The past few weeks have witnessed another disaster for the cryptocurrency industry. FTX, one of the largest crypto exchanges, lack. The price of bitcoin, the largest cryptocurrency, fell more than 20%. Industry-wide exposure to FTX is still unknown, with the creditworthiness of several companies still in question.
Crypto critics, including Securities and Exchange Commission (SEC) Chairman Gary Gensler, used the event as a a call for more regulation. However, traditional regulations can actually compound financial risk in the crypto industry. Decentralized blockchain technology offers better solutions to protect consumers and reduce financial risk.
This year has seen a string of failures from high-profile crypto companies. The $25 billion Celsius crypto lender failed and was accused of false declaration its exposure to risk. Three Arrows Capital (3AC), the $10 billion hedge fund, was based in Singapore but asked bankruptcy At New York. Now FTX adds another major collapsewhich appears strength come from fraudulent and illegal activities.
However, as many in the industry have noted, these failures all involved traditional financial firms operating in the crypto space. These were not decentralized exchanges or protocols. Their failures stemmed from problems common to many traditional financial firms: illiquidity, insolvency and, in some cases, perhaps outright fraud.
Decentralized blockchain technology can limit or eliminate these risks in a simple and transparent way. Every transaction on the blockchain is publicly visible. Access to funds may be restricted to authorized parties. Requirements such as minimum levels of liquidity and collateral can be programmed into protocol code to limit or eliminate financial risk.
Uniswap, for example, is a decentralized exchange built on the blockchain. Funds are deposited in on-chain pools, so all funds are visible and secure. Rather than trading directly with other counterparties, trades are made with the pool itself. Transactions are completely transparent and the size of each transaction is limited by available funds, so there is no way the pool will default. It is difficult, if not impossible, to defraud investors when not only the funds but also the computer code used to create the pool are fully disclosed to the public.
While traditional lending and financial intermediation relies on reputation and credit risk, blockchain technology-based crypto lenders often get around this problem by only issuing fully collateralized loans. The Aave protocol, for example, requires liquid collateral valued at more than 100 per cent borrowed funds. By way of comparison, US banks now hold an average cash about 25 percent of loans and leasescompared to less than 5% before the financial crisis of 2008.
Even traditional financial companies operating in the crypto space can use this technology to limit risk and improve disclosures. Rather than audits by government regulators, companies can disclose their cryptocurrency reserves on the blockchain, a practice many are to push to become the industry standard. This could be particularly useful for disclosures by banks or traditional financial firms getting into crypto.
Despite the common perception that more regulations are safer, ineffective regulations often increase financial risk rather than decrease it.
In the early 2000s, for example, US regulators encouraged banks to buy large amounts of mortgage-backed securities (MBS). In retrospect, this was a disastrous mistake as MBS was a major cause of the 2008 financial crisis.
In the crypto industry, excessive regulations have pushed financial activity to offshore exchanges, including Bahamas-based FTX. Most of the Americans’ funds were deposited in the US subsidiary of FTX, but the risky activities that caused the exchange to collapse took place outside the jurisdiction of regulators. Despite ties to the risky offshore entity, regulators allowed FTX US to market itself as “the safe and regulated way to buy Bitcoin, ETH, SOL and other digital assets.”
Current regulations make it harder for consumers to protect themselves against risk and fraud. Americans cannot buy cryptocurrencies directly, but are legally required to go through centralized exchanges such as FTX. These rules make it harder for users to hold crypto assets in their own self-hosted wallets. Another option would be for consumers to hold their cryptocurrencies in fully regulated custodian banks that specialize in storing financial assets, rather than centralized crypto exchanges like FTX. Curiously, however, SEC regulations do not allow neither does that.
Even with the regulations in place, it is not clear that they will be enforced fairly. Rather than notice the illegal activity at Celsius and FTX, SEC Chairman Gensler was apparently busy sue Kim Kardashianwhile Federal Reserve Chairman Jerome Powell spoke about income inequality and climate change. Clear information shared on the blockchain is much better protection for consumers than bureaucratic regulators who may or may not be doing their job.
The recent turmoil in the crypto markets is a failure of regulators to do their job effectively. Crypto lenders like Celsius should be regulated like banks. FTX and traditional financial exchanges should be regulated as such. But pushing excessive regulations on the crypto industry is likely to make crypto more risky, not less. Decentralized blockchain-based protocols are already more secure and transparent than most regulated financial firms.
Thomas L. Hogan is a senior research faculty member at the American Institute for Economic Research (AIER). He was previously chief economist for the US Senate Committee on Banking, Housing, and Urban Affairs.