Thursday, January 26, 2023

Regulatory Capture In Action

On January 20th, SEC Commissioner Hester Peirce gave a long speech at Duke University entited Outdated: Remarks before the Digital Assets at Duke Conference essentially arguing against doing her job by regulating cryptocurrencies.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

7 comments:

  1. Commissioner Peirce writes:

    "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."

    There are four problems with this statement:

    1) It is true that people can transact their cryptocurrencies via DeFi "through the intermediation of code", but their tokens aren't useful for anything much until they are converted to fiat through an exchange, which is "a financial intermediary such as a bank".

    2) In practice the code that intermediates their transactions isn't just "smart contracts" but is a "intermediary" web front end, because interacting directly with the blockchain is too difficult and dangerous for ordinary mortals.

    3) Some of this code may be open source, but likely not all of it. And instead of trusting "a financial intermediary such as a bank" against whom you have legal recourse, you are trusting a pseudonymous developer against whom you have no legal recourse. And even if you have the rare skill of being able to read code and find some bugs, you're not likely to find all of them.

    4) More fundamentally, what is an intermediary? Intermediaries are paid to facilitate transactions. Transactions on blockchains are not free, there are always transaction fees. So the intermediaries in this case are the miners or the proposers and validators who, based on the fees you pay chose whether to include your transaction in a block. You have to trust them; you have no legal recourse against them. And they have you over a barrel, because you are in an auction for inclusion. When everyone wants to transact the fees the intermediaries exact spike enormously. Would you use a bank that used dynamic pricing in this way?

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  2. Thank you, Fred. That is a much better speech but it still falls far short of recognizing that the only reason companies like FTX, Coinbase, Kraken and others appear to have viable business models is that they are not effectively regulated. Were they regulated properly their competitive advantage would evaporate, because it is based on fraud and market manipulation. The sole technical innovation in cryptocurrencies is a means to avoid regulation using a false claim of "decentralization".

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  3. Chelsey Cox reports that SEC to increase scrutiny of crypto-trading firms and ESG funds in 2023:

    "The priorities were released two months after the securities agency issued new guidance, requiring publicly traded companies to disclose their exposure to the cryptocurrency market. It also follows SEC Chair Gary Gensler’s warning to cryptocurrency firms to “come into compliance” with securities laws after crypto exchange FTX filed for bankruptcy.

    This year, the SEC’s examinations division will focus its attention on broker-dealers and registered investment advisors who use emerging financial technologies, including crypto. Examinations will look at the “offer, sale, recommendation of or advice regarding trading in crypto or crypto-related assets” and whether standards of care were met or followed by advisors and routinely updated, as needed."

    And Allyson Versprille reports that Crypto Exchange Kraken Faces SEC Probe Over Unregistered Securities:

    "The Securities and Exchange Commission probe into whether Kraken offered unregistered securities is at an advanced stage and could lead to a settlement in coming days, said the person, who asked not to be identified discussing a case that hasn’t been made public. It wasn’t immediately clear which tokens or offerings are drawing scrutiny.

    Any action against Kraken could have significant ramifications for the industry, already facing sharp scrutiny in Washington after FTX’s collapse late last year. A settlement with the SEC could pressure other crypto firms to hash out deals with the regulator, which has repeatedly said most of the tokens being offered are securities that should be subject to the agency’s rules."

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  4. Dirty Bubble Media runs down the list of problems on the on- and off-ramps in Crypto Bank Whack-A-Mole and concludes:

    "Regulators and enforcement agents are now circling the crypto industry. In the wake of the collapses of FTX and Genesis, the pressure on anyone doing business with crypto entities will continue to grow. With key crypto servicing banks like Signature and Silvergate deserting the industry, these firms and their customers will face increasing challenges getting their hands on “fiat” currency."

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  5. martin C. W. Walker asks Are problems in the crypto industry down to "bad apples" or to ignorance of fundamental principles of sound finance?:

    "With arrests, bankruptcies and civil actions continuing, lobbyists and crypto advocates argue that the wrongdoing is due to individuals committing good old-fashioned fraud, rather than there being anything innately wrong with the industry or its products. A small amount of favourably drafted regulation and an end to "regulation by enforcement" is all that is needed to put the industry on a safe footing, they claim. If regulators, lawyers and accountants could finally "get it", the world could get on with enjoying the benefits of crypto "innovation".

    Perhaps, however, it is the crypto tycoons who are failing to "get" that some of the ways in which cryptocurrencies operate goes against decades of good practice in the financial services sector."

    His list of "some of the ways" is a good read.

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  6. In Crypto is intended to be hard to regulate, but at least the Treasury wants to have a go John Naughton gets it:

    "The first is that regulation of trade in cryptoassets can only be done by regulating the exchanges in which they are bought and sold. The UK will have jurisdiction only over those exchanges that are based here. Ultimately, regulation will therefore be done by regions over which even HM Treasury has no control. This may be unpalatable to devout believers in British exceptionalism, “global Britain” and so on, but it’s the reality.

    The second lesson is that permissionless blockchains can never be allowed within the financial services sector. And that’s fine because permissioned ones will do the job more efficiently and within the rule of law."

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  7. Max Reyes flags more trouble for the "crypto bank" in Silvergate’s Big Crypto Losses Feed Watchdogs’ Worst Fears:

    "In the starkest warning yet by a US bank catering to the sector, Silvergate Capital Corp. said Wednesday it needs more time to assess the extent of damage to its finances stemming from last year’s crypto rout — including whether it can remain viable. The shares plunged about 30% in premarket trading on Thursday.

    The firm, which already reported a $1 billion loss for the fourth quarter, said that figure could climb higher. The company is still tallying the cost of rapidly selling assets to repay advances from the Federal Home Loan Bank System. It may also need to mark down the value of some remaining holdings."

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