Regulatory Measures for Crypto Inclusion & Mass Adoption
If you Can’t Ban it, Regulate It ..
Since it was sparked by the development of Bitcoin in 2009, the crypto adoption has been rising despite the turbulences every now and then. Regulators response across the world varied significantly, but in general there is a growing trend to regulate the industry, as not doing so carries opportunities loss and is causing a lot of harm to investors dreaming of quick wealth without knowing the basics of investments and how do to proper due diligence.
In this regulatory vacuum, many bad actors managed to scam millions of investors globally through ICOs, hacks, code exploits, security breaches …etc, and it is extremely difficult for authorities to trace funds that end up in unKYCed wallets through irreversible transactions.
For the firs time, regulators are faced with borderless and decentralized threat/opportunity that is developing at a rapid pace, and they have to strike a fine balance between a total ban and over regulating. An agile and progressive approach to regulate the industry is more needed than ever, and it should be based on regulatory clarity & enforcement in addition to awareness building.
In its 2021 report “DeFi for Institutions”, Consensys described the pyramid in the chart above as “ the Maslow’s hierarchy of institutional needs in the DeFi space”. In this article, I will try to use it as a structure for regulatory and awareness measures to govern the industry and protect investors.
Typically Digital Currency Service Providers (DCSPs) include Centralized Exchanges (CEX) offering trading & custody services as well as entities that just provide crypto custody in offline cold wallets, I will expand the definition here to include crypto funds and crypto projects foundations.
I. Security & Infrastructure
- Regulators should consider a governance framework to specify the minimum level of infrastructure security that DCSPs should adhere to in order to demonstrate to regulators that they can be trusted with investors funds. Such framework should address disaster recovery strategy, data center tier rating, penetration tests frequency, cyber security audit, check & balance measures ...etc.
- It is crucial to have the right crypto insurance that covers the perils related to activity, e.g. Indemnity Insurance, Cyber Liability Insurance, Commercial Crime Insurance to cover various incidents like private keys theft, custody, hacks, smart contracts exploits, oracles failures, stablecoins de-peg, validators slashing, phishing , ..etc.
- Audit is necessary for all DCSPs to assess their compliance to rules and regulations as well as to high cyber security standards. Moreover, new crypto projects need to be audited prior to going public, particularly when it comes to bridges and smart contracts which have been heavily exploited lately.
II. Pre-Trade Compliance
Investors Compliance
In addition to the standard KYC/ AML measures, there are two elements to investors being qualified to invest in crypto, the first is related to being “fit” to invest in high risk assets and the second is about setting customized limits for each investor. Similar to “Accredited Investor” principle imposed by SEC on investors to qualify for investment in unregulated securities, regulators may consider imposing the following:
- Awareness: investors will have to take an introductory course to understand basic theoretical Blockchain concepts like DLT, NFT, Web3, Metaverse, DeFi, DAO..etc, followed by an exam to ensure that investors know the basics of handling private wallets, P2P transactions, protecting seed phrases and avoiding scammers.
- Limits: investors should NOT be allowed to invest more than a certain amount that is calculated based on a percentage of their income and total net worth.
Digital Currency Service Provider Compliance
There is a lot of legal and technical ambiguity in the crypto space that need to be clarified in order for DCSPs to comply with regulations. Ideally, there should be a global entity to coordinate regulators’ actions and minimize regulatory arbitrage arising from more favorable laws in certain jurisdictions.
Among the topics that need clear policies and guidelines: KYC/AML process, operating licenses, digital currencies classifications & custody, insurance, disclosures, segregation of investors assets from DCSPs, staking, smart contracts auditing, DAOs governance, data protection, green mining, crypto ads, stablecoins issuance, segregation of conflicting business lines , limits on lending & leverage, rating & audit requirements..etc.
III. Reporting & Accounting
All DCSPs reserves should be available to regulators instantly and continuously through the Proof of Reserve (PoR) to ensure 1:1 backing of all digital assets held.
One thing unique about the Blockchain space is that by design all transactions are traceable as they are natively being created and logged on Blockchains immutable records, which makes law enforcement much easier.
IV. Execution
Most central banks are actively exploring Central Bank Digital Currency (CBDC) and it is a matter of time before CBDC becomes the new standard in our daily life as soon as central banks decide on the regulatory rules as well as the technical issues related to system architecture, cyber security, interoperability, modus operandi …etc.
CBDCs are expected to play a bigger role in crypto markets by reducing the dependency on stablecoins as they offer more reliability and stability. Moreover CBDCs will accelerate crypto adoption with smoother on/off ramping. They will also enable authorities to flag and freeze illicit transaction, thus enhancing the compliance and governance of the space notwithstanding privacy concerns.
Some governments may opt to ban DeFi projects in favor of a CeFi model backed by CBDCs. Alternatively, central banks may consider supporting CBDCs interoperability with reliable DeFi projects as this will open doors for the tokenization of financial assets making them accessible and tradable 24/7.
Proper governance of the crypto space requires alignment between regulators at a global scale to ensure cross border law enforceability.
V. Monitoring
Crypto markets will need continuous monitoring by regulators to ensure full compliance and to be able to take timely decisions to trace illicit funds in coordination with licensed CEXs, and to protect investors as new challenges evolve.
To create a safe level playing field for all stakeholders, several aspects will need to be monitored like data storage & sharing, stablecoins coverage, conflicts of interests, insider trading, operational integrity & transparency, price discovery & reporting, price manipulation incidents, wash trading, pump & dump schemes, crypto trading bots ..etc.
VI. Research & Analysis
Finally, progressive regulatory approach is needed to make sure regulators stay on top of this rapidly developing field.
Regulators may need to develop Research, Monitoring & Evaluation (RME) functions to spot new trends and anticipate associated risks, and to be able to reshape and update the crypto strategy and amend regulations more often.
Regulator may also play the role of an incubator providing a sandbox environment for crypto startups, especially for DeFi projects that typically launch sophisticated products that need to be tested thoroughly prior to going live.
Conclusion
With the accelerating growth of crypto markets, there is a growing need for regulators to play an active progressive role to regulate the emerging industry using a balanced approach that protects all stakeholders without hindering innovation. The presented 6-layer model is an attempt to envisage the role of regulators at various interventions levels.
Note: opinions and thoughts expressed herein reflect only the author’s views.
References:
https://pages.consensys.net/defi-for-institutions-report-2021
https://blog.chainalysis.com/reports/2022-crypto-crime-report-introduction/
https://www.forbes.com/advisor/investing/what-is-accredited-investor/
https://decrypt.co/resources/what-are-proof-reserves-why-do-they-matter#:~:text=Proof%20of%20reserves%20(PoR)%20refers,on%20behalf%20of%20its%20customers.
https://www.sciencedirect.com/science/article/pii/S0166497221000183
https://coinmarketcap.com/alexandria/article/how-would-the-introduction-of-cbdcs-affect-defi
https://www2.deloitte.com/content/dam/Deloitte/xe/Documents/About-Deloitte/mepovdocuments/mepov25/cryptocurrencies_mepov25.pdf
https://www.wsj.com/articles/how-regulate-cryptocurrency-markets-11670110885
https://sanctionscanner.com/blog/the-challenges-of-regulating-crypto-assets-324
https://www.coinbase.com/blog/regulating-crypto-how-we-move-forward-as-an-industry-from-here
https://www.imf.org/en/Blogs/Articles/2023/01/18/crypto-contagion-underscores-why-global-regulators-must-act-fast-to-stem-risk
https://www.iosco.org/news/pdf/IOSCONEWS556.pdf
https://www.iosco.org/news/pdf/IOSCONEWS649.pdf
