Want Crypto Regulation? I will give you a crypto regulation

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Epistemic status: I don’t even know what I’m doing here. Then again, neither did Elizabeth Warren.

New cryptocurrency laws are likely coming to the United States, whether the industry likes it or not. A healthy outcome would be legislation that helps protect consumers without undermining, and perhaps furthering, the promise of crypto financial autonomy.

Here is an idea.

What if Congress imposed the separation of crypto custody and crypto exchange? In other words, a company could be allowed to match buy orders and sell orders between investors, or it could be allowed to store crypto on behalf of a client. No company would be allowed to do both. At most, an exchange could administer an escrow account holding funds for agreed and uncompleted trades. It would never be allowed to act as a de facto bank.

Marc Hochstein is the editor of Consensus, CoinDesk’s flagship annual event. The opinions expressed are his own, so please don’t take it out on his colleagues. This article is part of CoinDesks Policy Week.

Think about it.

From the Mt. Gox debacle nearly a decade ago to the FTX meltdown last year, a lesson crypto users continue to learn over and over again is captured by the alliterative tagline, not your keys, not your coins. Bitcoin and its descendants and imitators are digital bearer assets, more akin to physical coins, banknotes, or gold bars than digital cash in a bank account. Once the crypto is gone, it is gone. If you hand it over to a third party to hold for you, you trust them to A) not get hacked and lose the funds, B) not abuse or run away with the funds, and C) return your crypto when you do. ask.

Time and time again we have seen exchanges fail at one or more of these jobs. Yet too many users continue to trust exchanges to hold their money rather than practicing self-custody (storing coins in a wallet whose cryptographic private keys they control) or using a hybrid arrangement like a wallet. multisignature (multisig) (controlled by multiple keyholders).

The story continues

Segregation of funds

The most obvious reason for separating trading from custody is to prevent the mixing of funds, for example, FTX allegedly used client money to bail out its founding trading company Sam Bankman-Frieds. We could already hear the political decision-makers making noise in this direction. For example, here is Securities and Exchange Commission Chairman Gary Gensler in a September speech:

The mixing of different functions within crypto intermediaries creates inherent conflicts of interest and risks for investors. Thus, I have instructed staff to work with intermediaries to ensure that they register each of their exchange, brokerage, custody, etc. functions, which could result in the disaggregation of their functions into legal entities to mitigate conflicts of interest and improve investor protection.

SEC Chairman Gary Gensler

Separate legal entities seem like a good start, but why not go a step further and prohibit such activities from taking place under the same corporate roof? There is legendary precedent for this.

Four years after the stock market crash of 1929, Congress passed the Glass-Steagall Act, which separated investment banking (the high-risk activities of Wall Street) from commercial banking (the kind of banking practiced by the character of Jimmy Stewart in Its a Wonderful Life). The restriction was gradually relaxed during the 20th century and finally lifted in 1999 with the passage of the Gramm-Leach-Bliley Act. While the causes of the 2008 global financial crisis were complex and hotly debated, many argued that the removal of the Glass-Steagalls firewall was a significant contributing factor.

Senator Carter Glass and Rep. Henry Steagall, authors of the Depression-era US law that separated investment banking and commercial banking for decades.

Financial regulators in the United States have erected similar fences separating commercial banking and mortgage insurance from title insurance. Just as most people don’t bathe where they cook (although I once saw an apartment in London that had a shower in the kitchen true story), regulators and legislators have often concluded that there is different types of financial activities that are unhealthy to undertake in close proximity. The alleged mix of FTX would seem to suggest that crypto custody and crypto exchange are two such activities.

I’ve probably already lost the hardcore libertarians in the audience. I respect their worldview but, as noted, in the wake of FTX’s collapse, politicians are out for blood (and photo ops), so some sort of reform is probably inevitable.

Pragmatic crypto companies (or, if you prefer, crony capitalists) who engage with (or, if you prefer, spend boatloads lobbying) lawmakers may also object to my suggestion. I imagine they would balk at this amounting to banning centralized crypto exchanges, forcing costly restructurings of these companies and leaving only the decentralized ones operating in the United States.

To which I say:

Why are we even here?

Why not take the opportunity to entice users to do what crypto veterans have been advising them to do for years? Why not encourage them to use decentralized exchanges that don’t hold funds and keep their digital assets under their full control or, if they don’t trust each other to protect their keys, use a multisig setup? Isn’t self-sovereignty one of the reasons we were all here?

One could argue that self-hosted crypto wallets and decentralized exchanges are difficult for everyday consumers to use, and therefore leaving them as the only permitted on-ramps would slow adoption. Well, difficult winks. How did mass adoption go last time? For the next few years, whenever most people hear the word crypto, they’ll think of Bankman-Fried’s casino and the people who lost their life savings.

FTX’s Super Bowl announcement touted the exchange as the safe and easy way to get into crypto. Easy, perhaps, but it certainly wasn’t safe. Perhaps the industry should worry less about making things easy (which often involves centralization) and focus a bit more on helping people achieve the supposed goals of cryptos. Stop conditioning consumers to be the helpless Eloi in HG Wells The Time Machine, unless you want them to get eaten by subterranean Morlocks.

Meanwhile, a push towards decentralized exchanges would boost development and innovation in this part of the industry that is still largely supported by a few dedicated and idealistic developers. With demand comes investment and growth. One of the biggest issues with using decentralized exchanges (for bitcoin, at least) is low volume. More participants would address this issue.

Plus, it would slow down mass adoption! could be a selling point on Capitol Hill, especially with lawmakers like Senator Warren, who is clearly skeptical of the technology’s benefits. A Glass-Steagall-type firewall could even be a bargaining chip to induce the most zealous policymakers to back down from efforts to enlist software developers, miners, and other participants in the blockchain network as as unpaid whistleblowers for the government. This could perhaps give crypto-friendly lawmakers the means to prevent regulators from enforcing the travel rule that requires financial institutions to share sensitive personal information of senders and recipients with each other as part of a money transfer to wallets controlled by individuals.

Anyway, just a thought. I’m sure there are better ideas. Talking about what

Shameless take time

For much smarter answers to the tough policy questions facing the industry than my half-baked troll above, Consensus 2023 will feature a one-day Crypto Policy Forum on April 28.

Regulators, lawmakers, and industry stakeholders will discuss the political fallout from the 2022 stock market crash, the advance of central bank digital currencies, tensions around stablecoin regulation, expanding enforcement from anti-money laundering and anti-terrorism rules against cryptocurrency services and the challenges in applying 20th century securities laws to 21st century decentralized protocols. View the preliminary agenda here. There will also be opportunities for more intimate discussions about the thorniest off-stage issues, stay tuned for more details on that.

Registration is open for the event (April 26-28 in Austin, TX), and unlike any coin, ticket prices are sure to increase in the coming months. This is the only price prediction I will ever make. As a reward for reading to the end of my screed, use coupon code POLICYWEEK15 for 15% off.

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