How Can The Crypto Industry Regain Trust?

It’s easy to be complacent when things are going well. The crypto industry experienced a bull run unlike any other through 2019 and 2020, with the extraordinary event of the COVID pandemic becoming the catalyst for a huge influx of retail investors in 2021. As the price of crypto, and Bitcoin in particular, hit all-time high after all-time high, everything on the outside looked good. However, we now know that the fundamental business mechanisms and profit formulas of many of the crypto asset service providers (CASPs) that rode this wave of positive momentum were deeply flawed. There was very little transparency, very little business risk management and, as a result, a number of high profile figures in the industry were blindsided by this overnight success.

A flawed profit formula

Let’s face it, any profit formula which can turn one dollar into one hundred dollars needs to be questioned. The high profile collapses of Terra Luna and FTX et al. are classic examples of something being too good to be true. There was a disconnect between money on the balance sheet and money in reserves; value was created from thin air, and the distance between virtual money and physical money was greatly exaggerated. One can’t defy the rules of gravity – any business in the financial services needs the liquidity to be able to facilitate requests from clients to withdraw or remove funds, and to use as collateral if needed.

Proper financial controls and proof of reserves

The utopia of decentralized finance shouldn’t cloud over the fact that the crypto industry still heavily relies on fiat currencies. It is the access point for the majority of investors and, ultimately, it is how we still value crypto; the value of Bitcoin, along with thousands of other tokens, is still typically expressed in US dollars. With this in mind, CASPs need to have adequate reserves in both crypto and fiat. Circle is a great proponent of this, albeit we have to recognize stablecoins are conceptually only adjacent to crypto; but still the idea that each USDC token is pegged 1:1 against the US dollar, which Circle always keep in reserve, shows that one can run a successful business whilst adhering to the rules of (financial) gravity.

Now, let’s address the elephant in the room; if we are to see full transparency in riskier business models, then company accounts have to be audited by a regulated third-party; it is simply not good enough for a CASPs to state that they have the funds available to them. Clients who have deposited funds need to know how they hold and dispose of their assets, manage liquidity, and hedge themselves in certain positions. More CASPs should demonstrate their proof-of-reserves and make this information available to the public, as we see with players like Safello, the Swedish crypto exchange. They are clearly trailblazing in a positive, responsible way in an extremely troubled market. It takes quite a bit of entrepreneurial courage to do that, but it’s absolutely the right thing to do.

Alongside adequate financial controls, any business also needs to have a structure of governance that mitigates further risk. Too often, we see the fallacy of the single bad actor; the CEO that wielded unchecked power and is ultimately fuelled by greed. Any crypto provider will have both internal and external stakeholders; it is their fiduciary duty to check the health of the company and provide feedback and advice to those who make decisions that affect them and potentially the entire market.

Self-governance vs external regulation

From recent events, it is quite clear that self-governance doesn’t work. Too often, we are seeing huge breaches of trust, and subsequent collapses of key players, with very little warning. Self-governance requires accountability from CASPs, but this is a devolved accountability; an internal force from within. It doesn’t matter how transparent and financially sound each individual CASP is if they are only governing themselves; instead there needs to be an external force to check on the health of the industry as a whole.

That being said, regulation isn’t working effectively either; the existing and incoming frameworks are far too concerned with preventing fraud and implementing anti-money laundering rules, rather than addressing the key issues of (often complete) lack of business risk management and poor financial fundamentals. Yes, this goes against some of the ideologies of DeFi, but we need regulation in place that ensures transparency and accountability are at the forefront of any change. If we follow the paper trail and identify the source of wealth for CASPs, then we can perhaps be better positioned to predict future risks.

The role of MiCA

We do, of course, have the promise of MiCa, which will implement blanket regulation in the crypto industry across all EU member states. It has the potential to create more trust between CASPs and their clients, but it should be noted that it still doesn’t address the underlying financial fundamentals that were to blame for the recent high profile collapses. Each EU member state needs to implement MiCa correctly, but also evaluate CASPs that are in their territory and again push for better transparency. Some CASPs will (yet again) seek the easiest territory to become regulated, often in less mature economies, and local authorities need to be fully aware of the risks to the local economies when they accommodate them.

More regulation = more trust?

A knee-jerk reaction would be to increase regulation and assert more control over the crypto industry, but any regulation needs to be proportional to the issues at hand. It cannot be driven by panic and fear; it needs to be driven by the legitimate concerns around market stability and protecting the consumer. We also shouldn’t be too concerned about any negative effects of increased regulation. When you prescribe something, it often acts as a trigger for people to innovate and build within the newly established framework, and many CASPs have risen to this challenge to create products that satisfy the needs of both clients and regulators. In fact, this linearity helps to develop the financially sound elements of a business at a sustainable pace, which helps increase trust.

Ultimately, if we are to see trust return to the crypto industry, then CASPs and regulators must be more closely aligned; identifying risk earlier and implementing the tools to manage this. This doesn’t just come in the form of more regulation, but better communication and transparency. We can’t guarantee preventing more high profile collapses in the crypto industry in the future but, if we have the foresight to predict them and then the courage to develop certain failsafe mechanisms, we also have the ability to mitigate the impact on trust and confidence in the industry.

About The Author

	Adam Bialy is the founder and CEO of Fiat Republic, the compliance-first, API-driven and highly secure and scalable bridge between banks and crypto. He has more than 14 years’ experience in high-growth payments startups and banks. Previous roles include ex-Sainsbury’s Head of Payments, ex-CPO of OpenPayd, as well as senior product roles at Raiffeisen Bank, Ukash, HyperJar and Onvi.

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