Cryptos resist regulation despite growing systemic, fincrime risks

Multifunction crypto intermediaries (MCI) continue to resist regulation despite their growing systemic and financial crime risks, as well as consumer conflicts. While MCIs are not currently on a par with globally systemically important banks (G-SIBs), they share similar risk characteristics and could evolve to become “too big to fail” if not regulated properly, said senior regulators and blockchain intelligence professionals at a recent conference.

Speaking at the Blockchain Intelligence Forum in Bucharest, Nico Di Gabriele, senior team lead for crypto asset policy and financial crime at the European Central Bank (ECB), said: “People who have been working in finance know the rules that have to be complied with in the financial sector, but in the crypto sector, we have seen the appearance of many companies created from scratch by persons who had no clue about how the financial market works and what the minimum standards applicable are. They have been [speaking out] against regulation.”

Financial stability does not come “as rain from the sky”, Di Gabriele added, but from people ensuring the steps the industry must take to improve knowledge of rules. “Academia may help. Regulators may help as well. But if there is not an upscaling in the legal skills in the industry, we will find it difficult to tame the risks that are inherent in the crypto asset sector.”

Black boxes

Blockchain proliferated because of a promise of transparency but this is disappearing because MCIs internalise transactions. Most crypto transactions occur inside a ‘black boxʼ on MCIs’ internal ledgers that are not always available for regulatory scrutiny. This makes it difficult for regulators to understand MCIs’ solvency and involvement in money laundering activities, said Dr Bernhard Haslhofer, co-founder of Iknaio and the crypto finance research group lead at the Complexity Science Hub in Vienna.

“You have this on-chain ecosystem, but you have huge, very centralised black boxes in there, and the most you can do as a supervision authority is understand the entry and exit points of the black box,” Haslhofer said. “But also then at the end of the day, we are talking about hot, cold, warm wallet addresses, right? The only piece you can see on-chain basically represents the entry and exit points of those black boxes.”

Regulators need to get data from inside the black boxes in a systematic fashion and to analyse it to understand questions such as: does the MCI own the assets it sold to its users? Is this MCI involved in some illegal activities? For some regulators, however, that is a big challenge, Haslhofer added.

Too big to fail

Traditional finance (tradfi) services are restricted in the amount of services they provide, partly to prevent conflicts of interest and to promote market integrity, investor protection and financial stability, while MCIs are vertically integrated and offer a wide range of services without the same restrictions as tradfi. In 2023, the Financial Stability Board (FSB) warned that MCIs’ vertical structure could “exacerbate vulnerabilities” to risk, particularly financial stability.

MCIs such as Binance, ByBit and Coinbase have grown rapidly to post huge daily trading volumes almost equal to JPMorgan, Wall Street’s biggest firm — yet few are regulated in a way that reflects their size and risk, said Luke Wilson, global head of public sector at Allium, a US blockchain intelligence provider.

“When you look at how fast this industry has caught on globally, you must start thinking about the regulatory aspect. Itʼs not just one country, itʼs global. Binance does not even have an office in the US, but they trade more than quadruple what Coinbase trades,” Wilson said.

MCIs’ growth could be attributed the lack of a level playing field between crypto and tradfi. For example, few MCIs have implemented the FSB’s global stablecoin recommendations, or policy recommendations for crypto and digital asset markets from the International Organization of Securities Commissions (IOSCO), said the ECBʼs Di Gabriele.  

“We should as regulators, but also as citizens, be mindful of the lesson that was brought to us by the great financial crisis in 2007 and 2008, and that crisis, among the others, was caused by entities that had become too big to fail. Maybe we do not yet have an MCI that is too big to fail, but it appears to me that they have the potential,” he added.

Similar risk, smaller scale

Skyler Pinna, director and technical advisor on crypto at the New York State Department of Financial Services (NYS DFS) said there are parallels in risks between MCIs and G-SIBs, but that the scale is different. The 2022 failure of crypto exchange FTX produced limited contagion and demonstrated the lack of interconnectedness between MCIs and tradfi. That could change however, as the MCI market continues to grow on the back of venture capital investment.

“Thereʼs a lot of investment behind these protocols and this can put incentives not quite in alignment with running a safe and sound business. Thatʼs [without] considering the actual responsibilities that MCIs have [in] safeguarding and holding consumers assets in ways that result in them not getting hacked, like we saw with ByBit — really understanding what those cold storage practices are and how they migrate the balances between hot and cold wallets. Thatʼs a cataclysmic source of risk, which I think is not really well understood, and certainly not well evaluated at this point in time,” Pinna said.

Maha Al-Saadi, head of regulatory affairs, financial services, at Qatar Financial Centre Authority, took a different view of MCIs’ systemic risk. MCIs are global, operate 24/7 without safeguards afforded by tradfi and are increasingly interlinked to tradfi, she said. The changing policy toward crypto in the US will drive uptake and increase the interlinkage between MCIs and traditional financial players, for example BlackRock or JPMorgan.

“I would argue that the risks are there. I hope that we will not be having a situation like the financial crisis [again], but we have the tools to be able to look into it. But if you look into the overall way of supervising it, of the way that smart contracts are drafted, the use of and cooperation of blockchain intelligence tools and private public partnerships, there is a way for us to take action,” Al-Saadi said.

“We do not have to wait for them to get that important or for a horrible incident to happen, [such as] for people to lose their funds. I would argue that [MCIs] could be even more dangerous, because the loss of liquidity could happen instantaneously.”