts and token programs. In the very near future crypto markets will need similar entities to help the retail market along as well. The trick will be figuring out which types of organizations people will trust to do this, and how quickly it can be done.
Until next time.
-Jack