Regulatory Capture In Action

On January 20^th, SEC Commissioner Hester Peirce gave a long speech at Duke University entited Outdated: Remarks before the Digital Assets at Duke Conference essentially arguing against doing her job by regulating cryptocurrencies.

Below the fold I point out how she is shilling for the cryptosphere, with a long list of excuses for inaction.

Right from the start it is clear that Peirce has swallowed the industry line that "crypto has immense potential" but that "it is still the early days":

Underlying these lessons is the truth that technology takes time to develop and often must combine with innovative developments in other fields to realize its full potential. In the interim, it can appear, particularly to outsiders looking in, awkward, useless, or downright harmful.

Peirce cites but ignores the letter that I and 1500 other insiders wrote pointing out that the technology was in fact "awkward, useless, or downright harmful". Molly White's It's not still the early days demolishes the idea that we only have to wait a while for the amazing future that Peirce envisages:

a multitude of potential uses, including smart contracts, payments, provenance, identity, recordkeeping, data storage, prediction markets, tokenization of assets, and borderless human collaboration.

Note that every one of this list of crypto-bro buzzwords is something we can already do, so the maximum possible benefit from cryptocurrencies is some marginal improvement in productivity. Peirce doesn't acknowledge that the innovation in the cryptosphere amounts to nothing more than replicating existing financial services, just without that pesky regulation that prevents scammers from maximising their profits.

Peirce then starts the list of excuses for inaction by appealing to crypto-bros better instincts:

The first and most important lesson of the evening for people who believe in crypto’s future is that they should not wait for regulators to fix the problems that bubbled to the surface in 2022. They can act themselves to root out harmful practices and encourage good behavior. Regulatory solutions, which tend to be inflexible, should be a last resort, not a first resort. People working together voluntarily are much better at fixing things than regulators using their inherently coercive power to impose mandatory solutions. Privately designed and voluntarily implemented solutions can be both more effective and more tailored because the people driving them better understand the technology and what they are trying to achieve with it. Iterating and experimenting with private solutions is easier than it is with regulatory ones. Moreover, private solutions avoid the systemic risk that comes from an industry homogenizing because everyone has to fit into the same regulatory parameters.

Surely we can depend upon the well-intentioned actors in the cryptosphere to voluntarily give up the profits they have been accumulating from enabling fraud, theft, money laundering and ransomware. It is in their best interests, after all.

Pierce continues to lecture the crypto-bros:

remember the point of crypto. It is not driving up crypto prices so that you can dump your tokens on someone else. Digital assets need to trade, so centralized venues or decentralized exchange protocols are necessary, but trading markets are not the ultimate point. Nor is the point of crypto to lend your crypto assets so that other people can trade them, although lending markets, in which everyone is aware of the risks, are not inherently problematic. Rather, at its core, crypto is about solving a trust problem: how can you interact and transact safely with people you do not know. Traditionally, people have looked to centralized intermediaries or government to solve this problem, but technology like cryptography, blockchain, and zero-knowledge proofs offer new solutions.

The "new solutions" replace trust in identifiable, regulated institutions against which you have legal recourse, with trust in pseudonymous code developers, unregulated offshore entities, and vulnerability-ridden software, against none of which you have effective legal recourse. Clearly a huge improvement.

Peirce's detachment from reality continues:

although crypto enables reduced reliance on centralized intermediaries, as long as companies are actively involved in crypto, people should take the same precautions as they would when dealing with any other company. Unthinking trust in centralized intermediaries is antithetical to crypto. As you assess a company’s products and services, consider the associated risks. For example, if a company plans to take your assets and lend them to someone else, who is that person, and what happens if that person cannot return the assets or if the company goes bankrupt? Regulation is not a silver bullet, but understanding whether, by whom, and how the company is regulated can help you calibrate your own due diligence. For their part, crypto companies should take the steps necessary to earn and keep their customers’ and counterparties’ trust.

In practice, of course, Peirce is right that almost everyone's interface to cryptocurrencies is via centralized companies. But the fact is that almost all of these companies make great efforts to prevent people taking "the same precautions as they would when dealing with any other company". Take Binance for example, the largest exchange but which claims not to be located or regulated anywhere, and has just been found to have been comingling customer funds and collateral. Or Coinbase, the supposedly trustworthy US exchange, whose customers only found out after the fact that they were unsecured creditors without protection. Or Gemini, which didn't exactly tell their customers that their funds were all sent to Genesis, which lent them to Three Arrows Capital. Might regulation play some role in ensuring that people had accurate information upon which to base "the same precautions"?

Peirce is clear that:

What we should not learn from the events of 2022 is that the failures of centralized entities are failures of decentralized protocols.

Source

No indeed! Despite a lack of actual decentralization, decentralized protocols have their own ways of failing. Peirce cites but doesn't pay attention to Web3 is Going Just Great where Molly White has recorded at least ten DeFi hacks and rug-pulls in the last three months. It is true that none approach the multi-billion dollar losses of FTX and Genesis, but that is because the DeFi space is much smaller.

Peirce makes an important point:

we have to take a nuanced approach that recognizes differences across blockchains, distinctions between Layer 1 blockchains and the chains and applications built on top of them, and differences among crypto assets. The crypto industry encompasses a wide variety of experiments being conducted by many different people, so we must avoid painting them all with the same regulatory brush. A centralized trading venue is a world away from a public, decentralized blockchain, but they all get talked about in one breath in Washington regulatory circles.

Note that Peirce's speech up to this point has failed to make the essential distinction between permissioned, centralized systems and permissionless, purportedly decentralized systems. But then Peirce writes:

preserving the core of crypto—decentralization—is lso [sic] important. Decentralization can help support the resilience of the financial system. Decentralized finance (“DeFi”), enables people to interact with one another through the intermediation of code rather than relying on a financial intermediary such as a bank. DeFi deserves special consideration because of its unique properties, some of which take the place of functions that regulation otherwise might perform. DeFi is self-executing, open-source code operating on top of public, permissionless, decentralized blockchains. Anyone can participate, but nobody has to, and everyone participates on the same terms, which everyone knows beforehand.

This is 100% pure gaslighting:

• These systems are not actually decentralized.
• Where is the evidence that even if they were "Decentralization can help support the resilience of the financial system."?
• In practice, there is an intermediary controlling the DeFi system.
• Just because the code that is claimed to run the protocol is open source doesn't mean that everyone has an equal understanding of it.

Peirce is unduly optimistic about technology here:

Attacks on DeFi protocols are common, but early auditing, testing, and investigating the incentives that are built into the DeFi code can identify problems.

Even if they could "identify problems" adequately, which experiment shows they can't, absent regulation there is little incentive either to spend money "auditing, testing, and investigating", or to spend money fixing any problems that were found. In many cases of DeFi "hacks" it is strongly suspected that the beneficiaries were insiders with privileged knowledge of the vulnerability.

This is just a sampling of Peirce's excuses for regulatory inaction. It is really depressing to see someone who is paid to ensure the integrity of financial markets throw up their hands and explain how their job is just too hard and they need to wait for the idustry to self-regulate or for Congress to provide new tools.