The short timeline between the FTX exchange's collapse in November 2022 and the U.S. Securities and Exchange Commission’s (SEC) vote in February 2023 to expand the types of digital assets included in the so-called Custody Rule shows that regulators are moving quickly to take actions they perceive will safeguard the crypto industry.
As much as regulators have been harped on by crypto insiders for not understanding the space and setting precedents that hamper innovation, requiring exchanges to separate custody from trading will be enormously positive for the future of crypto.
Mike Belshe is the CEO and co-founder of BitGo.
Crypto regulatory solutions outpacing traditional finance?
Modern traditional finance segregates business lines such as trading, financing and custody and uses a robust system of checks and balances. It therefore makes sense for digital assets to follow that same framework, learning from the past mistakes of traditional finance. Even when looking at a small subsection of the history of traditional finance regulation, the advancement from the FTX crash to sensible rulemaking about crypto custody happened much more quickly.
For example, in the years leading up to the stock market crash of October 1929 (the “Great Crash”), people bought stocks in large numbers and speculated by borrowing money to buy more shares. This worked as long as stock prices kept increasing, with the decade of the Roaring Twenties being one of a 10-year bull market with plenty of pump and dumps, insider trading and market manipulation.
When the crash occurred, people who’d bought their shares of stock on margin lost the value of their stock portfolio and owed money wherever they’d gone to borrow money to buy their stock. When people tried to withdraw their money from financial institutions, panic ensued and even the New York Bank of the United States collapsed.
As a result of the lessons learned from the Great Crash, the SEC was created and consumer protections were instituted. The SEC's recent actions also reflect a reaction to lessons learned, and this proposed rule change is intended to bring order and protect market participants.
Forward-moving crypto regulation solutions
The SEC’s proposal that registered investment advisors be required to use an independent, regulated, qualified custodian is prudent and good for the digital asset industry. Qualified custodians, which have a fiduciary duty to clients, would hold client funds in segregated accounts. The custodian must also meet rigorous regulatory standards with audits to protect those funds.
Speaking as co-founder and chief executive of one of the cryptocurrency industry’s most important custodians, I propose additional constraints meant to protect investors:
- Regulators should also require issuers of stablecoins to keep a 1:1 reserve at Federal Deposit Insurance Corp. (FDIC)-insured banks. Although stablecoins are supposed to be redeemable with the assets that back them, no legal requirement exists for issuers to maintain proper reserves and to prevent rushes like what happened to the then-unregulated New York Bank. Requiring an audit of stablecoin reserves quarterly and real-time reporting on mint-and-burn activities would be a sensible step.
- Make all exchanges on-chain auditable. This measure will take proof-of-reserve statements from a partial solution that provides some transparency to a more complete one. FTX blended its digital asset holdings with fiat and let liabilities significantly exceed those reserves with highly undesirable results. Going further with the idea, the government could even create a digital registry of debt on a blockchain.
Although no one would have ever wished for an FTX collapse, this same type of crash had spurred necessary rule-making and role delineations in traditional finance to protect investors. Despite growing pains, the crypto industry appears to be evolving much faster by learning from the mistakes of its own industry and traditional finance before – a trajectory that is likely to continue.