How to Regulate Crypto

Regulators around the world have begun taking tentative steps to regulate crypto and digital assets. Such assets are a new frontier in finance. And available evidence does not encourage much trust or confidence in their value or, for that matter, utility.

How, then, should they be regulated?

A panel discussion at the Bank of International Settlements last month sought to answer that question. There was much hand wringing about the status of virtual asset providers or VASPs. But the discussion ended as it had started: without clear guidance about the status for VASPs or, indeed, the direction of regulation for these assets.

Risky Virtual Assets

The BIS panel discussion outlined three types of risks associated with the regulating technology-based systems.

Governance of opaque permissionless systems is one. The consensus process is not transparent and it is also not clear if decision makers in such systems have conflicts of interest.

Legal and compliance risks associated with Anti-Money Laundering (AML) and Know Your Customer (KYC) practices are another. Most institutions operating in the traditional finance network comply with the practices to be a part of the international network.

The situation in crypto is the opposite as most services have chosen to remain outside the system. For example, Binance and Tether, the world’s biggest crypto exchange by trading volume and stablecoin by market cap respectively, are unregulated. The so-called decentralized finance (DeFi) systems are also unregulated and do not implement AML/KYC rules.

Another problem in the same category of risk is that of settlement. Settlement at permissionless distributed systems is probabilistic and not final because participants in a consensus can revise the order and timestamp of transactions. Finality is ambiguous and based on the idea that the longer a transaction is considered settled the lesser its chances of being reversed. This means that there will never be “settlement finality”.

The third risk relates to technology. Apart from the ever-present risk of hacks and system failures, virtual assets also layer on the consensus risk in permissionless systems. A 51% attack can cripple consensus in such systems and lead to a breakdown.

Complicating matters further is the novelty of DeFi tech. “It is an elusive and constantly moving thing,” said John Schindler from the Financial Stability Board (FSB), referring to technological developments in its ecosystem. “It doesn’t have a lot of data and that makes analysis hard.”

Reframing the Question

The portability of digital assets across borders makes their regulation an interesting and daunting exercise. However, the current ecosystem of assets is hardly a case study for regulation. Beyond the buzzwords and technical gobbledygook, there is hardly anything new or innovative in the products and services designed in the current crypto or DeFi ecosystem.

Therefore, it might be an idea to replace the question of how to regulate VASPs with whether they should be regulated at all.

Same Risk, Same Regulation

The notional value of tokens in crypto runs into billions and trillions of dollars. But those valuations are erroneous and based on dubious tactics like wash trading employed at these exchanges. There is very little actual money floating around in these markets.

Most parts of the crypto infrastructure are wobbly and still under construction. That may account for the absence of data in decentralized finance. While its technology is useful and is currently being implemented in the design of CBDCs, DeFi is rife with hacks and frauds.

Major players in its ecosystem are centralized and so-called permissionless systems are actually controlled by a cabal of investors and developers. Even systems like Ethereum, which claim to be decentralized and have received a pass from regulators for the time being, are moving towards consolidation in their activities.

A consequence of this is that all crypto systems are subject to the same problems as traditional finance. Bank runs are common. As are system breakdowns and regulatory scandals.

In this context, it might be apt to quote one of the panelists. Neil Esho, Secretary General at the Basel Committee on Banking Supervision at BIS, said that they were approaching regulation from a technology-neutral standpoint. “Same risk, same regulation,” he explained.

That might be a good approach for a workable and efficient system. Crypto’s currently inefficient and leaky technology does not deserve the consideration.

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