Memery Crystal and Rosenblatt’s Web3 Breakfast Briefing – 6 December 2022

Key takeaways:

• FTX and other ‘crypto crashes’ in 2022 more about failings in ‘traditional’ asset/liability and risk management, governance and due diligence, less the fact that they were ‘crypto’ businesses.
• Regulation doesn’t mitigate desire or ability of bad actors to do bad things. Those with an interest to defraud people or systems will always exploit new access channels, including ‘new’ crypto markets.
• FTX failure highlights need for greater segregation of activities e.g., market-making, custody, lending, hypothecation etc. Can’t have all eggs in single crypto entity baskets.
• Blockchain facilitates ‘hyper transparency’ in digital asset transaction lifecycles; public record of every transaction – and related action – on public record (nowhere to hide). This offers greater market stability even without regulation.
• Perception/reality gap between high level Government/regulator proclamations about UK’s leadership in financial technologies and markets and reality of ongoing prevarication and procrastination with respect to regulatory approvals and market supervision.
• Regulators need to hire individuals that can read code and decipher smart contracts; without that skillset it’s challenging to effectively oversee digital assets and digital businesses.
• Should (and can) regulation (among other things) be decentralised, removing regulatory blocks and bringing much needed efficiency, via “baked-in” compliance in token issuance and other digital assets?
• Data privacy and protection remains a key challenge, particularly with respect to smart (programmable) money. Decentralisation of personal data and how ownership is transferred to the individual is biggest challenge for next 5-10 years.

Opening the meeting, Laura Clatworthy, Rosenblatt Partner noted that in a year in which ‘metaverse’ became the Oxford Dictionary’s second most popular new word of the year (behind ‘goblin mode’), Elon Musk took over Twitter, the rise and fall of NFTs, and a number of crypto firms – most recently FTX – collapsed, it was a timely moment to look back at the year, and to talk about what’s coming down the line.

Given its timeliness, our panel gave their perspectives on FTX, noting that while it was not the only big crypto crash in 2022, its downfall is less to do with ‘crypto’ and more to do with old-fashioned failings in risk management.  In this regard, Laura made reference to FTX’s bankruptcy filing by its new CEO John Ray, who wrote in it:

“Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here…From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented.”

FTX is particularly disappointing given that blockchain technology is designed specifically to mitigate such risks and also to support the operation of transparent, well-funded lending and collateralisation programmes.  Indeed, decentralised technologies like blockchain support hyper transparency in the transaction lifecycle, with every activity associated with the transaction on public record (no hiding place).  In the absence of regulation, this provides for a more stable environment, which is why it is also being looked at within the traditional finance ecosystem.

“The Financial Stability Board has been pushing for hyper transparency for years for ‘all trades, visible to everyone’. This could be achieved by doing everything on blockchain, including highly visible collateralisation.”   Alex Batlin, Bitpanda 

As Helen Disney of The Realization Group noted, FTX was licensed, but registration and regulation doesn’t stop bad actions and bad actors.  As such, “regulators should deal with FTX like any other insolvency; the fact it has a crypto vein is incidental to the underlying bad behaviours”.

Protecting access to assets, not assets themselves

“Crypto has uniqueness but the same rules of risk management apply in terms of asset/liability matching, leveraging, trading and lending other people’s money.  Given that many of these crypto firms have traditional finance backgrounds, this shouldn’t have been an issue.”

While traditional and DeFi risk management and collaterisation can be achieved on blockchains, the role of custodian remains important, albeit in the new model taking custody of security keys, not assets themselves.  It is also possible to manage segregation of duties/activities through segregated keys, ensuring only the right people can access and move assets and funds, for example.

“There are too many activities sitting with exchanges: custody, market-making, lender of last resort, hypothecation. So, when there’s a problem it’s not about a run on a particular bank, but on the entire market”.  Hirander Misra, GMEX

Challenge of regulating code not people

While the FCA is on ‘something of a crypto sprint’, its cross-industry consultations have been inconclusive about whether and how to regulate, from no regulation at all to voluntary registration (and ‘credible jurisdictions’). The unique challenge with regulating decentralised finance is that it requires rules around software code, not human behaviours. The FCA and other regulators do not have sufficiently skilled resources to translate complex code constructs within a regulatory framework.

Conversely, software code by definition is ‘trustless’ – meaning that you do not need to trust a human being or authority to implement it, rather it is done automatically through the coding. Code has no cynical, ethical or moral ‘bent’ (unlike humans) and will only act as instructed. Further, regulators should not overreact to the FTX situation.   Fundamentally they need to get it right, and not use regulation as a ‘big stick’.

Closing the gap between intention and action

“Regulation must move more quickly.  We’ve been talking about it for years and now we’re playing catchup, reacting rather than driving change”.

Daniel Tunkel, Memery Crystal’s Head of Regulation, observed that while crypto needs regulation, the FCA doesn’t currently have all the answers, and while the idea of the UK as a pivotal digital hub was great, there remains something of a perception/reality gap between what UK Government and supervisory bodies are saying at a high level, and the ability of ‘those doing the grunt work’ to translate good intentions into workable policies and actions. This may be “forcing people to run away to other jurisdictions, UK regulators are just not getting it right at the moment”.

Crypto more prone to fraud than traditional markets?

Our panellists felt that overall, the ‘size’ of crypto frauds was still considerably less than fiat currency money laundering and MLM/Ponzi/cold-calling scams in today’s traditional – and regulated – markets. That said, there is a need for regulators to be more active in blacklisting schemes – traditional and new ‘crypto’ scams alike.

“The most recent cases of fraud are issues of fraudulent behaviour by individuals, and not reflective of the crypto markets in general. Fraud is fraud, irrespective of where it occurs. Fraud existed long before crypto. There is legislation that protects against fraud and this should be enforced across the board. With transactions on the blockchain you have added transparency that you don’t have in cash transactions, or even some transactions to offshore opaque accounts. The blockchain acts as an immutable source of truth that can be used to fight against fraud.”  Eva Lawrence, Figment

There is potential to ‘bake’ compliance into tokens themselves, creating an atomic record (“just a number on a ledger”) and, in effect, regulating the asset itself rather than its surrounding parameters. Building compliance logic within the asset itself could create a guarantee at source that a digital asset can only be used as prescribed and intended, and could for example, “refuse to be sent to a money launderer”.

2023 focus areas

• Progression of Elon Musk’s Twitter agenda to ‘bring crypto to the masses’ picking up where Libra failed in the creation of new ‘e-money’ and ‘e-payments’ concepts and technologies. Musk certainly has the resources (people and money) to compete in this space (alongside many others like Mastercard, Revolut, Curve, Stripe et al dabbling in this arena) but more importantly, he has form in the ‘develop fast and break things’ model (Tesla, his space programme…).
• Further asset class tokenisation (including derivatives) will be a strong flavour in 2023. Blackrock, Citi and other major players are working on tokenisation (products and ETPs) initiatives, and associated liquidity management challenges.  Beyond tokenisation, other product opportunities to explore in the hybrid trade/defi space include swaps on a defi protocol.
• Gaming, an already enormous franchise in the Web 2.0 space, will become its own crypto market in which tokens earned in games could be ‘cashed out’ to spend in other ways (e.g. food/rent). Players like Decentraland are also focusing on greater interoperability between Web 2.0 and 3.0.
• Alongside tokenisation, greater focus on decentralized autonomous organisations (DAOs), are being more commonly considered and used by crypto and blockchain businesses alike as a legal structure with no central governing body, whose members share a common goal to act in the best interest of the entity.
• More industry consolidation: “the fallout isn’t over” with firms going back to basics, and huge fundraising rounds, and with a potential move back to the more well-known jurisdictions and with demonstrably strong corporate governance key in due diligence of crypto businesses. There is also an opportunity for low-priced ‘fire sale’ purchases by players like Goldman Sachs.
• Continuing debate around how data privacy is managed in a decentralised world, in terms of ownership, collection and use. This will be a major industry challenge for the next 5-10 years.

At this event, Rosenblatt Partner Laura Clatworthy and Memery Crystal Head of Financial Regulation, Daniel Tunkel, were joined by industry experts Helen Disney (The Realization Group – winner of crypto AM personality of the year), Alex Batlin (Bitpanda Custody), Eva Lawrence (Figment – winner of the Crypto AM Best Staking Product 2022) and Hirander Misra (GMEX –winner of the Crypto AM Fintech Development of the Year).