The article by professors Arner, Zetzsche, Buckley and Kirkwood reminds us how, in 2022, the crypto ecosystem experienced a significant decline in market value, losing approximately $2 trillion even before the collapse of FTX Group. The failure of FTX, one of the largest financial failures since the 2008 global financial crisis, highlights the need for a coordinated and global approach to crypto regulation. Despite being presented as an alternative to traditional finance, crypto has evolved to display the same market failures and externalities as traditional finance, a process referred to as the financialization of crypto. Therefore, appropriate regulation is essential for the survival and prosperity of the crypto ecosystem. Major jurisdictions such as Singapore, Hong Kong, the EU, and the UK are implementing or designing new regulatory measures, while the US government is also planning to regulate crypto.
Then, they move to discussing the context of the Crypto Winter of 2022-23 and the need for regulatory and supervisory systems to address the market failures and externalities that have arisen in the crypto ecosystem.
They argue that the recent crises in the cryptocurrency market are due to the financialization of crypto, which has led to the emergence of Systemically Important Crypto Intermediaries (SICIs) dominating the ecosystem. They classify these SICIs as forms of "shadow finance" due to lack of regulation and transparency. They argue that despite its transformative technology, the crypto industry is not immune to conflicts of interests, centralization, and financial risks. They also criticize the centralized nature of major crypto exchanges, which they argue should only be used for licensed firms.
In this context, the authors propose a set of regulatory solutions to address the financialization of crypto, including licensing and supervision of related conduct of business, disclosure and transparency requirements, segregation and custody rules, market abuse regulation, restructuring and resolution legislation, and cross-border harmonization and coordination.
Despite the initial promise of crypto as a new type of finance that avoids the risks associated with traditional finance, agency, operational, and financial risks have evolved across the ecosystem, proving that crypto is not immune to traditional risks. Trust in the market requires transparency, comparable information, and protection from fraud and abuse, and regulation is essential to proper market functioning. Where the causes of problems are similar, so should be the remedy: financialization requires the regulation of crypto. An approach which recognizes market failures and externalities (both positive and negative) and addresses these through regulation, enforcement and supervision, as well as international cooperation and coordination, is necessary for crypto to survive (and to thrive).
The authors discuss three key objectives of financial regulation: financial stability, market efficiency and transparency, and customer, depositor and investor protection.
First, financial stability regulation is designed to prevent or reduce the most significant externality which arises in the context of finance: financial crises and in particular systemic financial crises. While crypto has not yet reached the financial dimension that warrants intervention to ensure stability of the whole financial system, it is characteristic for financial technology to grow very fast and any crypto model has entered the stage of "too big to fail." Accordingly, regulators may well wish to ring-fence certain crypto assets from other crypto assets and insulate crypto from traditional finance, and vice versa.
Second, market efficiency and transparency focus on promoting market functioning, transparency, and efficiency. Market efficiency seeks a semi-strong form of informationally efficient markets, that is, markets in which prices reflect all publicly available information. However, information in the crypto market is available in a non-structured, unorganized manner and made available through various private and unregulated channels. Investors lack the necessary information to properly evaluate investment opportunities and related risks. Crypto is characterized by non-financial information about the IT architecture, systems design and stability, which are often central to project evaluation. Therefore, regulation should focus on standardization of information disclosure requirements as well as on information quality assurance mechanisms.
Third, financial regulation focuses on customer, investor and client protection, and seeks to maximize rational behavior while recognizing that rationality is often not the dominant characteristic of human behavior. Regulation can reduce fraud and theft and further promote trust while reducing the need for costly self-protective measures. In conclusion, the passage argues that financial regulation is necessary for the crypto market to thrive and survive.
Looking at the risks and challenges associated with the partial decentralization of functions within the financial ecosystem of cryptocurrency and DeFi (Decentralized Finance), a few consideration can be espressed. While crypto is not immune to the risks of traditional finance, the partial decentralization of functions in DeFi systems creates technical and financial complexity, making regulation and enforcement a challenge.
One of the main concerns regarding customer and investor protection in the crypto industry is the technical structure of segregation and custody. Currently, custody is commonly practiced in omnibus accounts that are permanently online and linked to the distributed ledger, and crypto intermediaries often manage clients' private keys. This creates a single point of failure, and cyberattacks, fraud, or malfunctions could result in exposure of the private key, or prompt fraudulent or malfunctioning transactions. Furthermore, some intermediaries have re-used client assets held in custody without proper governance in place, and the industry seems to make no use of the tracing feature implicit in blockchain and distributed ledgers’ endless chain of transactions, making it difficult to assess who holds an asset in bankruptcy and fraud cases.
Crypto staking is another challenge associated with partial decentralization. It involves bundling governance rights to influence the outcome of the voting mechanism, and users may lend their tokens or governance rights attached to them to other users for a fee or altruistic motives. However, this results in a dominant stakeholder, contrary to the disclosed functioning of the ecosystem. The lack of segregation and custody often means that investors are taking on high levels of risk via the providing crypto intermediary.
Another concern is represented by insolvency and resolution, where the partial decentralization of these ecosystems makes it difficult to maintain business continuity in the event of insolvency. The lack of financial incentives to maintain the system, users providing less liquidity, and developers investing less in cyber defense may pose challenges in incentivizing and integrating multiple actors in insolvency, resolution, and restructuring proceedings.
These challenges require a new regulatory framework that takes into account the partial decentralization of functions within the financial ecosystem of cryptocurrency and DeFi.
The custody of crypto assets must be secured in a way that prevents single points of failure, and a tracing feature should be implemented to provide clarity on asset ownership. Furthermore, regulation should address the issue of dominant stakeholders in crypto staking and provide adequate investor protection. The regulatory framework should be designed to promote innovation while ensuring financial stability, cybersecurity, asset recovery, and investor protection at large.
Hence, the Authors discuss the need for regulation in the world of decentralized finance (DeFi). While DeFi offers a unique approach to traditional finance, it still requires regulation to avoid market failures and externalities.
The article suggests a number of regulatory approaches that are needed to successfully address the issues that arise as a result of financialization in the world of crypto. Licensing is a core requirement for the successful evolution of the crypto ecosystem, which is to be accompanied by proper organization and adequate human and IT resources. In addition, regulatory treatment and differentiation of services provided should be implemented, and terms such as "exchange" should be reserved to entities that bring together third parties' supply and demand in crypto assets in an appropriately designed and managed environment. Disclosure and transparency are also important in financial markets. Thus, mandatory disclosure rules that are part of the standard repertoire of regulators should be implemented, along with the obligation to submit a Plan of Operations to explain the systems architecture and ensure systems resilience.
In conclusion, they discuss the advantages and challenges of cryptocurrency and highlight that some of the challenges faced in traditional finance are also present in crypto, such as agency risks, conflicts of interests, lack of transparency, counterparty risks, operational risks, and the dominance of individual intermediaries in certain crypto assets. To address these issues, they recommend to apply the principle "same function, same risks, same rules."
Due to the partial decentralization of crypto, multiple entities should work together to deliver compliance, cybersecurity, asset recovery, and investor protection. This poses difficulties in ensuring business continuity in the event of insolvency, and licensing and mandatory disclosure of details of IT architecture and business continuity arrangements are recommended to address this issue.
Additional expertise is required on the part of intermediaries, gatekeepers, and regulators due to the technical and financial complexity of crypto. Fit and proper tests and transparency ensured by a business plan approach are suggested to enable market participants and regulators to understand this complexity. Cross-border coordination is essential as it is difficult and costly to enforce regulations in a cross-border situation. Clear rules and coordinated cross-border regulatory action can assist in enforcement.
Regulators must address the features of traditional finance in their forthcoming regulation and develop adequate responses to its special features to enable crypto to have a future as a regulated and supervised financial industry. However, the rapid innovation in the markets and the difficulties of regulating decentralized algorithmic-based trading, lending, and investment in the cloud will remain a challenge. Hence, cross-border coordination is critical to enable regulators to share knowledge regarding new practices and problems and enhance regulatory learning globally.