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Addressing the Risks in Crypto

25 Jan, 2023

Crypto market ups and downs are nothing new; however, 2022 was a year for the crypto books, filled with losses, hacks, and exchanges going under; it is no surprise that the ecosystem is addressing crypto risks head-on. 

As explained by the Bank of International Settlements (BIS), there are 3 possible ways to solve crypto risks, namely to ban crypto activities altogether, keep crypto separate from traditional finance (TradFi) and the "real" economy (BIS’s wording), or regulate crypto as per TradFi. 

Below we will look at the pros and cons of each. 

3 Suggestions for Solving Crypto Risks 

1. Banning Crypto Activities: 

This radical approach suggests that countries either ban selected crypto activities or crypto completely. If effective, the positive is a supposedly safe financial system (barring the attacks we see in TradFi). 

The downsides are significant: 

  • For starters, all crypto innovations, technology, and jobs created from the ecosystem would be lost or rendered useless.

  • Studies show that through the ban on crypto, the usage actually increases, as seen in China last year (CNBC)

  • It would involve copious manpower from authorities to actively enforce and maintain, which ultimately means taxpayers’ money. 

  • Lastly, as most countries have laws in place to protect individual rights, a direct ban could conflict with many principles of society. 

Banning crypto would be disastrous. None of the intended outcomes would be achieved. But it would also set back crypto years.  

2. Separating Crypto Activities:

Another option would be to separate crypto activities from the “real” economy. The first step would be to stop its flow alongside TradFi; for example, digital assets will no longer be used as a payment method for goods like groceries. The tokenisation of real-life assets will also cease, as seen in the case of NFTs. This separation would seek to limit crypto’s functionality in hopes that it becomes a niche only used by a select public. 

The problems with this option are: 

  • This plan would be hard to execute in existing economies where crypto is active. Many TradFi banks are moving into the crypto realm and offering their patrons investment options. How would these investment profiles be handled to ensure the investors get fair compensation? Assuming the bank has the funds, would they be paid out for their crypto investments? While crypto businesses should back the crypto it holds 1 for 1; this isn't globally enforced. Would the bank sell off the cryptocurrency it holds? 

  • Nothing will be accomplished by keeping the crypto market separate from TradFi. Crypto will continue, probably with even less regulation creating further loopholes for nefarious actors, ultimately creating even more channels for illicit activities.  

  • It would involve a lot of work for a theory that doesn’t hold strong. The crypto market has had its ups and downs more than once. No ripples were felt in TradFi or the economy each time this happened. Additionally, there is no evidence to show that crypto could affect TradFi in the future. 

This option sounds nice in theory, but I believe that the reality separating these two fields in finance would be a fool’s errand.

3. Regulating Crypto Activities: 

Regulating crypto would entail applying rules to its activities, as we see in TradFi. Compared to the previous options, this seems like the most logical option and is currently being orchestrated in various territories.    

Regulation of crypto activities would involve identifying the activities performed by entities in the ecosystem and applying similar guiding principles as seen in TradFi. The envisioned outcome would be regulatory consistency within these activities and improving existing frameworks. 

The problems encountered with regulating crypto include: 

  • Determining a uniform way to identify activities and a uniform language to label these activities has proven a challenge in itself. Take the European Union’s Market in Crypto Assets Regulation (MiCA) definition of a CASP and compare it to the Financial Action Task Force’s (FATF’s) VASP as well as the functionalities of these entities, and we are already presented with differences.  

  • TradFi regulations cannot be applied to crypto in a 1-on-1 manner. While we have seen this attempted in many frameworks and regulations, this notion is a quick solution to crypto regulation and will not stand in the long run. Law and regulation makers need to figure out solutions specific to crypto to benefit crypto users and entities while maintaining a safe ecosystem.  

  • Global agreement to one regulation. To date, we have seen various regulations taking shape, which is promising, yet there is no single regulation. Crypto would benefit from a single regulation. Compared to TradFi, cross-border transactions are more common due to their ease; for example, no currency conversion is required. A problem with these cross-border transactions is that most regions have their own implementation of crypto regulations, making it difficult for customers and crypto businesses to transact.    

Will Global Adoption of the Travel Rule Help?

While only a recommendation for countries to implement, the FATF’s Recommendation 16 (the Travel Rule) is a prime example of a set of regulatory guidelines and seems to have the most global traction. Currently, it is the regulation that has seen the most global traction. Occasionally jurisdictions add additional guidelines to further safeguard its ecosystem, as seen in Switzerland with its zero threshold. 

To date, the regulation of digital assets has been a rocky road. We have seen various states of implementation of the Travel Rule across the globe, creating regulatory gaps in various scenarios and allowing for legislative arbitrage. While this incremental rollout is not the sole cause for nefarious activities on the blockchain, one could argue with global adoption; these risks could be significantly decreased. 

When implemented by a government agency or national organisation, the FATF’s Recommendations become law, therefore, regulation. Based on the pros and cons previously discussed, regulations are the favoured option to reduce crypto risks. 

In Parting

I am of the firm belief that crypto is here to stay. Despite the 2022 rollercoaster, crypto has proven its resiliency more than once. Democratising finance is the way forward, along with supporting crypto technology. Crypto is not a rich man’s game; neither is it a get-rich-quick solution. All markets have ups and downs but always make a comeback. As long as we are investing and spending, crypto will not die out.

Written by:
Harm Aarts
Senior Software Engineer
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