Upcoming Hearings Must Reach Consensus on Crypto Regulation

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Following the collapse of FTX and the loss of billions of dollars in customer deposits, there is an urgent need to reach consensus now on how to regulate cryptocurrencies.

With Congressional hearings scheduled for next week, questions remain open about how commodity-like digital assets should be regulated while encouraging and enabling responsible financial innovation. Regulatory approaches should ensure the fundamentals of self-custody where people hold their own digital assets outside of exchanges and consider the role of smart contracts and decentralized autonomous organizations that cannot be similarly regulated than traditional businesses.

Let’s start with stablecoins and custodial exchanges, as they represent the most risk and are singularly responsible for the current crisis.

Stable Coins

On May 7, 2022, someone sold the Terra stablecoin for US$2 billion. Such a large transaction disrupted the algorithm underlying Terra which sought to ensure that a Terra token was always traded for 1 USD. Terra collapsed within days, as did decentralized financial institutions (DeFi) with large Terra holdings, beginning the crypto plunge we’ve been experiencing for the past seven months.

Stablecoins are meant to be a low-risk intermediary between traditional finance and DeFi, with value pegged to fiat currency. Regulations can help reduce risk by imposing resiliency requirements and providing certain federal safety nets.

Regulatory options include imposing cybersecurity requirements on the stablecoin and its infrastructure; require systematic disclosures and reports; and require corresponding dedicated fiduciary assets as collateral. If a stablecoin reaches regulatory thresholds, the organizations that manage them could gain access to Federal Reserve programs to help ensure liquidity, such as advances and loans. Rep. Patrick McHenrys’ (RN.C.) stablecoin bill primarily addresses these topics, and the sense-sponsored bipartisan bill. Cynthia Lummis (R-Wyo.) and Kirsten Gillibrand (DN.Y.) partially address cybersecurity issues.

Another option is for the United States to launch a central bank digital currency (CBDC), also known as the digital dollar. A wholesale CBDC could enable bank-to-bank type transactions, while a retail CBDC could compete with stablecoins.

Custody exchanges

The collapse of FTX is an example of a custodial exchange, a crypto exchange that accepts customer deposits like a traditional bank that failed to properly manage its customers’ risk. It essentially staked its clients’ assets and balanced those liabilities with mark-to-market asset accounting that did not take into account liquidity discounts estimated at over 90%. Once people realized how much the assets held by FTX were worth on the open market compared to customer deposits on the books, it became clear that they were insolvent, which led to a rapid breakup of FTX with these entities closely related to the FTX complex.

Custody exchanges should be the low-risk option for those who want to own and trade cryptos those who don’t want the complexity of managing their own wallets and executing trades directly on-chain. Regulation here would protect retail investors.

Options include codifying anti-illicit financing requirements (know your customer, anti-money laundering and counter-terrorist financing); limit the mixing of client funds; require disclosures and reports to regulators and customers; and better delineate their banking and investment services. In return, the banking side of these exchanges could receive FDIC insurance for stablecoin holdings. The Lummis-Gillibrand bill meets most of these requirements, but so far no legislation has been clear on extending FDIC coverage to regulated stablecoins held by custodial exchanges.

Some additional questions:

The general theme of the legislative proposals to date is that we should regulate stablecoins like currencies, other digital assets like commodities, and custodial exchanges like banks. Such succinct clarity can help reduce regulatory arbitrage. Is it the consensus? What is the potential role of a CBDC in relation to accessing Federal Reserve programs to provide liquidity to stablecoin markets? What is the right way to look at possibilities and alternative options to provide a digital interface for fiat dollars in the cryptocurrency markets? Like many critical infrastructure sectors, blockchain infrastructure is privately operated and is the shared substrate of DeFi services. How can we adopt lessons learned from other industries and up our game in cybersecurity for DeFi infrastructure? Information Sharing and Analysis Centers (ISACs) serve as forums to coordinate cyber response in critical infrastructure sectors. Do you think federal agencies could benefit from the creation of a new ISAC for the new class of cyber actors and cyber threats facing digital assets? Industry-standard economic modeling tools lack the sophistication to model the macro and micro-economic interaction between this emerging class of digital assets and their derivatives. Should the federal government invest in the development of new modeling and simulation capabilities to understand the interplay between regulatory regimes and new digital asset classes in this rapidly evolving field? How can we preserve the underlying decentralized and democratic values ​​of permissionless finance as we seek to increase the resilience of DeFi through increased regulation? The World Trade Organization shines the spotlight on US trade policy The profiteering myth in the right to work debate

As policymakers address the regulation of commodity-like assets, it would be appropriate to use the upcoming hearings as an opportunity to reflect on how regulations can simultaneously encourage and enable responsible innovation in the broader realm of Web3.

T. Charles Clancy is senior vice president at MITER, where he leads science, technology, and engineering for the nonprofit research institution. MITER is an apolitical, conflict-free operator of six Federally Funded Research and Development Centers (FFRDCs). Clancy was previously the Bradley Professor Emeritus of Cybersecurity at Virginia Tech and a researcher at the National Security Agency. He is a member of the IEEE.

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