Regulation is the Enemy of Decentralization

Traders use decentralized exchanges to mask their identity.

Decentralization Is the Great Equalizer?

You have likely read a lot about how decentralization through blockchain technology is going to change the world. The public conversation first started seriously when Bitcoin became a sensation after the price of the coin went from below the dollar in 2011 to close to $20K per coin last December. Behind Bitcoin is the blockchain, a technology that introduced the idea that a system can be decentralized where no one, including Bitcoin’s inventor Satoshi Nakamoto and the government, can have any influence over Bitcoin.

So what is it? There are better, more robust descriptions of Bitcoin out there, but here is the gist: Bitcoin is a digital currency run on a network of tens of thousands of servers that are calculating a special hash key to permit transactions to be completed and recorded permanently and immutably between anonymous parties online. These transactions are recorded publicly on Bitcoin’s blockchain, where anyone who cared to look can see the Bitcoins currently in existence and the digital addresses at which they are held.

This whole process allows parties that don’t know each other to exchange payment, in this case Bitcoin, without having to rely on a third party. It’s an elegant solution to the double spend problem that was previously such an issue with online transactions: if someone sends me a digital asset, how do I know that they didn’t make a digital copy of it and keep it too? Therefore, how can you even create scarcity for a digital asset and thus help it retain value? Bitcoin was the (first) answer.

In the wake of Bitcoin’s success and the promise of blockchain, the idea of decentralized systems has inspired thousands of entrepreneurs to create new applications using the blockchain too. The process of creating new decentralized applications was made even easier by the Ethereum blockchain, released in 2015, which is built with a programming language called Solidity that enables smart contract creation.

Using Ethereum, anyone can make their own decentralized application, their own token, their own governance and network protocols. Queue accelerated growth. Companies such as Crypto Kitties, which launched in November 2017, have generated tens of thousands of transactions, even when there is no other value to Crypto Kitties outside of them being collectibles.

The primary benefit and the primary problem with true decentralized applications is that they exist without any one person or party in control of it. Sure, the creators of a particular blockchain application can issue updates to it, called forks, in which previous blocks on the blockchain remain written in the old code but new blocks are created with the new code.

However, these forks are inherently optional and require adoption by the consensus. If a group of users decides not to adopt the update, it creates a hard fork, where the blockchain is replicated into two separate iterations, each going its own independent way. This is how Bitcoin Cash was released.

The idea of decentralization is very appealing to the marketplace because of its trustless approach to solving real world problems. Decentralized systems can solve dilemmas without requiring users to trust a gatekeeper, an arbitrator, or anyone at all (though it does require trust in the software code the system is built on, particularly for non-engineers, and trust in the governance framework of that system).

Who cares about equality? I want to make money

This is all well and good until we start talking about the applications that handle the trading of securities, something that in the U.S. is regulated by the Securities Exchange Commission (the SEC). Most every country has some form of financial regulators tasked in this role.

Most of these regulators have now acted in some way to impose some modicum of control and investor protection to ICOs, though what form that action has taken varies from country to country. In the US, the SEC has defined most every token as a security, and so any ICO, and the tokens issued through that ICO, most comply with federal securities laws, Bitcoin and Ethereum being the two noteworthy exceptions to the rule so far. In China, ICOs are banned altogether.

Today, the websites that call themselves exchanges and trade cryptocurrencies and tokens that were issued through ICOs are not regulated. There are none of the safeguards that securities laws have put in place. In many cases, these exchanges also require investors to deposit their cryptocurrencies into the exchange’s custody in order to trade them on the platform. The disastrous downside of this decision is that the exchange can be hacked and investors can lose all of their money. This has happened to many cryptocurrency exchanges already, something that has been well documented in the news.

Decentralizing Exchanges

As ATMs replaced bank tellers, decentralized exchanges hope to replace institutional exchanges, but the issue is not that simple.

Because of the current security issues with crypto exchanges, the blockchain industry decided to experiment with decentralized exchanges, in which no one company or website holds the customers’ cryptocurrency. Instead, investors can trade directly from their wallets and exchange their cryptocurrencies into other currencies or into other wallets quickly and safely.

One of the popular decentralized blockchain protocols is 0x, which has been described as a crypto Craigslist in a recent TechCrunch article because the platform “connecting traders without ever holding the tokens itself.” The problem with 0x, pronounced zero-x, is that it does not take into account that most ICOs in the last 12 months issued security tokens instead of utility tokens.

In the United States, only broker dealers and registered exchanges can trade securities for investors. Investors can go directly to other investors and trade as long as no one else is compensated for finding an investor or for executing a trade. But wait, isn’t 0x exactly that: a protocol that connects investors to other investors and so is uncompensated?

The 0x protocol in itself may be in compliance with regulations, but there are a number of companies who are working with the 0x protocol that are for-profit businesses, whether as market makers or interfaces for the investors. It is a matter of time before the SEC realizes that and investigates decentralized exchanges only to find they are trading securities without being registered as broker-dealers and that someone is profiting off those trades besides the participating investors.

Apart from these concerns, there is another question: of whether a decentralized exchange can operate in compliance with the SEC. The best way to look at this question is to analyze some of the rules required:

• Rule 144: This rule states that a person who is affiliated with a company, either as an officer or a 20%+ shareholder, cannot trade more inside of a three month period the greater of 1% of all of the outstanding shares or the average weekly trade computed for the previous four calendar weeks. How would a decentralized exchange know this information if they are not identifying the people trading on the exchange and monitoring trade volume? How would a decentralized system cap the trading of an executive officer even if it were able to identify the investor?
• Wash trading: An alternative trading system must have a surveillance process in place to avoid any manipulation of the market by investors. Wash trading, or painting the tape, is when one investor is constantly trading between between itself (or perhaps a small group in collusion) with the purpose of luring in other investors who are attracted by this false appearance of liquidity. Recently, Kraken has been accused of allowing this type of behavior with Tether trades.
• Pump and Dump: This classic scheme pumps up the price of a cryptocurrency by a large group of investors acting together to purchase a specific cryptocurrency in high volume in a very short period of time and artificially increase the price. The hope is that unsuspecting investors will jump in too, attracted by the sudden price increase, only to soon find out that there was no real demand in the price spike. These investors then lose their money when the pump investors sell early at an agreed-upon price. Regulated exchanges and broker-dealers are required to monitor unusual pricing and halt trades if there is a surge of unusual activity or the investigation shows a pump being orchestrated on Telegram or Discorde.

Decentralized exchanges aren’t designed with gateways in place to facilitate the level of control over investor trading that the above rules demand (and this is just the top of the barrel). Indeed, the very concept of a decentralized exchange is to not have those measures in place because those measures are expensive, they require compliance teams, and that means introducing fees to cover those expenses. Most decentralized exchanges are run by nothing but a small team of engineers, in many cases working remotely out of their own homes. They keep costs down, and that lack of fees is also appealing to the traders on the platform. If I’m a trader, why go through the hassle of KYC (Know Your Customer) to trade on a platform with 5% fees, when I could start trading on a decentralized exchange immediately, and for free?

It gives decentralized protocols an unfair market advantage in attracting traders, but when the regulators come calling, these decentralized marketplaces facilitating the trading of securities will find that the odds have tipped out of their favor as they are shut down one by one for violating securities laws, and those that are left behind, the broker-dealers and the ATSs, will have the trading market to themselves.

If you liked what you read, please clap and give me a follow on Medium.