The Way to Regulation is Through Exchanges, Not Currencies

When governments talk about regulation, many people in the crypto industry get worried. While I think most of us want to see intelligent and thoughtful laws put into place to make the industry less susceptible to fraud, we also want to know that these laws are being written in good faith. When it comes to crypto — an industry whose intricacies are as exciting to those who understand them as they are enigmatic and contentious to those who don’t — regulation will not be easy.

Just last week, a judge concluded that XRP did not meet all of the criteria to be considered a security, giving the crypto market a much-needed confidence boost. Even so, this ruling does little to clear up the status of other crypto assets (PEPE coin anyone?). And with Alex Mashinsky’s arrest earlier this month, the memory of Celsius’ potentially fraudulent activity and SBF’s incredible flight from justice serve as painful reminders that the crypto industry needs to change.

Because the current state of government moves so slowly, blockchain has escaped any major regulation since Bitcoin was first launched in January of 2009, which has led to major innovations occurring in a relatively small amount of time. However, the lack of regulation has also resulted in major losses, namely widespread theft, scams, and fraud. Not only have businesses and individuals been hurt, but crypto’s bad press might lead to a possible slowing down of crypto adoption as fear, uncertainty, and doubt overshadow all of crypto’s potential.

"Indian government on cryptocurrency" by Cryptodost is licensed under CC BY 2.0.

The Future of Regulation

In general, wherever cryptocurrencies are legal, they are subject to anti-money laundering regulations and taxes. But in light of recent events, many regulators are beginning to take an even more aggressive approach to crypto. 

This Monday, the Financial Stability Board (FSB) issued a report sharing its recommendations to provide a more cohesive and consistent regulatory framework for cryptocurrencies worldwide. They want to protect investors and individuals, promote responsible innovation, and perhaps most of all, safeguard the integrity of the financial systems that underpin our society.

In 2022, 3 Arrows Capital went bankrupt after Luna and Terra collapsed, Celsius went bankrupt after a possible pump and dump scheme initiated by rumors that Sam Bankman Fried would be buying out its assets, and the crash of FTX became one of the most eventful scandals in crypto history. 

Then in 2023, we witnessed widespread bank failure, especially those associated with the crypto industry. With regulators picking through the rubble under the collapses of Signature, Silvergate, and Silicon Valley Bank, and UBS rescuing Credit Suisse, the ghost of the 2008 Great Financial Crisis is weighing heavily on many industry experts’ minds. While one cannot ascribe cause and effect to the events of 2022 and 2023, it is clear that the financial institutions of the world, both crypto and traditional, are intertwined.

Indeed, the legitimacy of the banking sector—and moreover, the legitimacy of crypto exchanges—is coming under fire, leading many to wonder what steps world governments will take to make the pain go away, both in the short and long term.

The Current Problems in Regulating Cryptocurrencies

Many crypto industry professionals have argued that not all digital assets fall under the definition of a security, and that the SEC should instead write new rules to tackle issues in the crypto sector. The biggest conflicts at present are, firstly, that there is no consensus on what to label these assets, and secondly, how existing regulation for securities, commodities, and property tries to force cryptocurrencies into a narrow definition that does not fully reflect the asset’s complexity.

Kelly LeValley Hunt, founder of Mint Gold Dust and investor in all things web3 since 2014, told me over the phone that tackling cryptocurrency regulation is an insurmountable task that looks at the situation from the wrong angle. “Each currency has its own flavor, so it’s difficult to put them all in the same group,” she said. “The different currencies are going to be used for different things, and they’ll be used differently in different parts of the world. We need to start to adjust to that.”

“We don’t need regulation for crypto, but for the people who handle crypto. The exchanges should be regulated not dissimilar to how we regulate banks.”

Kelly LeValley Hunt

The use cases of cryptocurrency are much more diverse than fiat, or traditional paper currency. Not only can it function as a store of value, a unit of account, or a medium of exchange—though these uses will likely come later as volatility lessens—but it can also represent membership in a group, enact voting rights, or unlock future airdrops of digital assets. And that doesn’t even begin to take into account the differences between fungible assets (like bitcoin and ETH) and non-fungible assets (like NFTs), the latter of which does function, at times, as digital property.

Furthermore, we already have examples of how countries regulate fiat currencies across borders, and that is through the exchanges. “We don’t need regulation for crypto,” LeValley Hunt added, “but for the people who handle crypto. The exchanges should be regulated not dissimilar to how we regulate banks.”

"Ethereum Classic Wallpaper - Cryptocurrency Contract" by EthereumClassic is marked with CC0 1.0.

Regulation: Rules and Realities

There are several features of bank regulation that are attractive to the crypto industry, namely, community investment, insuring a certain amount of funds, and other consumer protections. However, some are antithetical to how blockchain works. 

Blockchain is a revolutionary technology that has offered us a new way of conducting business and viewing the world. Bitcoin, the first and perhaps most well-known cryptocurrency, was launched right after the Great Financial Crisis, and its pseudonymous founder Satoshi Nakamoto clearly stated in the genesis block that Bitcoin was intended to be in direct opposition with traditional finance.

Not only would it require all transactions to be transparent, accessible, and immutable, it would also allow users to access the network trustlessly, or without disclosing any personal information. For this reason, any attempt to enforce KYC requirements, for example, could in effect stifle the progress of blockchain-based marketplaces, as people who value privacy will likely leave the marketplace entirely.

But another element of compliance would be for crypto exchanges to set up data centers that maintain all of the information of the network. “Right now, when you regulate a bank, the bank has to be up and running, their data center has to be up and running 5 9’s,” LeValley Hunt said. “That means, 99.999% of the time. This is what the regulators dictate in the United States.”

According to the C&C Technology Group, a data center will consume 1,000 kWh per square meter in order to maintain their servers. Multiply that by the area of a single data center, then consider the fact that most banks have at least two “hot,” or physical data centers (a primary and a backup), and one “cold” one on the cloud, and you can imagine the amount of energy needed to power just a single bank or exchange.

Which is not to say that this should not happen. In fact, blockchain technology has become a driving force in the adoption of green energy, as it is often cheaper and thus better for crypto industry players’ bottom line. It is entirely possible that this move could bear fruit for both regulating crypto exchanges and lowering harmful energy consumption.

"ETC Wallpaper - ETC Cryptocurrency Investment" by EthereumClassic is marked with CC0 1.0.

Moving Crypto, and the World, Forward

Without meaningful and tailored regulation, the crypto industry will continue to be a breeding ground for bad actors, scams, and avoidable financial catastrophes. Privacy, sovereignty, mobility, and decentralization are the foundational tenets of blockchain technology.

Therefore, any actions made in the pursuit of regulating crypto must keep these ideals in mind if they are to succeed, because compromising these ideals could in fact lead to the destruction of the industry itself. It would leave us with a shallow imposter whose characteristics are all too similar to the traditional finance world that blockchain aims to leave behind.

Blockchain is not necessarily a panacea to the problems we are witnessing in the banking sector, but many of its features certainly lend themselves to improving how we secure our assets in a way that has never been seen before. Namely, transparency would allow for an open conversation about what assets exchanges are investing in and what activities they are engaging in.

“In 20 years, the exchanges will be our banks,” LeValley Hunt said. And if that is indeed the way forward, then more exchanges might have to take Coinbase’s lead and bite the bullet now, before it is too late to build the trust and consumer loyalty they need to survive. 

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