You Want Crypto Regulation? I’ll Give You Crypto Regulation

Maybe Congress should separate custody from exchange, the way it severed Wall Street from commercial banking nearly a century ago. This piece is part of CoinDesk’s Policy Week.

AccessTimeIconJan 26, 2023 at 5:20 p.m. UTC
Updated Apr 9, 2024 at 11:19 p.m. UTC
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Epistemic status: I don’t even know what I’m doing here. Then again, neither does Elizabeth Warren.

New cryptocurrency laws are likely coming in the U.S. whether the industry likes it or not. A salubrious outcome would be legislation that helps protect consumers without undermining, and maybe furthering, crypto’s promise of financial autonomy.

Here’s an idea.

What if Congress mandated the separation of crypto custody and crypto exchange? In other words, a company could be licensed to match buy orders and sell orders between investors, or it could be allowed to store crypto on a customer’s behalf. No firm would be permitted to do both. At most, an exchange could administer an escrow account holding funds for agreed-upon, uncompleted trades. It would never be allowed to act as a de facto bank.

Marc Hochstein is the executive editor of Consensus, CoinDesk's flagship annual event. The views expressed are his own, so please don't take it out on his colleagues. This article is part of CoinDesk’s Policy Week.

Think about it.

From the Mt. Gox debacle nearly a decade ago to FTX’s collapse last year, a lesson that crypto users keep learning over and over again is captured by the alliterative slogan, “not your keys, not your coins.” Bitcoin and its descendants and copycats are digital bearer assets, more akin to physical coins, banknotes or gold bars than to the digital money in a bank account. Once crypto is gone, it’s gone. If you hand it to a third party to hold it for you, you are trusting it to A) not get hacked and lose the funds, B) not misuse or abscond with the funds and C) give your crypto back when you ask for it.

Time and time again we’ve seen exchanges fail at one or more of these jobs. Yet, too many users continue to trust exchanges to hold their money rather than practicing self-custody (storing coins in a wallet whose cryptographic private keys only they control) or using a hybrid arrangement like a multisignature (multisig) wallet (controlled by multiple keyholders).

Segregation of funds

The most obvious reason to separate trading from custody is to prevent commingling of funds, e.g., FTX’s alleged use of customers’ money to bail out its founder Sam Bankman-Fried’s trading firm. Already we’re hearing policymakers make noises along these lines. For example, here’s Securities and Exchange Commission Chairman Gary Gensler in a September speech:

The commingling of the various functions within crypto intermediaries creates inherent conflicts of interest and risks for investors. Thus, I’ve asked staff to work with intermediaries to ensure they register each of their functions – exchange, broker-dealer, custodial functions, and the like – which could result in disaggregating their functions into separate legal entities to mitigate conflicts of interest and enhance investor protection.
SEC Chairman Gary Gensler

Separate legal entities sounds like a good start, but why not go further and forbid such activities to take place under the same corporate roof? There’s a legendary precedent for this.

Four years after the 1929 stock market crash, Congress passed the Glass-Steagall Act, which separated investment banking (the high-risk activities of Wall Street) from commercial banking (the kind of banking Jimmy Stewart’s character practices in “It’s a Wonderful Life”). The restriction was gradually loosened over the course of the 20th century and eventually lifted in 1999 with the passage of the Gramm-Leach-Bliley Act. While the causes of the 2008 global financial crisis were complex and hotly debated, many have argued that the removal of Glass-Steagall’s firewall was a big contributing factor.

Financial regulators in the U.S. have erected similar fences separating banking from commerce and mortgage insurance from title insurance. Just as most people don’t bathe where they cook (though I did once view a flat in London that had a shower in the kitchen – true story), regulators and lawmakers have often concluded there are different types of financial activities that are unhealthy to undertake in close proximity. FTX’s alleged commingling would seem to suggest crypto custody and crypto exchange are two such activities.

I’ve probably already lost the hardcore libertarians in the audience. I respect their worldview but, as noted, in the wake of FTX’s meltdown politicians are out for blood (and photo ops), so some kind of reforms are probably inevitable.

The pragmatic (or, if you prefer, crony capitalist) crypto companies that engage with (or, if you prefer, spend boatloads to lobby) lawmakers may object to my suggestion as well. I imagine they’d balk that it would amount to a ban on centralized crypto exchanges, forcing expensive restructurings of such firms and leaving only decentralized ones operating in the U.S.

To which I say:

Yes, Chad.

Why are we even here?

Why not take the opportunity to incentivize users to do what old hands in crypto have been advising them to do for years? Why not drive them to use decentralized exchanges that don’t custody funds and to either keep their digital assets under their full control or, if they don’t trust themselves to safeguard their keys, use a multisig setup? Isn’t self-sovereignty one of the reasons we’re all here?

One might counter that self-hosted crypto wallets and decentralized exchanges are difficult for everyday consumers to use, and so leaving these as the only permitted on-ramps would slow adoption. Well … tough tiddlywinks. How did “mass adoption” work out last time? For the next few years, whenever most people hear the word “crypto,” they are going to think of Bankman-Fried's casino and the people who lost their life savings.

FTX’s Super Bowl ad pitched the exchange as “the safe and easy way to get into crypto.” Easy, maybe, but it sure wasn’t safe. Maybe the industry should worry less about making things easy (which often entails centralization) and concentrate a bit more on helping people achieve crypto’s purported ends. Stop conditioning consumers to be the helpless Eloi in H.G. Wells’ “The Time Machine,” unless you want them to get eaten by subterranean Morlocks.

Meanwhile, a push toward decentralized exchanges would bolster development and innovation in that part of the industry which is still largely propped up by a few dedicated, idealistic developers. With demand comes investment and growth. One of the biggest pain points in using decentralized exchanges (for bitcoin, at least) is low volumes. More participants would address that problem.

Besides, “this would slow mass adoption!” might be a selling point on Capitol Hill, particularly with lawmakers like Sen. Warren, who is clearly skeptical of the technology’s benefits. A Glass-Steagall-like firewall could even be a bargaining chip to get the more zealous policymakers to back off efforts to enlist software developers, miners and other blockchain network participants as unpaid snitches for the government. Maybe this could give crypto-friendly lawmakers the leverage to stop regulators from applying the travel rule – which requires financial institutions to share senders’ and receivers’ sensitive personal information with each other as part of a money transfer – to wallets controlled by individuals.

Anyway, just a thought. I’m sure there are better ideas. Speaking of which …

Shameless plug time

For much smarter answers to the tough policy questions facing the industry than my half-baked trolling above, Consensus 2023 will include an all-day Crypto Policy Forum on April 28.

Regulators, lawmakers and industry stakeholders will discuss the policy fallout from the 2022 market crash, the advance of central bank digital currencies, the tensions around stablecoin regulation, the widening enforcement of anti-money-laundering and counter-terrorism rules against cryptocurrency services and the challenges in applying 20th century securities laws to 21st century decentralized protocols. Check out the preliminary agenda here. There will also be opportunities for more intimate discussions of the thorniest issues offstage – stay tuned for more details on that.

Registration is open for the event (April 26-28 in Austin, Texas), and unlike any coin the ticket price is definitely going up in the coming months. That’s the only price prediction I’ll ever make. As a reward for reading all the way to the end of my screed, use discount code POLICYWEEK15 for 15% off.


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Marc Hochstein

Marc Hochstein is the executive editor of Consensus, CoinDesk's flagship event. He holds BTC above CoinDesk's disclosure threshold of $1K and de minimis amounts of other digital assets (details on profile page).

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