Nov 17, 2022
Let’s not waste a crisis! Tgrade is right here, right now.
Another pillar crumbles
The implosion of FTX is still sending shockwaves around the crypto industry, and it follows a year in which Terra collapsed, triggering the bankruptcy of large crypto funds such as Three Arrows Capital and Celsius.
It feels as we approach the end of 2022 that crypto is staggering, punch drunk, while the regulators' circle, the many detractors indulging in an outpouring of schadenfreude, the DeFi maximalists repeat nothing to do with us, and the eternal optimists cry, “it’s time to build.
There are many opinions on what has just happened, as we heard with the collapse in Terra and the collateral damage that followed. What is clear is that a full picture will emerge from the rubble of FTX as did with Terra, and the response from the regulators and the industry will be telling.
Let’s not waste a crisis.
What we do know of 2022 is that the status quo is neither untenable nor indeed desirable. We cannot be in a situation where extreme volatility persists and that solid-looking institution turns out to be all fur coats and no knickers, which hurts their investors (particularly retail).
The complication is that there are competing visions for what the changes if any, are that need to happen. The interested parties all have an agenda and an outcome they are looking for. In this article, I will explore each of them and look at what the wider impact is of their objectives. I finish with a case of why Tgrade is the answer.
Centralised Exchanges
Centralised Exchanges (CEX) come in many forms, and many have been at pains to communicate that they have fully segregated customer accounts that they do not use for lending, that they have licenses, and have regular independent audits.
It is open season in bashing Centralised Exchanges, and some of the criticism is well-directed.
CEXs have made a positive contribution as they make it easy for people to get involved in cryptocurrencies. This is done by having an easy on-and-off ramp of fiat currencies (as long as your bank does not blacklist transfers in and out of exchanges), a simple way to buy and sell a wide range of tokens, and in some cases, earn by staking.
Where does it go wrong?
The critics point out that blockchain was going to eliminate the need for gatekeepers or intermediaries, and without the peer-to-peer, decentralised aspect then, it renders the technology useless. In an ideal world, a fully decentralised system exists with no intermediaries and removes the rentier capital model; however, it is more nuanced than all or nothing. There are benefits to their customers (or they would not use them)
CEX can be a malign presence of Proof of Stake chains where they can concentrate power and either do not get involved with governance or use their voting power to the agenda of the CEX and not necessarily what their holders want.
The order book trading can be subject to spoofing or even wash trades in some of the less reputable CEX, creating the illusions of liquidity. There is no transparency about whether the CEX is trading on their own behalf and trading against their customers.
There is a big question on some CEX around the jurisdictions they are licensed in and what protections are offered to their customers. It could be argued that their customers should do their research and only sign up to reputable companies, but as we have seen where there are webs of ownership, it is a daunting task to figure out what you are signing up for.
What do they do right?
Intermediaries provide a valuable service to their customers who may be nervous about holding non-custodial tokens and are not comfortable using Decentralised Exchanges.
The ability to move fiat in and out is an important service that the CEX provides. The alternatives are to use intermediaries that specialize in swapping fiat for tokens.
What do they stand to gain?
If there is a tightening up of regulations on who can market crypto assets, then the CEX has the right setup, can apply for the appropriate licenses, and it pushes up the barriers to entry. This would be a big win for the larger CEX and gives them a further grip on the markets.
In the EU, there is a regulatory certainty with the passing of MiCA legislation in 2022 and is a regulation that will be implemented in 2023/4. MiCA brings in the concept of Crypto Asset Service Providers (CASP), which requires an entity to be registered in the EU and comes with a list of obligations such as establishing safeguards, organizational requirements, safekeeping of clients’ funds and crypto assets.
The question is whether all CEX will embrace the regulation or move domiciles to jurisdictions with less regulations. If they move, then they will not be able to do business in the EU and possibly the US if the regulators crack down there too.
The incumbents
Traditional Financial institutions are working hard on blockchain projects but not in the same way as the rest of the industry. The effort has gone mainly into private chains and ways to use the technology to save costs, such as settlement coins.
There is some fear of missing out on the incumbents and concerns that the emerging sector may have an impact on their market share.
Where does it go wrong?
The incumbents have no real presence in the crypto markets and have called out the industry as being a scam, Ponzi scheme, etc. They have an interest in containing the industry.
What do they hope to gain?
If the incumbents can shape the crypto/blockchain space to their favor and regulations mandate the structures that mirror how the incumbents are set up, then it creates a big barrier to entry and helps seal their position. It will significantly slow innovation as there is no big pressure on the incumbents to compete through innovation.
With the right lobbying pressure, the incumbents can hinder the crypto markets by pushing the industry to the fringes, and the lure of mass adoption fades.
Legislators and Regulators
The regulators around the world are increasing their efforts to understand the industry and find out how to prevent the organizations becoming too big without the necessary capital and organizational structures, such as segregating client money and crypto.
Blanket legislation on crypto would be a disproportionate step as it could be argued that Terra was badly designed and FTX was not entirely clean in how it was structured, and gambling with client funds is never clever.
Had FTX collapsed before MiCA was finalized, there would have been big pressure to introduce rules to mitigate what they thought happened.
Where does it go wrong?
The challenge legislators and regulators face is in understanding how the strands of crypto work, giving them enough room to innovate without harming people, ensure consumers are protected, and the markets are fair and orderly.
There is an instinct to apply existing legislation to the new models by making claims that the emerging digital assets correspond directly to the traditional assets; therefore, the same rules apply. The critical questions need asking, and for that to happen, good knowledge is needed of how these assets and markets work. It is hard to accrue the knowledge required in a rapidly innovating market, and it needs the industry to educate the legislators and regulators and address their concerns.
From a legislator's mindset, it is preferable to insert intermediaries into the processes so they have people accountable and capital reserves to monitor, etc. This should be resisted, especially if there are mechanisms in place which are equivalent. For example, a subset of DeFi has lending protocols that over-collateralize and have automatic margin calls. This contrasts with traditional systems where there is some collateral, and margin calls are done at the discretion of the institution at a customer level. Which one is more robust?
What do they hope to gain?
Legislators and Regulators want to ensure that citizens are protected, the markets are fair and orderly, and that there are steps to ensure the proceeds of crime do not flow through the financial market infrastructure.
They have been slowly looking to legislate and introduce laws that apply to crypto, and it has been challenging to act on decentralised groups that transcend borders. The reality is, however, that people have residency somewhere and are not borderless or decentralised, and rules can be made to restrict access to consumers and companies no matter where organizations are based (including nowhere).
The best outcome is to find legislation that leaves enough room for innovation while curbing some of the exuberance and bad practices we see in today’s crypto industry.
Politicians
Cryptocurrencies and blockchains are something that divides politicians; crypto has been framed as a right-wing libertarian endeavor, and on the other side, as an exciting opportunity to connect individuals.
There is also a desire from some politicians to be seen to be backing the new technologies as a way of creating centers of excellence; in other words, it could provide much-needed jobs and help with tax revenues by creating a cluster.
Where does it go wrong?
If there is an idealistic opposition to cryptocurrencies and blockchains, then every crisis is seized on as a further opportunity to “clamp down” or ban the activity.
The politicization of crypto is not helpful as an emerging sector; it does not need division and entrenched views but is seeking a fair landscape to operate in that has technological neutrality or is accepted that there are equivalent controls that achieve the sentiment of the rules.
What do they hope to gain?
Clearly, where there is division, there will be some looking for strict rules to further their political ideology, and there will be others looking to resist rules motivated by their ideology.
Neither of the extremes of the spectrum is helpful to the industry and will need compromises as well as political astuteness to drive for sensible frameworks.
DeFi
There has been a degree of smugness from some of the DeFi community seeing the demise of FTX with the message of this couldn’t happen here, and to some extent, they are correct. The DeFi protocols do what they do best when there is mayhem in the markets; they carry on working without a glitch, lending platforms maintain their stability and automatically liquidate any positions nearing margin limits, DEX tirelessly operates and maintains prices and liquidity 24/7.
Where does it go wrong?
There is a resistance from the DeFi community to implement any rules. There is no gatekeeping on who uses the protocols, and it opens the issues of the suitability of the protocols for anyone to use and that there are no checks for the origin of funds (are they from the proceeds of crime?).
There is an argument that despite the big burden on people and businesses in AML checks, there has been very little impact on the flow of money of the proceeds of crime, so why does it matter that DeFi protocols don’t check? The argument against checking suitability is that people should be making their own checks whether they understand the assets they are buying and selling.
What do they hope to gain?
The hope is that DeFi remains under the regulatory radar for the near future. The case can be made that DeFi is a fast-paced world, and premature regulation could be harmful and inflict damage to the sector, thus potentially setting back innovation for a long time. The other view is that regulations will drive DeFi to other jurisdictions where there is less regulatory scrutiny.
Why Tgrade is more relevant than ever
The Luna and FTX collapses and the knock-on effects onto the other bankruptcies are not a simplistic case of regulate, and this will never happen again.
The biggest question is around doing something. Regulate what? Central Exchanges? What about DeFi? Are the rules pushed onto crypto and blockchains, or does the wider community draft the rules and work with regulators?
The foundations
Tgrade was built for businesses and real-world assets. The groundwork was put in place with Stichting Ocean Blue, incorporated in Amsterdam, Netherlands, which is the legal entity behind Tgrade. There is a written constitution for Tgrade, which sets out the rules, who has authority, and how it is derived, and a code of conduct for the validators.
A lot of work was done at the consensus layer to address the issues we found in Proof of Stake, which we implemented as Proof of Engagement. We opted not to include delegators, thus making validators principals and not agents. The layers make a very robust chain and make us confident that the value of the assets issued on Tgrade can far exceed the market capitalization.
The framework
The biggest problem for regulated businesses or businesses that need to know about the origin of funds or who they are dealing with is the pseudo-anonymous blockchain addresses.
The solution was to build an on-chain governance system that allowed for the creation and maintenance of permissioned groups. The permissioned groups are referred to in Tgrade as Trusted Circles.
Care was taken to ensure that the mechanism is self-sovereign and that whoever sets up and maintains a Trusted Circle is free to decide the governance.
How does this help with the current crisis?
With Tgrade, we have, in effect, created a public, permissioned blockchain.
The public aspect is the robustness of a decentralised network with safeguards in place; the permission part is where it gets interesting.
There are several steps we follow with Trusted Circles.
Here and now
The Trusted Circle is created to leverage DeFi-like protocols, with automation, risk management built in. The interesting part for a regulated business is that there is an off-chain onboarding process connecting identity with a Tgrade address. The KYC and AML monitoring are in place. Now we have a regulatory-friendly setup.
What next?
The initial implementation of Trusted Circles is just the start.
- Adapting the Trusted Circle to use verifiable credentials means we have a more decentralised onboarding process where we can specify the criteria for entry to the Trusted Circle without needing to collect information about the participant. We also use verifiable credentials to do real-time sanction checks and suitability checks when interacting with a digital asset permissioned to the Trusted Circle.
- We can introduce privacy layers to the Trusted Circle as needed to build on the trust and verifiable credentials safe in the knowledge that it would not be abused by criminals.
- As business needs dictate, it would be possible to design cross-Trusted Circle transactions without intermediaries.
The Trusted Circle framework is a very simple implementation (which took years to come up with) that helps balance transparency, trust, and accountability.
Being able to demonstrate this will help educate regulators and assure businesses and their customers that there is a way to balance the potential of blockchain within a sensible framework.
Don’t wait for the regulations to be made; build on Tgrade and demonstrate you meet the spirit of the regulations around customer protection, fair and orderly markets, and combat the flow of proceeds of crime.
Further Reading
For further reading, I wrote a blog post about smart contract counterparty and crypto custody risk. In the context of the Transfer of Funds Rule (TFR), I posed the question of what a wallet is, and what we are really talking about is keys, as wallets do not contain anything. One of the big questions in the space is around how we address AML, and in this article, I proposed a radical turnaround with financial crime units monitoring the chains.
Tgrade is here and now. You have the tools and structure to build a regulatory-friendly business while harnessing the power of smart contracts.
Finally, I wrote on how to build a business on Tgrade and followed this with an article illustrating the steps a business would take to build on Tgrade, and for those thinking ahead, I wrote an article on how to build a MiCA-compliant business on Tgrade.
