The Disrupt Weekend

Stablecoin Reserves

Stablecoins are supposed to be redeemable 1:1 for whatever asset that backs them. But there’s no actual legal requirement for stablecoin issuers to hold reserves equal to circulating supply. That’s a problem. When a stablecoin loses its peg there’s a possibility that holders will rush to redeem their coins, resulting in something very similar to a bank run.

We should require stablecoin issuers to maintain 1:1 reserves at banks insured by the Federal Deposit Insurance Corp. Quarterly audits of reserves and real-time reporting on mint-and-burn activity should be mandatory.

Separate Trading and Custody

The market structure where customers have to keep their money with the exchange is fundamentally flawed. You don’t have to know anything about crypto to see why that is not a good idea. Suppose the Nasdaq approached the SEC about being its own custodian. That conversation would never happen.

The problem isn’t just that it’s just too easy to dip your hand into the cookie jar. Even if you are completely honest, there’s still a problem with counterparty risk.

If there’s anything we should learn from the FTX collapse, it’s that assets should be stored until required for trading by external, qualified, regulated and insured custodians. This creates a check and balance for verifying reserve assets under any exchange’s control.

Require Digital-asset Exchanges to be 100% Digital

Disallow direct trading of digital assets with fiat or off-chain assets. This will make all exchanges on-chain auditable, enabling a proof of reserves that actually works. With pure digital exchanges with fiat represented digitally as a regulated stablecoin, we could have proof of reserves for everything in real time.

The last thing you have to solve is the liabilities component. If we fix settlement and clearing to be all digital, we could build a pretty robust and efficient system with compliance baked in. What’s happening today is that exchanges are trying to build a business in a hybrid world because they don’t have any other choice. We can put fiat and securities in digital wrappers as a transition.

Regulate Digital-asset Exchanges’ Use of Omnibus Wallets

Many crypto custodians use omnibus wallets where the funds of multiple clients are commingled under a single address. This makes key management easier for the custodian, and also makes it easier to enable efficient off-chain transactions. The downside is that individual clients no longer have visibility into their transactions or into counterparty risk. It’s also unclear what happens to each customer’s funds in the event of a bankruptcy.

Define Securities for the Digital Era

This is the most cited complaint about the SEC: It is relying on a definition of securities developed in the 1940s to underpin its enforcement efforts. Builders in crypto have honest questions about how the rule applies to them, and they deserve answers.”

See Also: The World’s Best Crypto Policies: How They Do It in 37 Nations
See Also: MiCA at the Door: How European Crypto Firms Are Getting Ready for Sweeping Legislation
See Also: What You Need to Know About Crypto Regulation in Hong Kong, Singapore, Japan

“Regulators must work within the framework of the Bank Secrecy Act (BSA). This law lays out a comprehensive framework for AML/CFT – shorthand for anti-money laundering and combating the financing of terrorism rules – built on the foundation of “know your customer,” aka KYC. But stringent KYC within decentralized finance (DeFi) is not only unnecessary, it’s all but impossible.

DeFi platforms do not actually hold user funds, so it’s not clear how KYC is even relevant. Sure, these protocols oversee and approve users’ financial transactions, but DeFi’s non-custodial nature makes it all but impossible to implement effective and responsible KYC policies. For instance, if the SEC were to shut down Uniswap, a popular decentralized exchange, 1,000 developers around the world would simply deploy forks without batting an eye.

Instead of updating existing legislation, Congress should unravel the BSA.

The foundational problem with the BSA is that when it was written large sums of money could only be transmitted through intermediaries. Further, transaction databases were siloed within each intermediary, making them easy to surveil. In this context the BSA is logical and effective.

But blockchain and DeFi have changed the game, enabling the legal exchange of vast sums of money with no intermediary. Such transactions are also permissionless, meaning they require no administrative oversight and are largely anonymous. This contradicts the basic assumptions of the BSA, rendering it largely impractical and unenforceable.

Yet, the BSA’s KYC framework is so ingrained within U.S. regulators’ compliance culture that it has become gospel. But in the real world, guilt until proven innocent has never been an effective means of regulation. KYC is not an end in itself but a means to an end. Preventing money laundering and terror financing need not require a broad brush stroke that kneecaps new business models and stunts innocuous user activity.

The reality is that crypto comes with its own regulatory tool: the blockchain. Rather than siloing transaction databases across multiple financial oversight bodies, the blockchain ledger provides a single consolidated database for all relevant transactions.

Instead of KYC, regulators should shift to KYT, or Know Your Transaction. Given blockchain’s open-source nature, the noncustodial design of most DeFi platforms, and users’ ability to effortlessly spin up multiple addresses, the only way to effectively regulate the space is on the individual transaction level.

After all, it’s not the financial histories of individual users that should concern regulators but the origins of the funds. KYT would institute blockchain review mechanisms that would follow the money and prohibit unsanctioned transactions. KYT could be even more effective than KYC, enabling authorities to monitor the entire transaction database, not just the red-flagged transactions within submitted SARs.

The BSA is considered untouchable, but when the law was first drafted back in 1970, its creators could never have imagined today’s financial reality. It’s time to haul this outdated regulatory mechanism into the 21st century.”

“Most crypto assets do not create a legal relationship between an identifiable “issuer” and the owner of the asset. We would argue crypto assets are not themselves “securities” under current law. (We also argue that characterizing crypto assets as “temporary” securities until extrinsic factors like “sufficient decentralization” cause them to “morph” into non-securities is not supported by current law and would be bad policy if adopted by courts.)

Even if an entity has been deemed the “issuer” of a crypto asset, that entity and the individuals who act as its officers and directors will have to take on responsibilities that will frequently either be of little or no relevance to owners of the crypto asset. This is because, unlike with shares in a company or debt obligations of a company, the value of a digital asset may only be very tangentially related to the issuer’s operations or its financial condition.

Additionally, there are myriad provisions in U.S. securities laws that are at best opaque and at worst nonsensical, when applied to crypto. This includes disclosures for where and how crypto assets would be allowed to trade, how custody rules would be applied, whether a “transfer agent” would be needed (and how that could possible apply), margin rules, settlement rules, broker-dealer rules, investment company and investment advisor rules and many others.

Not only are there numerous practical challenges here in mapping requirements intended for traditional businesses to deemed issuers of crypto assets, there is the larger question of why any company or group of individuals would want to take on these responsibilities when they neither have access to all information relevant to the crypto asset nor are being compensated for taking on these many potential liabilities.

The bottom line is that, without a radical re-imagining of the entirety of our securities laws, it is very difficult to see how most crypto assets can practically function as securities and still keep their intended purpose.

Instead, a solution along the lines of Title III of the Lummis-Gillibrand Responsible Financial Innovation Act would make much more sense. That Title would add a new section to the securities laws that imposes sensible disclosure requirements on those companies that fundraise through the sale of crypto assets without attempting to treat the crypto assets themselves as securities.”

“So why is he so bullish on crypto? “It’s not about crypto,” says Emmer, clarifying that it’s about what crypto is facilitating – the movement towards Web3, or what he prefers to call the “ownership economy.”

That goes to everything I believe in, which is restoring the individual’s right to make his or her decisions about what they want to do in the marketplace. Or who they want to do it with. Or how they want to get that done. And they don’t have to have a middleman. Ultimately, this is about restoring liberty and choice to individuals.

What happens next with congressional legislation is perhaps crypto’s most burning question of 2023 and Emmer is at the tip of the policy spear.

I think you’re going to see a lot of bipartisan work to get to the bottom of why the [Securities and Exchange Commission] wasn’t doing his job,‘ he says, referring to the FTX meltdown. ‘What was [Chair] Gary Gensler and company really doing?’ He describes Gensler as “very arrogant” and speaking “from the mountaintop,” and then ‘we find out that they’re working with a fraudster that bilked the people out of billions of dollars … Republicans and Democrats are going to be involved with that.’

We’re going to focus obviously on legislation, and I think it’s going to be to place key guardrails around the industry. Market structure guardrails. Stablecoin guardrails. Things like that.

The roots of the problem, says Emmer, is that Bankman-Fried was incentivized to set up shop in the Bahamas, which let FTX’s execs hide their shenanigans. In other words, the dithering of Congress meant that companies sought refuge in the Bahamas, and when that happens all bets are off. So the trick to preventing a future FTX, argues Emmer, is not smothering regulation, it’s an embrace of transparency and decentralization. ‘What we’re talking about is decentralization,’ says Emmer.

That’s what blockchain and crypto rides on. That’s what it’s all about. Open, permissionless, transparent. Anyone can see what’s going on in the blockchain. It literally is the answer, the antidote, to Sam Bankman-Fraud and all of the scammers that have come before.”

“A court document filed by prosecutors on Friday alleges that Bankman-Fried messaged FTX US General Counsel Ryne Miller on Signal, asking to reconnect and “vet things with each other.”

Prosecutors said Bankman-Fried’s message was a thinly-veiled attempt to “influence [Miller’s] potential testimony,” which they described as “particularly concerning” given Miller’s first-hand knowledge of Bankman-Fried’s conduct around the time of FTX’s collapse.

Federal prosecutors wrote a letter to U.S. District Court Judge Lewis Kaplan on Friday, requesting that he modify the conditions of Sam Bankman-Fried’s bail to include ban on private communications with current and former employees of FTX and Alameda Research. Prosecutors also requested that Judge Kaplan prevent Bankman-Fried from using ‘any encrypted or ephemeral call or messaging application, including but not limited to Signal.'”

See Also: Sam Bankman-Fried Seeks Right to Transfer FTX’s Crypto