Regulation Is Key to Rebuilding Trust in Crypto Everyone involved in the industry has their role to play in ensuring that certain standards of protection are met, thereby strengthening the blockchain industry, and rebuilding its reputation.
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The crypto industry is diving into 2023 with some significant new year resolutions. Following several collapses and market downturns the past year, blockchain advocates are reconsidering their priorities and changing tack in order to secure the industry's longevity. Regulation can be the cornerstone to this recovery and future success of cryptocurrencies: offering security, reassuring customers, encouraging mainstream adoption, providing legitimacy, and, ultimately, rebuilding the industry's reputation.
Of late, we've seen centralized crypto companies masquerade as banks, behaving in the same way, but without any of the legal compliance that the tightly regulated traditional banking system adheres to. Investors are then misled into blindly trusting these exchanges and companies, without being afforded the same security guarantees. As the crypto industry moves away from its roots as the so-called "wild west" of the capital markets, and towards a more secure and regulated market, institutions will play a key role in this transition. Institutions have the infrastructure and experience to work closely with regulators in facilitating more widespread adoption of crypto in a highly compliant manner. Building greater harmony in regulatory frameworks globally will be a major step forward in this journey.
We're (not) all in this together
Looking at the current international regulatory landscape, there is disharmony across regulatory approaches. Multiple different authorities within the same country are often all fighting for control of the crypto agenda, with the battle among the Securities and Exchange Commission and Commodity Futures Trading Commission in the US the most well documented.
While this is an important first step, each group operates under their own definitions, enforces different rules, and exhibits different levels of urgency, resulting in fragmented rules and enforcement for crypto providers. Inconsistencies in regulation provide opportunities for malicious actors. To avoid certain locations becoming hubs for illicit activity, like the "crypto crime" on Bitzlato recently reported by the US Department of Justice, there is an opportunity to set the global standard for a more harmonized framework.
Certain countries have been leading by example from the get-go. Switzerland, with its strong financial reputation of wealth and high-security, has developed FINMA and the associated Distributed Ledger Technology (DLT) Act, a structured framework of rules and definitions that crypto operations must be carried out within. In the UAE, the Abu Dhabi Global Market's Financial Services Regulatory Authority has established a regulatory framework to guide financial blockchain innovation. This formal recognition of cryptocurrencies provides the foundation for the UAE as a crypto hub, attracting business and encouraging investment from the region. Abu Dhabi-based Venom Foundation just announced a US$1 billion blockchain fund, and at the conclusion of 2022, there were 1,650 crypto companies operating in the UAE.
Where regulation goes, institutional interest will follow, proving the value and legitimacy of such frameworks. For example, regional banks are selecting Swiss crypto companies to partner with for their digital asset ventures, and Emirati institutions have been able to interact with crypto in confidence due to these clear rules of the road.
What are the rules of the road?
One of the biggest legacies of FTX founder Sam Bankman-Fried is the lesson of due diligence, a necessary process when interacting with a high-risk asset class. For due diligence to be effective, no stone can be left unturned: exchanges, banks, crypto companies, partnerships, customers, and the assets, all must be verified to not only protect the crypto investors from the malpractices of institutions, but also to protect the institutions from nefarious investors.
Several initiatives are necessary to secure a comprehensive level of protection, the first being liquidity reserves. By setting clear guidelines on what type and size of reserves crypto companies should have, and by regularly stress testing these reserves, there is a backup in place for whenever needs be. It is also important to provide institutional-grade custody over customers' assets, following the same standard in strength of security that investors are accustomed to in traditional banking.
Custody solutions must be subject to regular audits if security is to be maintained. Additionally, auditing is key to identifying any potential risks and addressing them in a timely fashion, before things get out of control. Much of the recent crypto crash was due to customers' funds not being segregated from the company balance sheets, and instead being used in high-risk bets. Assets must be held separately so that, by default, they belong to the client, and not to the exchange or bank. Regulators must demand a certain level of transparency, and consistently monitor compliance to ensure similar events do not reoccur.
Many crypto customers do not have the technical understanding to conduct their own due diligence, and so trust in the expertise of the exchanges and other companies handling their investments. It is then the responsibility of regulators to ensure that no entity takes advantage of this trust, and that everyone abides by good practice.
As has always been the case with any novel technology, the budding digital economy is developing rapidly, and regulators are often left scrambling to catch-up. For example, the new intersection between artificial intelligence and blockchain will require a reconsideration of legislation. Regulators carry a heavy burden when imposing standards that foster innovation without choking the market. Crypto exchanges, central banks, and other industry heavyweights should form a consortium to offer feedback and first-hand insights to regulators, sharing expertise that can appropriately tailor regulatory guidelines.
And what about DeFi?
The final hurdle in regulating the crypto industry will be decentralized finance (DeFi). A smooth relationship between regulation and DeFi is complex as many of its core principles, such as open governance, which directly conflict with the authority of regulators.
That said, there is space to find the right balance for service providers to offer innovative services in a safe and compliant manner, with centralized finance (CeFi) and DeFi playing different roles, depending on investors' priorities. Permissioned DeFi, a convergence of traditional finance and DeFi that is enabled by the secure guardrails of institutions, can provide such a balance.
Everyone involved in the industry has their role to play in ensuring that certain standards of protection are met, thereby strengthening the blockchain industry, and rebuilding its reputation. Regulators must construct cohesive guidelines that everyone can trust, collaborating to restore confidence in the system. Regulation will help to rebuild trust. The crypto industry needs institutions with the infrastructure and expertise in compliance and consumer protection to entice a wider cohort of users to engage confidently with a new asset class, as well as the next phase of finance.
Related: Future Foresight: Phoenix Group Co-Founder Bijan Alizadeh On Why He Continues To Look At The Crypto Space With Realistic Optimism