3 Challenges and Solutions to Address Insolvency of Crypto Platforms

The crypto industry is sometimes compared to the Wild West during the cattle ranching, railroad, and gold rush eras in the 1700s & 1800s. This comparison isn’t exactly unfair.

One could draw parallels between the lawlessness of those states and the regulatory vacuum that today’s crypto giants have enjoyed. For a long time, the world’s largest Crypto exchange didn’t even list a head office, out of an apparent desire to evade regulatory scrutiny by the financial regulator of any office they could have named.

Elsewhere in the crypto industry, hundreds of investment scams are launched every day with the sole aim of parting investors from their cash.

It’s no surprise that crypto enthusiasts and investors from all walks of life are considering how the issue of insolvency risks can be solved. All investors want to see high financial returns from this emerging asset class, but insolvency risk is anaemic to investment returns for several reasons:

• Higher risks mean investors must apply a higher discount rate to expected future returns when calculating a present value. This objectively means that any financial instrument or crypto asset would have a lower present value.
• Insolvency risks put off many investors from investing at all in the crypto asset class, because they have deemed it to not be ‘investment-grade’, and therefore it does not meet their basic requirements. This particularly applies to institutional investors who manage upwards of £ trillion in investor money.
• Platform insolvency risk adds an extra layer of price volatility on top of the underlying risks of the asset itself. Crypto will be more likely to move up and down if investors panic regarding the status of the platform hosting the assets.
• Uncertainty over the practical application of law to crypto assets leaves investors unclear about what would happen if a major exchange fell into bankruptcy. Simply identifying the assets, themselves is a major challenge, given that the blockchain only records a pseudonym (the wallet address) rather than the identity of the underlying owner.

Potential solutions to the insolvency issue

The following ideas have been suggested as fixes to the current ‘Wild West’ environment:

• Recognise crypto exchanges like stock exchanges and subject them to a similar level of regulation.
• This would move crypto out of the unregulated sector and bring them wholly within the oversight of the FCA or Prudential Regulation Authority
• Ensure that key management roles are fulfilled by fit and proper persons – a common theme in crypto projects is that founders’ identities are obscure, and their history sometimes shows worrying events.
• Apply capital requirements that will ensure the firm can sustain losses – crypto is very volatile therefore an exchange needs to recognise that its fee income from trading will also be very volatile, whereas its overheads will likely remain quite flat.
• Require crypto platforms to segregate client assets
• Apply minimum standards for cyber security as platforms are huge targets for cybercriminals and a hack can bring an exchange down like Mt. Gox

These are practical suggestions because they’re targeted primarily at the organisations that manage and govern crypto transactions, rather than the technology itself. Some of the core challenges of regulating crypto are inherent in the design of the code and are virtually unsolvable without a ‘hard fork’ that may be necessary to update the source code to operate differently. Some changes that are necessary to bring full accountability to the system would fundamentally alter how crypto works to the point where many enthusiasts would render the crypto project pointless and too like pre-existing financial instruments.