Deterring adoption? Balancing security and innovation in crypto

Security processes are necessary to protect crypto users but regulators may force companies to adopt processes that stifle innovation.

The cryptocurrency space moves rapidly, so much so that every year, there’s a new trend: from initial coin offerings (ICOs) to nonfungible tokens (NFTs) only a few years have passed. In the face of such astounding innovation, crypto companies and regulators face a growing challenge: balancing security practices with new products and features.

Some companies’ approach is to move fast and adopt new innovations as they become available, leaving security processes such as Know Your Customer (KYC) and Anti-Money Laundering (AML) checks as a secondary objective. Popular cryptocurrency exchange Binance seemingly used this strategy up until this year when regulators started cracking down.

Binance‘s KYC policies initially allowed users who did not fully verify their identities to withdraw up to 2 BTC per day. The exchange listed margin trading pairs with major fiat currencies and allowed leverage up to 125x from its futures trading platform, but had to reduce available leverage and delist margin trading pairs when it reportedly started being investigated by the United States Internal Revenue Service and Justice Department.

The exchange has since taken a compliance-friendly approach to its business and has implemented mandatory KYC processes for “global users, for every feature.” The move saw it lose around 3% of its total user count.

While Binance was forced to remove some of its offerings and scale down leverage on its platform, other exchanges are still providing users with these same products. Speaking to Cointelegraph, Yuriy Kovalev, CEO of crypto trading platform Zenfuse, noted finding regulations that allow compliant companies to compete is a challenge that needs to be addressed:

“Finding a way to balance regulation that protects investors and innovation is hard, especially in a space where new financial offerings appear every few months.”

Speaking to Cointelegraph, CEO of cryptocurrency exchange Bittrex Stephen Stonberg pointed out that cryptocurrency regulations are now “quite complex” and are being handled differently in different jurisdictions

Stonberg implied that customer safety should nevertheless remain a priority as “more robust and clear-cut regulation — like in the traditional financial sector — is needed to really ensure client assets and data are safe and secure.” As an example, Stonberg pointed to Liechtenstein’s Blockchain Act, which “provides a lot more certainty and clarity around how an exchange needs to onboard new clients and protects a clients’ assets.”

Regulatory clarity is seen as a necessity by some players in the industry, as without it, innovation may be left behind. In a recent blog post, Nasdaq-listed crypto exchange Coinbase noted that its plans to launch a lending program were halted by the U.S. Securities and Exchange Commission (SEC), which threatened to sue it “without ever telling [them] why.”

Coinbase said it attempted to “engage productively” with the SEC but never received clarification on the SEC’s reasoning or on how it could alter the product for it to be compliant. A proposed alternative has involved leaving regulators out of the picture. The Commissioner of the Commodity Futures Trading Commission (CFTC) Brian Quintenz has championed this alternative, at one point calling for cryptocurrency exchanges to regulate themselves, echoing the sentiment of many in the industry.

Is self-regulation a viable alternative?

The concept isn’t new: Organizations like the Financial Industry Regulatory Authority (FINRA) have helped enforce initiatives meant to protect securities investors with brokers and broker-dealer firms. In Japan, a self-regulatory body for the country’s crypto exchange sector, the Japanese Cryptocurrency Exchange Association (JCEA), has been formed.

Stonberg does not believe the answer is down the self-regulatory path, as the “complex nature of this digital ecosystem makes regulation tricky.” To him, self-regulation would mean “unwinding” all of the hard work achieved on the regulatory front for crypto and “re-complicating the regulatory environment, putting a block in progress.”

The pseudonymous founder of Flare Network-based decentralized finance (DeFi) platform Flare finance CryptoFrenchie told Cointelegraph that he believes in the “abilities of decentralized platforms and centralized platforms alike to deliver a self-regulated environment that reacts effectively to meet (or exceed) the needs of modern-day regulatory requirements.”

The DeFi project founder added that current systems have “proven to be incapable of meeting the needs of the current financial system,” and added:

“To apply these same systems to an even more fast-paced environment like crypto could prove to be more stifling to its potential than supportive.”

Founder and CEO of crypto exchange CEX.IO Oleksandr Lutskevych suggested self-regulation may be an option, saying that in the firm’s experience, self-regulation is the answer “when there is an absence of an applicable regulatory framework.” Speaking to Cointelegraph on his firm’s path, Lutskevych said:

“Until a framework for cryptocurrencies was formalized in certain countries, we adopted a self-regulation approach, implementing best practices from other leading financial organizations.”

Cryptocurrency platforms, both centralized and decentralized, should “seek to analyze their own systems and develop modules specifically designed to deliver the needs of current regulatory systems,” said CryptoFrenchie.

Do decentralized exchanges pose a threat?

While the debate on self-regulation continues, another one has grown over decentralized trading platforms and their impact on the market. Non-custodial decentralized exchanges allow users to trade directly from their wallets, often without even registering with an email address.

Some critics have argued that decentralized exchanges (DEXs) make centralized platforms’ KYC and AML efforts worthless, as bad actors can carry out their illicit activities through these platforms. Others suggest DEXs, even those run through decentralized autonomous organizations (DAOs), can improve their transparency to help blockchain sleuths and law enforcement organizations find illicit transactions.

To chief investment officer of digital asset investment firm Arca Jeff Dorman, decentralized applications (DApps) and other projects can contribute to the safety of the cryptocurrency space. Speaking to Cointelegraph, Dorman said the industry needs to set standards, adding:

“Companies and projects need to recognize the importance of setting up transparency dashboards, and analysts across the industry need to roll up their sleeves and do the dirty work of bringing transparency to projects that are not doing it themselves.”

Bittrex’s Stonberg pointed out that the “best way to conceal illicit activity isn’t cryptocurrencies, but old-fashioned money.” The CEO added that blockchain-based transactions are “more traceable than any other financial activity.”

Stonberg told Cointelegraph that he believes decentralized exchanges should build AML and KYC policies that they can implement, but added that the industry is “still in the early stages of seeing how decentralized exchanges will play out.”

Lutskevych suggested that tools that can track the origin and previous history of crypto assets could one day be used in decentralized exchanges to keep illicit funds out of their platforms. He noted that “basic information can be traced” on the blockchain, although that data is “far afield from what the Financial Action Task Force guidance requires of centralized exchanges to gather.” Lutskevych added:

“Decentralized mechanisms that can prevent funds of illegal origin (money laundering, ransomware, hack) from entering a DEX with a protocol’s smart contract are currently being explored and developed.”

Lutskevych concluded that it is possible for decentralized platforms to leverage KYC and AML procedures to address regulators’ concerns. He noted that implementing KYC by itself may not be enough to deter illicit activities and protect users.

Raj Bagadi, founder and CEO of DeFi and traditional banking services bridge Scallop, told Cointelegraph that the growth of the decentralized finance industry poses a challenge for regulations, but suggested that a solution could be a “regulated blockchain.” Referring to products in development, Bagadi said:

“We can ensure that wallets on a blockchain undergo a KYC/KYB process. This means that the account holder is identified and that all funds on the chain can be traced — ultimately creating an inhospitable environment for illicit activities and deters it right from the beginning.”

Fundamental crypto rights

Binance has recently seemingly weighed in on the subject by publishing what it called “fundamental rights for crypto users.” The exchange argued that every human being should ”have access to financial tools” that “allow for greater economic independence.” It also noted that “responsible crypto platforms have an obligation to protect users from bad actors” and implement KYC to “prevent financial crimes.”

Commenting on Binance’s crypto rights push, Lutskevych suggested that the move was an “advertising campaign” from a company “that didn’t start touting these values until very recently,” making it more of a “marketing strategy.”

Through a website dedicated to crypto users’ fundamental rights, Binance called on industry leaders, regulators and policymakers to “help shape the future of global finance together.” The exchange added that it believes it should be “up to each nation’s policymakers and their constituents to decide who should have oversight over the industry.”

Related: The stablecoin scourge: Regulatory hesitancy may hinder adoption

Crypto, Binance wrote, belongs to everyone. While the exchange believes that regulations are inevitable, any policymaker tasked with overseeing the space has a monumental task to perform, as keeping bad actors at bay without stifling innovation has so far proven to be a challenge.

The strategy cryptocurrency companies seemingly agree on is based on cooperating with regulators to find solutions that won’t stop users from having access to innovative digital currencies or services created within their ecosystem. Regulators’ lawsuits against large crypto firms appear to show only one side is happy to cooperate.