Post-FTX: Crypto Regulation
Benzinga x FirstWatch Crypto
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This piece was written in conjunction with Dan Nuñez Cohen, Senior Policy and Regulatory Counsel for Crypto.com. The views expressed are the personal views of the authors. The views in this article do not express the views of Crypto.com or any other organization.
Crypto Regulation is Inevitable
Congress will act, the major concern now is whether it will be an overreaction.
We will skip ahead to what you already know: FTX collapsed. The FTX story dominated the business and media news cycles, and was largely negative for crypto. At best, FTX was a poorly managed company. At worst, it was a ponzi scheme with ties to multiple politicians.
One thing that is worth mentioning is that Sam Bankman-Fried, at the time of FTX collapsing, was not popular in the crypto industry. This tweet from Richard Chen of 1Confirmation, an established crypto VC fund, was very telling. Richard argues that SBF’s regulatory efforts were self-motivated, bad for crypto, and potentially not his own.
There is a lot of irony that SBF was aggressively lobbying for regulatory changes to the crypto industry because he turned out to run one of the most fraudulent crypto companies to date. This tweet is also relevant to this discussion because it gets at the crux of what was being debated in the industry before FTX collapsed, regulating CeFi versus DeFi.
CeFi vs. DeFi
To understand where we are with crypto regulation, we need to understand the distinction between DeFi and CeFi.
DeFi is technology; CeFi are companies.
DeFi protocols are lines of code that execute on a blockchain that give users the ability to trade and lend peer-to-peer. They are similar to blockchains in that no one person or entity controls them.
CeFi is a term to describe companies acting as crypto intermediaries. There are some good CeFi companies, and there have unfortunately proven to be a lot of bad ones, like FTX. CeFi companies such as Binance, Huobi, OkX, FTX, Voyager, or KuCoin are off-shore unregulated crypto banks. This is one of the worst case scenarios for the industry for the following reasons.
Most operate outside of the US; it’s estimated 90% of crypto trading is off-shore
Many can operate in ways that would be illegal in the traditional finance system
Most original crypto users hate them because of “not your keys, not your coins”
A few CeFi companies have emerged as well-managed, user friendly institutions that take the peer to peer and permissionless virtues of crypto seriously, like Coinbase, Crypto.com, Kraken and Gemini among others.
The bad actors are obvious, and FTX was the worst one.
Regulation for CeFi
The media, most of Congress, and agency regulators associate crypto with CeFi, and generally do not understand DeFi as well. Therefore, for the crypto industry to grow, it is both inevitable and necessary to put more rules and regulatory clarity around CeFi companies.
What FTX did wrong
FTX has done a number of outright fraudulent things, but some of the basic principles of what they did were:
Dip into client funds for risky trades
Not custody 1:1 holdings of client assets
Not maintain a separation of functions for matching trade orders, custody clients’ funds and proprietary trading (this is standard for investment banks)
Have terms of service and conditions that are not enforceable in the US
Lack any type of oversight - they didn’t even have a board of directors
Lack controls to prevent conflict of interest between affiliates of exchanges (FTX and Alameda)
FTX owned their market maker Alameda, this would be like Citadel and the New York Stock Exchange being owned by the same person.
Most of these activities would never be allowed in the traditional financial system based on a system of laws going back to the 1929 financial crash.
Rules that Need to be in Place
Congress and agency regulators will act as swiftly as they can to stabilize the industry, add legitimacy for institutions, and protect consumers.
Here are some of the ways that crypto companies will most likely be regulated in the coming months:
Mandatory internal and external audits of client assets held in custody
Periodic publication of proof of client assets with real time data
Enforcement of conflict of interest and risk management rules
Minimum uniform capital standards for lenders
Ensuring offerors of non-investment products (i.e., retail or institutional custody) do not invest or dip into client funds and maintain 1:1 holdings of client assets
Ensuring exchange platforms (entities who match bid/ask orders, rather than entities who sell from their inventory) have separation of functions for matching, custody and trading
Ensuring the terms of conditions of products being offered are accurate
For DeFi, introduce new set of cyber-security standards to safeguard protocols from hackers
How Should the Government Think about Consumer Protection
The US should build on its existing laws for financial intermediaries and actually do the hard work of adapting them to CeFi.
In addition to the ideas mentioned above, some specific ideas that would be effective are:
Model risk disclosures tailored to specific types of products
Disclosures should be accessible, readily understandable, and material
For CeFi, the government should look at the activity offered and apply the existing financial services rules but tailored to the realities of blockchain and digital assets (i.e., money transfer should be regulated as money transfer; investments as securities)
For DeFi, the government should focus on cybersecurity vulnerabilities, protocol governance, and education on cyber risks and fraud so users can identify them on their own. Followed by enforcement against bad actors.
Should the SEC Have Jurisdiction Over Crypto?
There’s a narrative in the crypto community that if the SEC controlled crypto, it would be the end of the crypto industry. That’s simply not true, but there are nuances. The three main functions of crypto tokens are use as payment instruments, digital commodities, and digital securities. Each function can be controlled separately and the regulatory bodies can take steps to smoothly establish guidelines for each.
The SEC should get to regulate centrally controlled crypto tokens that function as securities. The SEC needs to establish specific guidelines on what constitutes a centralized crypto project and what tokens behave as securities. The current process of “regulation by enforcement” is causing a lack of trust between crypto and the SEC, and pushing a lot of crypto off shore. If the SEC can create a process to get existing tokens regulated as securities, without threatening lawsuits, it will allow the industry to further blossom.
The CFTC should continue to enforce anti-manipulation and fraud rules over centralized entities trading in crypto commodities (such as bitcoin and ethereum), as it does with commodities like oil, and to oversee any centralized exchanges offering derivatives.
Because crypto also functions as a payments system, centralized entities that allow for that type of function, like retail exchanges, the Cash App, or any service offering crypto payments, should be regulated by the traditional players: FinCEN and state banking regulators.
Federal and State Banking Regulators
Any centralized services offering custody of client assets should be regulated by federal and/or state banking regulators and should be registered as trust companies or money transmitters.
The Treasury and the Fed
Stablecoins are great mechanisms for payments. To protect the dominance of the dollar, the Treasury Department, in conjunction with the Fed, will most likely oversee all centralized stablecoin issuers.
Is Crypto Going Away?
Crypto is not going away. However, because of FTX and others, some of the freedom that crypto participants have enjoyed up until now will disappear. This is unfortunate, but inevitable.
It’s currently an unruly adolescent that the government has mishandled. For everyone to succeed, rules will have to be put in place. The US government has indicated that it might want to send crypto to military school, but we advocate for a less aggressive approach. Institutional interest in crypto was blossoming before FTX, and a measured approach here could be the catalyst crypto needs for more widespread institutional adoption.
It is our view that both DeFi AND CeFi need to continue to foster growth in the crypto industry. While DeFi is closer to the founding ethos of decentralized and transparent cryptoassets, CeFi will help to onboard users and work with institutions.