Discussions about crypto regulation and compliance, or lack thereof, are increasingly losing their bearings. The general objectives of financial regulation are to maximize consumer protection, prevent fraud and abuse, and ensure orderly markets. Broadly speaking, the mission is the same for all regions, countries and financial regulators.
Cryptocurrency regulation and compliance
Discussions of regulation and compliance in crypto have been overly industry-focused, at the expense of users. If exchanges are obsessed with whether new or existing regulations should be complied with, they miss the opportunity to consider how consumers can best benefit.
As a director of regulatory affairs and a compliance consultant, I tend to look at crypto regulation and compliance objectively. Put your ideology aside when recommending or attempting to implement a compliance framework for your customers.
It all boils down to a simple point: “What do I need to do to ensure compliance?” If things are too strict, it will have a negative impact on the business model. Anything that is too lax will lead to long-term failure (often in the form of official enforcement action).
I am no exception. As a former chief compliance officer for a crypto startup, I know compliance pros who are held accountable for their preferred compliance programs and whose failures can define their careers. When considering two contrasting business models in the crypto world: decentralized and centralized services, one can only borrow ideas from the other to address the potential for failure of each.
Decentralized and centralized risks
The U.S. Treasury previously released a report on financial crime-related risks posed by DeFi (decentralized finance), including money laundering, theft, fraud, and sanctions evasion. “DeFi services often have administrative structures that provide some degree of centralized operation and governance,” the Treasury said.
In my compliance mindset, this means that it is not only impossible, but irrational, to impose the same kind of regulatory control that you can expect from a centralized organization.
The “Digital Asset Anti-Money Laundering Bill” proposed by the U.S. Senate in December 2022 also seeks to bring all services dealing with digital asset transactions under the jurisdiction of the Bank Secrecy Act, an anti-money laundering law in the United States. It looks like you’ve come to the same conclusion as me.
We don’t need governments to point out that DeFi has unique risks. A quick look at crypto theft, rag-pulls, hacks and scams reveals DeFi’s many shortcomings.
There are, of course, problems with centralized organizations. Many organizations in the United States have also been fined for not registering their securities with the Securities and Exchange Commission (SEC), which means there is little or no consumer protection for such products. It means it didn’t exist.
All of these moves come after the humiliating year of 2022, when billions of dollars worth of crypto assets were lost to fraud, manipulation, embezzlement, bankruptcy and more. Moreover, most of these losses could have been prevented if the organizations in question did not have direct control over the users’ assets.
combine the best of both worlds
Then, how should we take advantage of each of the decentralized type and the centralized type?
You can borrow transparency and accountability from a centralized organization. It is an inherently accountable organization with representatives who act as the public face. In other words, it will be a regulated organization that has an obligation to consider the best interests of users and honestly disclose risks, and can enforce the necessary disclosure of information to do so.
Transactions of unknown origin recorded on the blockchain do not represent a sufficient level of transparency. Such organizations must also implement cybersecurity controls, fraud and money laundering prevention mechanisms, and smart contract audits alone are not enough.
On the other hand, what can be learned from decentralized organizations is that while the service provider completes the settlement of transactions, the custody of assets always remains with the user.
It is necessary to think again that the ultimate goal of crypto-assets is to provide individuals with a better financial system than the existing system.
The ultimate goal of regulation, on the other hand, is to ensure that consumers are protected. Combining the two gives the best results. In order to achieve a fair and convenient system for all participants, it is necessary to mix the philosophies of centralized and decentralized finance.
Appropriate rules already exist to oversee crypto assets, aimed at consumer protection. What the industry needs to do is embrace the right aspects of centralization without losing sight of the decentralized spirit.
｜Translation and editing: Akiko Yamaguchi, Takayuki Masuda
｜Original: True Consumer Protection in Crypto Lies Between Centralization and Decentralization