Regulatory Clarity Won’t Bring an End to Crypto Risk

Like a ship emerging through the fog, the outlines of regulatory clarity are becoming visible in many different parts of the world, even though the United States isn’t one of them. From Japan to Dubai to the EU, the rules and regulatory models for cryptocurrencies, digitized real world assets and stablecoins are taking shape.

Paul Brody is Global Blockchain Leader for EY (Ernst & Young) and the author of "Ethereum for Business: A Plain-English Guide to the Use Cases that Generate Returns from Asset Management to Payments to Supply Chains."

The future is one where it will be possible to legally issue all kinds of digital assets, and that legal and regulatory structure will reduce risks and unleash a torrent of investment in the space. So pack your sunscreen, the blockchain summer is coming.

It’s worth, at this moment, contemplating what the limits of regulatory clarity will bring. Let’s just start with something simple like cryptocurrencies. Regulatory clarity will certainly reduce or largely eliminate the risk of crypto exchanges absconding with your digital assets. It will also eliminate the possibility that people will buy an asset one day only to find it is illegal and illiquid the next day.

Regulatory clarity will also give people more confidence in stablecoins, knowing they are backed by actual currency or government bonds and overseen by banking or securities regulators. It’s notable already that many stablecoins are backed one-for-one by currency, and actually have a lower risk profile than a traditional bank deposit, which can be re-loaned out to other people. Europe’s incoming MiCA regulations implement similar rules for a wide range of asset-backed coins, not just currency, but oil, gold and other commodities as well.

What regulation cannot do is protect people from making bad investment decisions. And the opportunity to do so in a world of digital assets is nearly unlimited. Take something basic like cryptocurrencies. The premise of a digital asset like Bitcoin is that it functions like gold, only better. The supply is limited in total, and the release process is governed by an algorithm.

What isn’t limited is the number of bitcoin clones and variations out there. There are literally thousands of them. Most of them are likely, in time, to become worthless. How can consumers differentiate between all these competing claims and what responsibility, if any, do regulators have to prevent people investing money in dead-ends?

Beyond cryptocurrencies, there is a whole category of digital tokens that seem to function like shares in companies. These are often sold as “utility tokens,” which can be used in a new protocol, and function like payments, but they also function like an investment and are often pitched to buyers as investments that will go up in value.

There are several protocols in circulation that have full-time management teams and generate transaction fees that are intended (eventually) to pay for those management teams and, potentially, offer dividends to the token holders. Token-holders can even table management proposals and vote on them. That certainly looks and sounds like the way that many companies or business partnerships operate.

To be clear, there is nothing wrong with this. Quite the contrary: I’m immensely excited about the kinds of innovation that is going to be funded and scaled up by these protocols.

These company-like structures, complete with ecosystem tokens, are being used to fund and pay for a whole wave of new digital products and services. Some of them are just fun, but others are ambitious efforts to re-imagine how we manage computing, storage and even real-world assets. There is huge upside for the firms and people involved. Token sales that fund these initiatives are a form of crowdfunding and if startups can do this off-chain (and they can), there’s no reason they should not be able to do so in a well-regulated on-chain market.

What we do need to be honest about is the level of risk involved. There’s a reason why people are not generally allowed to buy shares in brand-new companies unless it’s clear they can comfortably afford to lose their money: it’s very risky.

More than 90% of all new startups fail. At EY, we found an even higher failure rate for the protocols and organizations built on the first wave of ICOs in 2017 and 2018. Many ICO and crypto investors have lost a great deal of money over the years on high-risk deals, often without ever understanding the protocols being proposed.

Historically in the U.S. and other countries, investing in startups has been restricted to higher net-worth individuals and professional investors who are thought to either fully understand the risks, or at least have enough money that losing some of it isn’t ruinous. There is strong academic evidence that ordinary consumers who try to play this game do badly. The average retail investor does a worse job of picking stocks than a random number generator. Just because risks are disclosed doesn’t mean they are understood.

With all that risk, there are significant opportunities. Not just for companies that want to raise money, or investors that want to invest, but also for a whole ecosystem of regulated advice and asset curation to grow up. This could be the single biggest opportunity for traditional finance firms that are used to already curating from the vast world of investment opportunities for their clients. Blockchain and crypto risk aren’t going away, but there may soon be much more opportunity and reward to go with that risk.