After The Fall: How To Regulate Crypto After $2 Trillion Collapse

It’s been a bad year for crypto, to borrow Sam Bankman-Fried‘s deliberately understated description of the misfortune which befell the most recognizable face (and hair) in the industry last month.

The latest data from CoinMarketCap suggests the total market value of all cryptoassets, including stablecoins and tokens, sat at just $810 billion as of Tuesday, down a mind-boggling $2 trillion from the peak and, notably, below the high seen during the late-2017 / early-2018 Bitcoin boom (figure below).

I described the $2 trillion figure in hyperbolic terms. You could argue it’s actually too small to matter — the polar opposite of too big to fail. Earlier this month, Bloomberg’s Felice Maranz offered a list of comparisons in an effort to show that crypto, “for all the drama, doesn’t pose much contagion risk.”

For example, “above-ground gold stocks at 205.3 tonnes are worth ~$11.7 trillion,” Maranz wrote, adding that average daily turnover for equities this year was nearly $600 billion, which means crypto’s market value amounts to just a day-and-a-half worth of stock trading. Zillow puts the total value of US private residential real estate at $43 trillion. And so on. The upshot: Crypto was small, now it’s tiny.

And yet, there’s still something unnerving about an $800 billion market for “pet rocks,” as Jamie Dimon called crypto earlier this month, in remarks that irritated at least one reader. (Maranz helpfully pointed out that the pet rock market “has yet to go to zero — you can buy one on Amazon for ~$30.”)

It’s impossible to keep track of the daily news flow out of the space, and it’s far from clear there’s any utility in trying. Bankman-Fried’s legal drama makes for “good” entertainment, and Binance is in the headlines seemingly every morning with assurances that it, and all entities associated with it, are just fine. A quick scan of Bloomberg crypto red heds from the past week is a good temperature check:

• December 13: *CRYPTO IS A `GARDEN OF SNAKES,’ CONGRESSMAN BRAD SHERMAN SAYS
• December 14: *WARNER: SEEING A LOT OF CRIMINAL ACTIVITY TAKE PLACE IN CRYPTO
• December 16: *MAZARS TO PAUSE ALL WORK FOR CRYPTO CLIENTS, BINANCE SAYS
• December 16: *INCREASED CRYPTO AND TRADITIONAL-FINANCE TIES A RISK: YELLEN
• December 16: *GENSLER SAYS CRYPTO A LARGELY `NONCOMPLIANT’ MARKET

I could go on. There are hundreds (thousands), but you get the point: Lawmakers and regulators are nervous.

Of course, there’s still no consensus on how to regulate crypto, and FTX’s spectacular implosion (the timeline below, from Goldman, is a handy reference guide) raised the stakes and increased the sense of urgency in Washington.

If you ask Goldman’s Jeff Currie, the bank’s head of commodities research, the “point of trust” is a good place to start when it comes to regulation. Currie spoke to the bank’s Allison Nathan for the latest installment of Goldman’s “Top Of Mind” discussion series.

“We argue that the FTX saga is a story as old as financial markets, and doesn’t reflect a failure of the technology, but of the lack of regulation around the ‘point of trust’ — anywhere money is exchanged on the promise of a future return,” Currie said.

The passages (below) are abridged from Currie’s longer remarks.

We believe crypto will likely once again flourish after the recent crises, as did a long history of other assets that were at the center of a speculative bubble and subsequently exposed fraud, like natural gas did after the collapse of Enron. The key to its success rests on regulators correctly figuring out what to regulate in the ecosystem to protect investors — the point of trust, not the ‘trustless’ blockchains themselves.

The recent crypto crises follow a well-known pattern in financial markets — a highly volatile and relatively new asset creates the potential for instant riches, drawing in many unsophisticated investors looking for the opportunity to make millions. To do so, they must often go through a ‘gatekeeper’ — institutions who make the underlying market and investors trust to hold their assets and have their best interests at heart. Eager and usually speculative investors are willing to hand money over to these institutions in the hopes of getting rich quickly. This is a tale as old as time; it did not begin with the advent of blockchain technology, and isn’t unique to crypto.

How should crypto be regulated to protect investors? The answer is complicated by its novelty and evolution, but [also] simple: Regulation is needed at the point of trust, where money is exchanged on the promise of some future return, because it is the time component that creates the opportunity for fraud. No opportunity for fraud exists when, say, a cow is exchanged for money in real time, but fraud has the opportunity to arise when payment and the acquisition of the cow are separated in time. As such, when a token is used as a financial instrument — as Terra’s Luna algorithmic stablecoin was when it was lent out on Anchor for a 20% yield — it should be regulated like all other securities. Until regulators can accurately classify which tokens fall into this category and which don’t, the opportunity for fraud in crypto will persist.

The question of trust in financial instruments and the need to regulate entities like crypto exchanges and lending platforms to enforce that trust is one that blockchains themselves are trying to solve. Accordingly, once the financial aspects surrounding digital assets are regulated, regulators shouldn’t interfere with the blockchains themselves.

Decentralized systems don’t pose counterparty risk in the same way as traditional banks. In decentralized finance lending protocols, collateral is visible to all members of the pool, and is automatically liquidated if its value approaches the value of the loan. Should the pool lend its resources to unsound borrowers, the collateral is automatically retrieved without a court proceeding or at a discount to the loan through the logic of smart contracts. This resolves the question of trust, the very thing regulation to safeguard investors would be intended for.