One of the consequences of the crypto crash of recent months is the growing clamour for regulations. The depth and severity of the crash has been blamed, in part, on the absence of rules we can all agree on.
“You need regulation [in crypto],” says Targ Patience, co-founder & CEO of idclear, a Gibraltar company offering due diligence services to assist businesses with compliance.
“You cannot have a financial system where you have these unexpected catastrophes, because even if you’re operating very sensibly, you can be affected by something that happens ‘over there’ because of interconnectedness and interoperability.”
This interconnectedness was clearly apparent in bitcoin’s recent plummet, driven down by Terra/Luna and Celsius’s crashes. And Terra’s crash had other ripple effects that adversely affected several crypto companies.
Regulation after 2008 crisis was ‘super inefficient’
Patience’s early career was in fraud investigation in corporate and investment banking in London, then as an investigations analyst in currency derivatives. He got involved in financial regulation after the 2007-2008 financial crisis, when he helped design the world’s first forex clearing service for LCH (London Clearing House) in response to the post-crisis regulatory reforms.
“What we need [in crypto] is not regulation like what came after the financial crisis,” Patience tells Moneyweb. “That was super inefficient. The G20 wanted global standards for global markets. And instead, the US wrote the Dodd Frank Act – they went off and did it in one way.
“And then Europe seemingly didn’t read it or talk to them. So they wrote the same thing but in different ways.”
Patience says the conflicting worldwide regulations were great business for consultants. Companies needed experts to make sense of all the rules across the world.
“It was very lucrative for law firms and consultancies, but madly inefficient for the markets. We need efficient crypto regulation and it needs to be more harmonised internationally.”
Lack of good regulation opens the door to potential blockchain abuse.
In an effort to reduce bitcoin’s carbon footprint on the world, a different consensus model – a method of validating transactions – needed to be designed. Bitcoin uses a model called Proof-of-Work (POW) where every computer competes to solve a cryptographic puzzle. But it is a carbon footprint nightmare.
One of the newer models was called Proof-of-Stake (PoS). In PoS, certain users ‘stake’ an amount of their crypto by locking it up in the blockchain. These stakers can then perform validations on transactions. The more someone has locked up (staked), the more likely they are to be picked as a validator. If their validation is found to be incorrect, they lose some of their staked cryptocurrency.
The theory of this model is that the threatened loss of staked cryptocurrency ensures the model’s integrity. People don’t want to lose their crypto.
But Patience points out that such a system is risky in the absence of knowing the identities of the validators, something that regulation would enforce.
A bad actor could accumulate tons of crypto or be the owner of multiple wallets and then manipulate the network.
“This is called a 51% attack,” says Vlad Totia, a blockchain research analyst at Zilliqa, a blockchain company. “If you own more than 51% of the validators then you could theoretically control the network.” Fifty-one percent attacks are easier to carry out on Proof-of-Stake than on Proof-of-Work networks, Totia says.
Centralised exchanges are already required to follow basic regulatory procedures, such as Know Your Customer (KYC) protocols which require proper identification of people who wish to open an account. The problem lies in decentralised finance (DeFi), a collection of decentralised apps that are owned by no one and so are not under any regulatory obligation to follow KYC or anti-money laundering procedures.
Because of this lack of regulation, hackers often resort to DeFi solutions to embezzle stolen crypto in the hopes of remaining undetected.
“I could control a thousand wallets,” Patience says. “So there are fundamental flaws from a risk management perspective.”
The same risk exists for decentralised autonomous organisations (DAOs), an emerging form of legal structure. DAOs are also owned by no one, and members have a right to vote on decisions based on how many governance tokens they hold. Without regulation and the requirements of KYC, it is impossible to know who holds voting powers and who doesn’t.
Regulation is inevitable, but it needs to be a group effort
“When seatbelts got introduced in the 1970s, people were livid,” says Patience.
But the use of seatbelts has been shown to reduce the chances of death or serious injury by 75%.
“Regulation is coming,” says Patience. “Having lived through the global financial crisis and seen the regulatory reforms that came with that, I observed that draft regulations are often really not fit for purpose. Regulators are obviously not super technical experts on every topic they need to regulate. They rely on industry engagement.”
Unification, alignment, and understanding within the crypto industry would help shape better regulations than were implemented after the 2008 crisis, and would therefore not “destroy how everything works”, Patience says.
As an example of the efficacy of positive regulation, Gibraltar has attracted most of the biggest centralised exchanges because the territory does have regulations in place. And these regulations were put together in cooperation with industry experts.
“[Crypto exchanges in Gibraltar] are regulated by the same people that regulate the banks, and that gives people trust and confidence,” Patience says.
Listen to Ciaran Ryan’s interview with FSCA head of enforcement Brandon Topham:
R Paulo Delgado is a crypto writer with an eye for the bizarre and the human stories behind the always fascinating leaps and stumbles of this new asset class.