A 5-Pronged Approach to Sensible Crypto Regulation After FTX

The collapse of crypto exchange FTX guarantees that crypto regulation will be on the U.S. legislative agenda for 2023 – at long last. Six bills were introduced in 2022, some broad ranging and others narrowly focused on various aspects of compliance or investor protection.

It’s clear that there’s a lot of confusion. The U.S. Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) are jockeying for position. There are many voices in the room. Some of the loudest still want no regulation. That includes people within the industry and anti-crypto lawmakers who think regulating crypto legitimizes it.

This opinion piece is part of CoinDesk’s Policy Week. Mike Belshe is CEO of BitGo, a regulated crypto custody, financial-services and infrastructure provider.

For my part, I would love to have comprehensive crypto regulation. In the U.S. we have some of the strongest financial markets in the world, and that is due in large part to regulation. Regulation will make crypto markets stronger.

But the regulatory regime that governs traditional finance wasn’t created in one fell swoop. It evolved over decades, with a lot of rulemaking happening in response to disasters like FTX.

The digital-asset industry is still in its infancy, but the problems we’ve seen with FTX are familiar. We have seen them before at QuadrigaCX and at Mt. Gox. We can get started now on the beginnings of regulatory oversight to prevent these types of losses. Here are five modest, sensible steps that could be taken now that don’t even require much crypto knowledge.

Stablecoin reserves

Stablecoins play an important role in the digital-asset ecosystem. They are intended to be less volatile than cryptocurrencies (err, stable!), and therefore more practical for everyday transactions. But they haven’t always been so stable.

Stablecoins are supposed to be redeemable 1:1 for whatever asset that backs them. But there’s no actual legal requirement for stablecoin issuers to hold reserves equal to circulating supply. That’s a problem. When a stablecoin loses its peg there’s a possibility that holders will rush to redeem their coins, resulting in something very similar to a bank run.

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See also: Can Banks Issue Stablecoins? / Opinion

That’s exactly what happened with terraUSD in May 2022. It wasn’t actually backed by a reserve asset. It relied on trading based on a mint-and-burn algorithm linked to the supply of LUNA, the native token of the Terra blockchain. Ironically, FTX founder Sam Bankman-Fried is now under investigation for manipulating the market for terraUSD, whose collapse touched off the industry crisis that ultimately exposed his other misdeeds at FTX.

But you don’t have to understand any of that to see that if a stablecoin is backed by a U.S. dollar, you need dollars in reserve equal to the amount of circulating stablecoins. We should require stablecoin issuers to maintain 1:1 reserves at banks insured by the Federal Deposit Insurance Corp. (Side note: FDIC insurance grew out of the bank failures of the early 1900s.) Quarterly audits of reserves and real-time reporting on mint-and-burn activity should be mandatory. We also need to implement safety and soundness controls with a diversity of banks proportional to reserve size.

Separate trading and custody

The market structure where customers have to keep their money with the exchange is fundamentally flawed. You don’t have to know anything about crypto to see why that is not a good idea. Suppose the Nasdaq approached the SEC about being its own custodian. That conversation would never happen.

The problem isn’t just that it’s just too easy to dip your hand into the cookie jar. Even if you are completely honest, there’s still a problem with counterparty risk.

See also: ‘FTX Has Been Hacked’: Crypto Disaster Worsens as Exchange Sees Mysterious Outflows Exceeding $600M

Many of these exchanges are also participating in various forms of lending. They are doing arbitrage and market making. They are trading and hedging on other exchanges. You can’t possibly measure counterparty risk on the exchange because it’s the sum of the exchange’s risk plus the risk of whatever other markets they are participating in.

If there’s anything we should learn from the FTX collapse, it’s that assets should be stored until required for trading by external, qualified, regulated and insured custodians. This creates a check and balance for verifying reserve assets under any exchange’s control.

If trading and custody had been separate, we might have found out earlier that FTX was deep into a fractional reserve situation. We would have prevented the hacking and stealing of assets that happened after the bankruptcy filing.

Require digital-asset exchanges to be 100% digital

Disallow direct trading of digital assets with fiat or off-chain assets. This will make all exchanges on-chain auditable, enabling a proof of reserves that actually works.

Right now, proof-of-reserves statements provide an element of transparency, but they aren’t a complete solution for determining who’s solvent and who’s not, for two main reasons.

See also: ‘Proof of Reserves’ Emerges as a Favored Way to Prevent Another FTX

One, you can’t do it for reserves on fiat, which cannot be represented in a digital way. Two, you can’t do proof of non-liabilities, which is really the thing that matters most. FTX combined fiat and digital reserve components, and as we now know, its liabilities far outstripped its reserves. With pure digital exchanges with fiat represented digitally as a regulated stablecoin, we could have proof of reserves for everything in real time.

The last thing you have to solve is the liabilities component. If we fix settlement and clearing to be all digital, we could build a pretty robust and efficient system with compliance baked in. What’s happening today is that exchanges are trying to build a business in a hybrid world because they don’t have any other choice. We can put fiat and securities in digital wrappers as a transition. Once we’ve gotten rid of the legacy wrappers, what we can do in an all-digital environment will be much stronger.

Regulate digital-asset exchanges’ use of omnibus wallets

Many crypto custodians use omnibus wallets where the funds of multiple clients are commingled under a single address. This makes key management easier for the custodian, and also makes it easier to enable efficient off-chain transactions.

The downside is that individual clients no longer have visibility into their transactions or into counterparty risk. It’s also unclear what happens to each customer’s funds in the event of a bankruptcy.

Omnibus wallets are acceptable only when the qualified custodian is aware of each of the exchange’s customers in the omnibus pool and assets are segregated in such a way as to provide bankruptcy protection to each customer. The custodian must also comply with anti-money-laundering and know-your-customer rules.

Define securities for the digital era

This is the most cited complaint about the SEC: It is relying on a definition of securities developed in the 1940s to underpin its enforcement efforts. Builders in crypto have honest questions about how the rule applies to them, and they deserve answers.

How hard would it be for the SEC to provide an updated definition, detailed guidance and sensible grandfathering policies? Having that clarity would go a long way toward providing protection to innovators and investors alike.

The SEC should listen more to Commissioner Hester Peirce, who has been outspoken in her view that the SEC shouldn’t be leading with enforcement. Enforcement is clearly in the SEC’s purview, but there’s an opportunity to make the enforcement load a lot lighter by providing appropriate guidance to begin with.

See also: 2023: The Year Regulators Finally Grasp Crypto?

What happened at FTX was a garden-variety type of financial fraud seen throughout the ages. The only thing it has to do with crypto and blockchain technology is that lack of regulation left an open field for unscrupulous players.

What we need right now is basic regulatory oversight aimed at preventing catastrophic investor losses. Designers and builders are more than capable of designing a better system to meet the requirements of regulators. Once people can’t be rug pulled or defrauded, then we can start to talk about more nuanced issues and to build something more comprehensive.

We’re going to get through this period. FTX isn’t the first exchange to run into trouble. It’s just the biggest. We could compartmentalize it as one guy who was a charlatan and go back to business as usual – but if we do that, we’re just setting the industry up for the next failure. Instead, if we use this opportunity to take a few simple steps in the direction we all know we need to go in order to thrive, we’ll come out better and stronger.