Cryptocurrencies need less regulation, not more

The last few weeks have seen yet another disaster for the cryptocurrency industry. FTX, one of the largest cryptocurrency exchanges, has failed. The price of bitcoin, the largest cryptocurrency, has fallen by more than 20%. Industry-wide exposure to FTX is still unknown, with the creditworthiness of several companies still in question.

Critics of cryptocurrencies, including Securities and Exchange Commission (SEC) chairman Gary Gensler, have used this event as a call for more regulation. However, traditional regulations can actually worsen financial risk in the cryptocurrency industry. Decentralized blockchain technology offers better solutions to protect consumers and reduce financial risk.

This year has seen a number of bankruptcies of high-profile crypto companies. $25 billion cryptocurrency lender Celsius has failed and has been accused of misrepresenting its risk exposure. Three Arrows Capital (3AC), the $10 billion hedge fund, was based in Singapore but filed for bankruptcy in New York. Now, FTX adds another major collapse, which appears to be from fraudulent and illegal activities.

As many in the industry have noted, however, these failures affected all traditional financial firms operating in the crypto space. They weren’t decentralized exchanges or protocols. Their failures stemmed from problems common to many traditional financial firms: illiquidity, insolvency and, in some cases, possibly outright fraud.

Decentralized blockchain technology can limit or eliminate these risks in simple and transparent ways. Every transaction on the blockchain is publicly viewable. Access to funds may be restricted to authorized parties. Requirements such as minimum liquidity and collateral levels can be programmed into the 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 safe. Rather than dealing directly with other counterparties, trades are made with the pool itself. Transactions are fully transparent and the size of each trade is limited by available funds, so it is impossible for the pool to 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.

While traditional lending and financial intermediation rely on reputation and credit risk, blockchain-based cryptocurrency lenders often get around this by issuing only fully secured loans. The Aave protocol, for example, requires liquid collateral valued at more than 100% of borrowed funds. For comparison, US banks today hold an average cash balance of about 25% of loans and leases, compared to less than 5% before the 2008 financial crisis.

Traditional financial firms operating in the cryptocurrency sector can also use this technology to limit risk and improve disclosure. Rather than audits by government regulators, companies can disclose their cryptocurrency reserves on the blockchain, a practice that many are pushing to become the industry standard. This could be particularly useful for disclosures by traditional banks or financial firms that get into cryptocurrencies.

Despite the common perception that more regulation is safer, ineffective regulation often increases rather than decreases financial risk.

In the early 2000s, for example, US regulators encouraged banks to buy large quantities of mortgage-backed securities (MBS). In retrospect, it was a disastrous mistake as MBS was a major cause of the 2008 financial crisis.

In the cryptocurrency industry, excessive regulations have pushed financial assets to offshore exchanges, including the Bahamas-based FTX. Most of the American funds were deposited in the US branch of FTX, but the risky activities that caused the exchange to collapse occurred outside the purview of regulators. Despite links to the risky offshore entity, regulators have 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 more difficult for consumers to protect themselves against risk and fraud. Americans cannot buy cryptocurrencies directly, but are instead legally required to go through centralized exchanges such as FTX. These rules make it more difficult for users to hold crypto assets in their self-hosted wallets. Another option would be for consumers to hold their cryptocurrencies in fully regulated custodial banks that specialize in storing financial assets, rather than centralized cryptocurrency exchanges like FTX. Strangely, however, the SEC regulations don’t allow it either.

Even with the regulations in place, it’s not clear they will be enforced fairly. Rather than notice the illegal activities of Celsius and FTX, SEC Chairman Gensler was apparently busy prosecuting Kim Kardashian, while Federal Reserve Chairman Jerome Powell talked about income inequality and climate change. Clear information shared on the blockchain is a far better protection for consumers than bureaucratic regulators who may or may not do their job.

The recent turmoil in the cryptocurrency 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 cryptocurrency industry could make cryptocurrencies riskier, not less. Decentralized protocols built on top of the blockchain are already safer and more transparent than most regulated financial firms.

Thomas L. Hogan is a senior research faculty member at the American Institute for Economic Research (AIER). Previously he was the chief economist on the US Senate Committee on Banking, Housing and Urban Affairs.

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