Following the collapse of crypto-exchange giant FTX, national governments are expediting the process of putting crypto regulations firmly in place. Many “crypto hubs” are reassessing how to capitalize on the benefits of the technology while proactively mitigating its risks. Noteworthy examples of jurisdictions where regulators are making headway — and grabbing headlines — include those in the United States, the European Union, the United Kingdom, Hong Kong and Singapore.
But the race to regulate crypto could actually be a problem, according to regulators at the supranational level. The Financial Stability Board (FSB) and the International Monetary Fund (IMF) are advocating the creation of globally coordinated crypto regulation standards before national authorities get locked into differing, even incompatible frameworks.
According to the FSB, the potential for across-the-board consistency and comprehensiveness of crypto-asset regulation is expected to “strengthen international cooperation, coordination and information sharing.” To achieve that, the FSB advocates equivalent regulations for digital assets and intermediaries that perform the same function as their traditional finance (TradFi) counterparts.
Meanwhile, on the user side of the equation, investors are now prioritizing self-custody crypto wallets and shifting toward decentralized exchanges, seeking greater transparency and control. This ongoing shift toward decentralized finance (DeFi) is causing national and supranational regulators to take another look at the benefits of decentralization, just as they set out to coordinate a global regulatory approach to crypto.
Shortcomings of centralized finance
As the FTX debacle revealed, the shortcomings and drawbacks of centralized exchanges (CEXs) reflect certain opaque qualities of TradFi, where much behind-closed-doors activity is accepted as a matter of course. In addition to the lack of transparency relating to balance sheets and client assets, centralized finance organizations keep their systems and records off-chain.
Meanwhile, DeFi offers permissionless financial products that offer high transparency regarding client funds and non-custodial wallets. In short, the undetected misuse of user funds we saw at FTX could never happen in DeFi. Built on public blockchains, the composability of smart contracts also enables considerable space for fintech innovation. For example, right now, we’re seeing a major uptick in efforts to improve DeFi’s user experience and user interface (UX/UI) design, especially as simple, user-friendly interfaces are the primary advantages for most centralized exchanges.
Prompted by the FTX scandal and the resulting upsurge in interest in DeFi platforms, regulatory bodies and TradFi institutions are taking a closer look at DeFi. Our team at SynFutures recently discussed the relative advantages of DeFi with the IMF, highlighting the benefits of decentralization, such as on-chain transparency as well as non-custodial and trustless solutions as a viable alternative to TradFi.
As we pointed out to the IMF, DeFi is about more than the single asset class of cryptocurrency. DeFi’s goal is to democratize access to all kinds of investment products and services. Where market trust has been forfeited to intermediaries and distracted by strong marketing fronts, DeFi reinstates the real operational backbone: solid code and permissionless systems.
DeFi’s potential to improve on TradFi
Given its open-source nature, DeFi has been able to iterate and innovate quickly, improving on existing TradFi infrastructure at a remarkable rate. However, the uncertainty that remains around DeFi hinders its mass adoption.
First, permissionlessness can be exploited by bad actors, enabling money laundering and illicit financing. Second, the absence of clear regulatory guidelines also means customers are more susceptible to becoming targets of Ponzi schemes or otherwise deceptive activities. Third, smart contracts can be subject to exploitation and hacks, especially when unaudited.
While DeFi prefers to differentiate itself from TradFi, it is imperative for DeFi to build upon and implement the existing security measures prevalent within TradFi, such as risk control, treasury management and regulatory frameworks. DeFi’s mass adoption hinges on accountability and consumer protections in the same way that TradFi globally has relied on regulatory and self-regulatory practices for functional stability. Moving forward, public trust in the industry will depend on government regulation and trusted blockchain applications.
My expectation is that efforts to institute a global crypto framework would likely start with replicating TradFi’s measures. This next step in establishing a pattern of proactive cryptocurrency regulation illustrates the global community’s continued effort to provide a clear framework for crypto services. Borrowing modes of governance from an already familiar TradFi network could also have a wider impact on how governments go about implementing regulatory measures. This would require all parties within the crypto industry, as well as within national and supranational regulatory bodies working together, to ensure the rules don’t limit innovation, and to support and protect both consumers and firms across borders.