[Full disclosure: this blogger was formerly CSO for a regulated cryptocurrency exchange. All opinions expressed are personal.]

After QuadrigaCX

Two lines of argument predictably follow in the aftermath of any cryptocurrency business failure. First is second-guessing by pundits about their favored silver-bullet technology that could have saved the failed venture— if only they implemented multisig/hardware wallets/Lightning or reformatted all webpages to Comic Sans, this unfortunate situation would not have occurred. Second involves increased calls for regulating cryptocurrency. The aftermath of Canadian exchange QuadrigaCX is following that script so far. Quadriga has entered into bankruptcy protection, with $190M USD in customer assets allegedly stuck in their cold wallet, because the only person with access to that system has unexpectedly passed away. 

Before taking up the question of what type of regulation would have helped, there is a more fundamental question about objectives. What outcomes are we trying to achieve with regulatory oversight? Or stated in the negative, what are we trying to avoid? There are at least three compelling lines of argument in favor of regulating some— not necessarily all— institutions handling digital assets:

1. Consumer protection: Simply put, customers do not want to lose money to security breaches or fraud occurring at cryptocurrency businesses they depend on
2. Stemming negative externalities: Cryptocurrency businesses must not create new avenues for criminal activity such as money laundering while the rest of the financial industry is working to eliminate the same activity in other contexts
3. Market integrity: Pricing of digital assets must reflect their fair value assigned by the market as closely as possible, not artificially manipulated by participants with privileged access.

I. Consumer protection

This one is a no-brainer: when people entrust their money to a custodian, they expect to be able to get those funds back. Quadriga debacle represents only one possible story arc culminating in grief for customers. If their court filings are taken at face value, this incident stemmed from an “honest mistake:” the company lacked redundancy around mission-critical operations, relying entirely on exactly one person to fulfill an essential role. To put it more bluntly, it was incompetence. But that is not the only way to lose customer money. Far more common and better publicized in the cryptocurrency world have been losses due to security breaches, where systems holding digital assets were breached by outside actors and funds taken by force. Meanwhile initial coin offerings (ICOs) have been notorious for dishonest behavior by insiders, culminating in so-called exit scams where ICO organizers abscond with the funds raised, without delivering on the project.

There is no bright line between these categories. If a wallet provider is “0wned” because they failed to implement basic security standards, is that routine incompetence or does it rise to the level of gross negligence? In any case, such distinctions do not matter from a consumer perspective. Customer Bob will not feel any better about losing his savings after learning that a sophisticated a North Korean group was behind the theft. (Not entirely hypothetical, since state-sponsored North Korean attackers have been targeting bitcoin businesses, particularly in South Korea. Nor is it surprising that a rogue country would embrace bitcoin to subvert embargoes when it is cut off from the global financial system, in the same way that criminals & dark-markets embraced bitcoin as early adopters.)

That said we need to spell out he limits of what counts as “unreasonable loss.” All investing comes with risk. Notwithstanding the the tulip-bubble perception created by remarkable run-up in prices in 2017, there is no law of nature that bitcoin prices can only increase. As painful a lesson it may have been for investors who jumped on the HODL bandwagon at the wrong time, it is possible to lose money by investing in cryptocurrencies. For the most part, that type of loss can not be pinned on the cryptocurrency brokerage where the buying/selling occurred. Individual agency for investment decisions is a core assumption of free markets. But even then, there are edge-cases. Suppose an exchange decides to list an obscure altcoin whose value later drops to zero because miners abandon it. Does the exchange share in the responsibility for losses? Even if the exchange did not make patently false representations— “buy this asset, it is the next bitcoin”— customers could argue that supporting trading in that asset constitutes an implicit endorsement. For the purposes of this blog post, we will punt these questions to courts for resolution and only focus on losses due to systemic failures in security and reliability.

II. Negative externalities

A very different line of argument in favor of regulatory intervention involves society’s interest in limiting negative externalities. That interest is compelling because the market participants are not directly harmed and may not have any incentive otherwise to correct this behavior. Consider a cryptocurrency exchange favored by criminals to launder profits from illegal activity— BTCe would have been a good example until its 2017 seizure. Arguably others customers of the exchange were not affected adversely from this behavior, at least not in their role as customers per se. After all, criminals in a hurry are not price sensitive: they could be willing to dump their bitcoin at much lower prices or pay a premium to buy bitcoin at higher price than comparable venues where they would not be welcome. That means in a sense everyone involved in that particular trade is better-off: the crooks are happy because they exchanged their ill-gotten gains into a more usable currency, customers who happened to be counter-parties on the other side of that trade are happy because they got a great deal on their bitcoin and the exchange is happy because they collected commissions on the trade.

Society overall however, is not better off. Easy avenues for converting criminal proceeds into usable cash helps incentivize further criminal activity. Economic activity that looks like a win-win for everyone within the confines of a single cryptocurrency exchange can be harmful in the bigger picture when negative externalities are taken into account. To libertarian sensibilities this may represent an overreach by the state to intervene in free-market transactions between fully informed participants: the criminal trying to dump bitcoin and some willing buyer interested in acquiring those assets. But pragmatically speaking, there is significant precedent for regulating financial services based on this premise and the argument that cryptocurrency is somehow exempt from similar considerations does not pass a sanity check.

III. Market integrity

If price discovery is the central function of an exchange, it is important for those price signals to represent true supply and demand. There are many ways the signal can get out of sync from underlying market conditions. For example, in the early days when Chinese exchanges dominated bitcoin trading— before the government got wise to use of cryptocurrency for evading capital controls— there were frequent allegations that self-reported volume on those exchanges was inaccurate. While the subsequent crackdown by PRBC put a damper on volume, even as late as 2018 observers continued to find compelling evidence that leading exchanges were continuing to misrepresent trade volume.

Even in the absence of complicity by exchange operators, financial markets are subject to manipulation attempts by unscrupulous participants. Deliberately employed strategies such as wash-trading and order-spoofing can distort the price signal that emerges. That distorted view poses a challenge both to participants and third-parties. On the one hand, other customers trading on the same venue are getting a bad deal: they could end up paying too much for their cryptocurrency due to artificially induced scarcity or receive less than fair-market value when selling because of inflated supply. On the other hand, when market data is used for pricing other assets—such as derivatives in the underlying asset or shares in a cryptocurrency fund— the noise added to the signal can have far reaching consequences, affecting people who had no relationship with the exchange where the manipulation occurs.

One of the more interesting cases of alleged market manipulation in bitcoin involves neither exchanges or customers. By some accounts, the stablecoin Tether had an outsized influence on price movements for much of 2017 and 2018. Some cryptocurrency businesses can not handle fiat money—their lack of compliance programs have turned these entities into pariahs of the financial system, with no correspondent bank willing to take their business. This is where Tether comes in. A digital asset designed to have one-to-one relationship to US dollar, tether exists on a blockchains and freely moved around, bypassing traditional channels such as wire transfer. Customers who could not directly deposit US dollars into their Bitfinex account could instead purchase tethers in equivalent amount, move those tethers over and place order on the BTC/USDT order book. In isolation the use of tether is not evidence of attempt to fabricate market demand— although it is arguably a lifeline for exchanges with weak/nonexistent compliance programs, since they are precisely the companies who can not establish banking relationship required to receive fiat currency. But suppose tethers could be printed out of thin air, without receiving the requisite US dollars to back the digital assets? Then Tether (the issuing company) could fabricate “demand” for bitcoin since individuals buying bitcoin with tethers (the currency) are effectively working with free money.  The ballooning amount of tethers in circulation, combined with the opacity of the issuing company— Bloomberg referred to it as the $814 Million Mystery— and lack of independent audits have fueled speculation about whether it is operating a fractional reserve.  At least one research paper found that most of the meteoric rise in bitcoin prices could be attributed to tether issuance. That is an outsized amount of influence for a single company: by issuing less than three billion dollars worth of a digital asset— whether or not those were backed by USD deposits as promised— Tether helped propel bitcoin to a peak market capitalization over 100 times that amount. While the Tether story is not over and the presumption of innocence applies, it underlines another argument for regulation: left unchecked, rogue actors can have outsized influence in distorting the operation of digital currency markets.

CP