After the collapse of FTX and the loss of billions of dollars on client deposits, it is urgent to build consensus now on how to regulate cryptocurrencies.

With congressional hearings scheduled for next week, open questions remain about how commodity-like digital assets should be regulated while at the same time encouraging and enabling responsible financial innovation. Regulatory approaches must ensure the fundamental principles of self-custody where people keep their own digital assets outside of exchanges and take into account the role of smart contracts and decentralized autonomous organizations that cannot be regulated in the same way as traditional companies.

Let’s start with stablecoins and custodial exchanges, as they pose the greatest risk and are singularly responsible for the current crisis.

stablecoins

On May 7, 2022, someone sold $2 billion dollars value of the Terra stablecoin. Such a large transaction disrupted the algorithm that underpins Terra which sought to ensure that a Terra token would always trade for $1 USD. Land unraveled in days and so did decentralized financial institutions (DeFi) with significant stakes in Terra, starting on crypto plunge we have been experimenting with for the past seven months.

Stablecoins are supposed to be a low-risk intermediary between traditional finance and DeFi, with value tied to a fiat currency. Regulations can help reduce risk by imposing resiliency requirements and offering certain federal endorsements.

Regulatory options include imposing cybersecurity requirements on the stablecoin and its infrastructure; require systematic disclosures and reports; and require holdings of dedicated equivalent trust assets as collateral. If a stablecoin meets regulatory thresholds, the organizations that manage it could gain access to Federal Reserve programs to help ensure liquidity, such as advances and loans. Representative Patrick McHenry (RN.C.) stablecoin banknote predominantly addresses these issues, and the bipartisan bill sponsored by Sens. Cynthia Lummis (R-Wyo.) and Kirsten Gillibrand (DN.Y.) partially addresses cybersecurity issues.

Another option is for the US to launch a central bank digital currency (CBDC), also known as a “digital dollar.” A wholesale CBDC could enable bank-to-bank type transactions, while a retail CBDC could compete with stablecoins.

Custody Exchanges

The FTX collapse is an example of a custodial exchange, a crypto exchange that takes deposits from customers like a traditional bank, which did not handle properly risk to your customers. Essentially he gambled away the assets of his clients and balanced these liabilities with accounting for assets at market prices which did not take into account liquidity discounts estimated at more than 90 percent. Once people realized how much the assets FTX held on the open market were worth in relation to customer deposits on the books, it became clear that they were insolventwhich led to a rapid breakdown of FTX along with those entities tightly bound to the FTX complex.

Custodial exchanges should be the low-risk option for those interested in owning and trading cryptocurrencies, those who don’t want the complexity of managing their own wallets and executing transactions directly on-chain. The regulations here would protect retail investors.

Options include codification of anti-illicit financing requirements (know your customer, anti-money laundering and combating the financing of terrorism); limit the mix of client funds; require disclosures and reports to regulators and customers; and better outline its banking and investment services. In return, the banking side of such exchanges could receive FDIC insurance for stablecoin holdings. The Lummis-Gillibrand bill addresses most of these requirements, but until now, no legislation has been clear about extending FDIC insurance to regulated stablecoins held by custodial exchanges.

Some additional questions:

• The overall theme of the legislative proposals to date is that we need to regulate stablecoins like coins, other digital assets like commodities, and custodial exchanges like banks. Such succinct clarity can help reduce regulatory arbitrage. Is this the consensus?
• What is the potential role of a CBDC vis-à-vis access to Federal Reserve programs to provide liquidity to stablecoin markets? What is the correct way to examine alternative possibilities and options for providing a digital interface for fiat dollars in cryptocurrency markets?
• Like many critical infrastructure sectors, blockchain infrastructure is privately operated and is the shared substrate for DeFi services. How can we adopt the lessons learned from other sectors and up our cybersecurity game for DeFi infrastructure?
• Information Analysis and Exchange Centers (ISACs) serve as forums for coordinating cyber response in critical infrastructure sectors. Do you think federal agencies could benefit from establishing a new ISAC for the new class of cyber actors and cyber threats facing digital assets?
• Industry standard economic modeling tools lack the sophistication to model the macro and micro interaction between this emerging digital asset class and its derivatives. Should the federal government invest in developing new modeling and simulation capabilities to understand the interplay between regulatory regimes and new digital asset classes in this rapidly evolving field?
• How can we preserve the underlying decentralized and democratic values ​​of permissionless finance while seeking to increase DeFi’s resiliency through increased regulation?

As decision makers address regulations for commodity-like assets, it would be appropriate to use the upcoming hearings as an opportunity to think ahead about how regulations can simultaneously encourage and enable responsible innovation in the broader field of web3 .

T. Charles Clancy is a senior vice president at MITRE, where he leads science, technology, and engineering for the nonprofit research institution. MITRE is a conflict-free, apolitical operator of six federally funded research and development centers (FFRDCs). Clancy was previously the Bradley Distinguished Professor of Cybersecurity at Virginia Tech and a researcher at the National Security Agency. He is a member of the IEEE.