Why Regulation Matters

May 11, 2019
Why Regulation Matters

Crypto Regulation - A Strained Relationship

There is a very real danger that financial regulation will become a wolf in sheep's clothing.”[1] Henry Paulson, former US Treasury Secretary.

When Henry Paulson wrote these words, he was cautioning against over exuberance of new regulation crafted in the wake of the 2008 financial crash. Speaking as a former financial markets lawyer, and having spent much of my career analysing and implementing global regulatory frameworks, I can attest to the inaccuracy of the maxim that “less is more” when it comes to regulating financial markets. The complex world we have created requires equally complex solutions, and in many cases these solutions come in the form of regulation.

This view may be unpopular with crypto-purists, who frequently advocate for a return to the founding values of bitcoin. These values were well articulated by Satoshi Nakamoto, who wrote that the driving force is for an “e-currency based on cryptographic proof, without the need to trust a third-party middleman...money can be secure and transactions effortless”[2]. This driving philosophy, of a decentralised and incorruptible framework, free from centralised manipulation, has long been adopted by libertarians and anarchists alike. As much as this rose-tinted view may have its attractions, such an approach – in a world full of regulation - still leaves us with more questions than answers: in our view regulation does indeed matter.

So Why Do We Need Regulation?

“If a man’s judgment is right, the rewards are his; if it is wrong, he is his only victim.” Ayn Rand[3]

To date, we have seen a number of high-profile events that have been a direct result of operating in unregulated and opaque regulatory environments – whether we take the loss of $450m of client assets by Mt. Gox in 2014, $72m by Bitfinex in 2016 or $535m by Coincheck in 2018, it is estimated that around $1bn has been lost. The consumer always bears the brunt of these events.

To many free market advocates, keeping cryptocurrency outside of centralised supervision seems to be an appropriate way to let the forces of the market pick the winners and losers. However, as these losers are frequently vulnerable retail users, it is increasingly hard to justify a laissez-faire approach - smart regulation is in the interests of everyone. At its core, good regulation should protect consumers, help foster innovation, mitigate negative behaviour (e.g. money laundering) and assist in growing an industry. My assertion is that, when the right balance can be found, the recent prudent regulation of the cryptocurrency sector can, and has been hugely positive.

Evolve or Die

Despite the negative press surrounding the shortcomings of the cryptocurrency markets, the industry has managed to flourish in the absence of clear regulatory certainty. Market capitalisation is currently $175bn[4], having reached a high of $400bn in 2018, from $2bn in early 2017. During these years, the application of existing regulatory frameworks to the cryptocurrency industry was hard, if not impossible – we were faced with a “square peg round hole” situation. The dearth of regulatory clarity stifled innovation and caused consumers to rightly question whether they should get involved in this nascent asset class.

To try to remedy the absence of regulatory clarity, many industry participants pushed self-regulation as the answer. We saw the development of initiatives such as the Virtual Commodity Association in the US, CryptoUK in London, the Japanese Virtual Currency Exchange Association, amongst others, as an attempt to engender a sense of confidence in the industry and to take the lead on future regulatory developments.

These industry-driven efforts bore fruit, as in 2018 we saw a wave of regulatory activity. The SEC in the US decided that it would apply securities law to a certain subset of digital assets, AUSTRAC in Australia implemented a crypto-specific AML and KYC regime for domestic exchanges, Japan obligated crypto exchange registration with the JFSA, Korea launched a supervisory framework for local exchanges and the UK’s FCA launched a consultation process to determine how to include crypto-assets within existing regulatory perimeters. This increasing certainty has given the cryptocurrency industry a new impetus to drive innovation and investment. To date it is estimated that there are nearly 800 crypto-focussed funds and 400 venture funds, of these, 104 are US-based funds registered with the SEC[5].

A Fair Balance

We can see regulation is here to stay, so should it apply to everything and anything? In my view, it is extremely important to strike the right balance. Regulation should foster innovation, not stifle it. A common-sense example of this would be utility tokens – these clearly deserve to remain outside of existing financial markets regulation, whereas tokens which look and act like a security, should fall within – it sounds simple, however in practice the costly services of lawyers are still essential.

So how does this apply to the Equilibrium Framework? As a starting point, in many respects the Equilibrium Framework possesses qualities that would appeal to regulation-minded folk (of which I would count myself), and crypto-purists alike. It is:

Transparent – open source code which can be verified by the community.

Auditable – activity at a transaction and governance level is fully disclosed and open to all.

Decentralised – no one person or group can “own it”.

Non-custodial – you or the smart contract, control and hold your assets at all times, there is no central counterparty risk.

Having watched the evolution of FIAT-backed, inherently centralised, stablecoins, we have witnessed the increasingly evident drawbacks at both an operational and regulatory level. These FIAT-backed assets trigger numerous regulatory requirements (e.g. rules associated with money transmission in the US and the Payment Services Directive in Europe) – the Equilibrium Framework, by design, has learned these lessons.

In the next article I will be considering the topic of community governance and why the Equilibrium Framework believes in the proof-of-stake model.

[1] On the Brink: Inside the Race to Stop the Collapse of the Global Financial System, Henry M. Paulson

[2] http://p2pfoundation.ning.com/forum/topics/bitcoin-open-source?xg_source=activity

[3] Capitalism: The Unknown Ideal, Ayn Rand

[4] As at 02 May 2019 on TradingView.com

[5] https://cryptofundresearch.com/