June 11, 2024 | Read Online

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"The focusing point of all human efforts, interests, desires, and ambitions."

- economist B.R. Ambedkar on money

Permissionless Preview: Kristin Smith on regulating crypto

The crypto industry financializes nearly everything it touches, which means that it often receives a level of attention far disproportionate to its size.

Would the technical minutiae of restaking, sequencers and data availability be the subject of such widespread debate without the financial incentive that tradeable tokens give us to debate them?

The semiconductor industry is at least 3x the size of the crypto industry (by market cap), but you can't buy a token in the latest modular semiconductors like you can with the latest modular blockchains — so we debate blockchains far more than we debate semiconductors.

Financialization is why crypto gets disproportionate attention from the US government, too.

If Tornado Cash was a protocol to anonymize speech, would anyone in government have paid it any attention?

Probably not.

A protocol to anonymize money, however, is a different story.

Because they involve money, financial products receive more regulatory scrutiny than any other type of product — and nearly everything in crypto is a financial product.

The result is that just as crypto compels us to learn about staking, sequencers and data availability, it also compels us to learn about staff accounting bulletins, the Bank Secrecy Act and an alphabet soup of regulatory agencies that we'd otherwise have no interest in.

These regulatory issues can get just as technical as smart contract code — and badly written regulations can be just as catastrophic as badly written smart contracts.

Fortunately, the industry has people like Kristin Smith, CEO of the Blockchain Association, making the case in DC for sensible crypto regulation.

Smith will be speaking at Permissionless III in October because regulatory issues remain front of mind in the industry — and rightly so.

All of the hacking, building and investing represented at Permissionless may be for naught if the industry becomes encumbered by overbearing or ill-informed regulations.

But a lot can happen between now and October, so I used this Permissionless Preview as an excuse to put some questions to Smith myself.

I came away from the talk more optimistic on the regulatory outlook, in part because of her answers ("the writing of code should not be influenced by legislation"), but also because listening to Smith is a reminder that the crypto industry has super smart, super dedicated people defending its interests in DC.

Here's the full transcript of what she had to say:

What is the purpose of commodities and securities regulations?

That's a good question. I think there are sort of two high-level objectives. One, we want to make sure that markets have integrity — that there isn't fraudulent activity going on. We also want to provide disclosures to investors so that they know what they're investing in.

Both the securities laws and commodities laws that we have on the books today were written many decades ago. Crypto assets pose different issues and that's one of the reasons why we've needed to figure out a fresh way to obtain those same policy goals, but do it in a way that works with blockchain networks.

Do blockchain protocols need disclosure rules?

What's different about transparent public blockchains is that all of the information is available. Where policymakers see a shortcoming is that oftentimes this information is difficult to access. It's not necessarily available to the public in a uniform way.

Over time, one of the best ways that investors are protected has been through disclosures, so this is a theme that we continue to see pushed forward. I think that certainly investors today can do their own research and find out a lot about a token that is affiliated with a public blockchain, but I think going forward, regulators and policymakers want to see a more uniform system.

But, yes, I think you can find more information better in real-time than you would be able to [by] looking at the filing on the SEC's Edgar database. But I think policymakers still want to have something regardless.

Why does crypto need a bespoke set of regulations?

What's different about crypto assets is that there isn't a centralized organization that ultimately maintains that network — maybe there was in the early days, but not in the later days.

It's complicated because US securities laws have this weird term, "investment contract," and the SEC has tried to show that a lot of the early-stage players in this space get captured by it. What we want to see is a place for digital commodity markets to be regulated.

We know that those markets have integrity, but we want to provide a pathway for new projects to easily launch and for investors to participate in the growth and development of those networks, with the proper disclosures.

What about the market integrity aspect you mentioned as one of the two high-level objectives?

When you have a centralized entity that's facilitating trades on someone's behalf, you want to know that that is being done properly. You want to know that the custody of those funds is happening correctly. You want to know that the trades aren't being front run. You want to know that there aren't conflicts of interest in place between the exchange and another counterparty. I think there are a lot of ways to do it.

Theoretically, it could be done at the CFTC or the SEC, but the CFTC seems to be the slight agency of choice, from an industry perspective.

What about decentralized entities?

Well, that's a longer conversation.

I think a lot of the concerns as to why you need centralized exchange regulation don't exist in DeFi, so it doesn't make sense to have the same kind of regulation. It's unclear who in the decentralized ecosystem would be responsible for complying with that regulation, if a network is indeed decentralized.

What we don't want to do is apply the old rules that work for centralized intermediaries to decentralized exchange protocols, because it's just not going to work.

Do US regulators have jurisdiction over peer-to-peer financial transactions?

Not today. At least they shouldn't today, right? If you look at SEC regulation, it's largely intermediaries-based. Even the Bank Secrecy Act deals with intermediaries.

I think peer-to-peer transactions are an incredibly important part of the ecosystem and we need to do more education on that. It's one of the reasons why we just launched a working group to focus on the importance of both self-custody and peer-to-peer transactions.

This is an educational effort that is ongoing — a really important one.

Should peer-to-peer transactions be unregulated?

In principle, yes. There might be some exceptions to that, but at a high level, just like I should be able to give you $5 and you should be able to give me $5, like we can with cash, we should be able to do that in the digital realm as well.

What would be the ideal outcome for crypto regulation? Should regulation only happen at the point of issuance?

That is an open and ongoing conversation. When it comes to something like illicit finance, there's already a lot of regulation that exists; FINCEN has provided a lot of guidance. When it comes to stablecoins, there's probably a gap there and we need to come up with legislation to fill it.

On market structure, opinions vary as to what that regulation should look like, but having centralized exchanges register and be subject to regulation is largely something that people agree on. But if we're going to do that, we also need to get clarity on when tokens are securities and when they are commodities so that we don't have to spend hundreds of millions of dollars on legal fees or years in court to figure out the answer.

Are there any jurisdictions whose crypto regulation you'd be happy for the US to adopt?

The problem with the US is that it's such a complicated and different system — it's apples and oranges compared to international jurisdictions.

For one, we have seven or eight different financial regulators, so it's not like we can just put all of this under one agency and have it done properly. Also, US securities laws have the term "investment contract," which is unusual and the source of the confusion when something is about a security or a commodity.

I think the US will have to take a US-focused approach to get through some of our unique jurisdictional and legal hurdles that we have to overcome.

Legislation is famously a messy process. Can DeFi survive a muddled outcome?

We need to do more analysis before figuring out if DeFi should be regulated. As I mentioned, a lot of the concerns that have led to centralized exchange regulation are because there are problems with having to trust a centralized entity. With DeFi, you don't have those same trust issues, but there are other issues, like around cyber security, etc., so we need to have more of a conversation before deciding if we need additional legislation in the DeFi space.

If we do get DeFi legislation, how would a decentralized protocol comply with it?

That's just it, they can't right? There's a question around whether somebody who's offering a front end to a DeFi ecosystem has obligations, but then you start getting into issues about free speech — and what if somebody put some code out there that other people pick up and use?

There's a much more comprehensive debate that we haven't had yet, before we can come up with those answers.

Will protocols have to be designed to comply with regulations from dozens of different countries?

Hopefully, protocols don't have to be designed based on any specific legislation. In the United States, the writing of code should not be influenced by legislation. What people do with it…there might be a situation where regulation is needed, but that's a discussion that we need to have.

Do legislators agree that the writing of code should not be influenced by legislation?

There are some members in the Senate and the House who think we need to mandate that certain features be written into code — I think we disagree with that as an industry.

That is not an opinion that is universally held by policymakers, but I think oftentimes that position that a policymaker takes is because they don't have a full understanding about how decentralized blockchains work. One of the challenges that we have as an industry — which we're making headway on — is that we need to do more education and shift the conversation more to: how can we more appropriately achieve public policy goals without violating the constitutional rights of participants in the ecosystem?

Opening a PayPal account requires KYC, but buying PayPal's stablecoin, PYUSD, with crypto does not. Is that a compliance loophole?

I don't think it seems like a loophole. If you want to buy PYUSD with US dollars, then you would also have to be KYC'd.

The on-ramps and off-ramps have always been regulated. If I go to a bank and withdraw dollars, KYC has happened. But I can give those dollars to you and you can give me old-fashioned subway tokens and we can conduct that transaction without having to conduct KYC.

But if I then put those tokens in a safety deposit box at the bank, then I would need to KYC again. I think the on-ramps and off-ramps are the appropriate points of regulation and the industry in the US has been compliant with that for years. But peer-to-peer transactions in the middle, facilitated by a DeFi protocol? I don't think that's necessary.

Where are legislators on that?

There are mixed opinions on that front. It's an open debate and one that may or may not be resolved in the years ahead.

Stablecoin issuers can freeze accounts at the request of law enforcement. Will that be good enough in terms of anti-money laundering procedures for US regulators and legislators?

It depends on who you talk to. US persons have an obligation to comply with sanctions requirements and that's not going to change. The bigger question will be, are there other kinds of transactions that will also have to be KYC'd? That's an open debate and discussion.

Is there a cost-benefit element to financial regulation? Should the amount of illicit crypto activity we tolerate be a function of how societally beneficial crypto is?

We certainly have to look at the whole picture. If you compare the crypto financial ecosystem to the traditional financial ecosystem, we're actually doing a lot better in crypto than we are in the TradFi world when it comes to clamping down on illicit activity.

In fact, the transactions that occur on these protocols are all recorded on a blockchain, so there's an audit trail of transactions and at some point you'll be able to trace that back to an on- and off-ramp that is KYC'd. And that law enforcement has a lot of tools in place to prevent these types of transactions from happening.

But blockchains are a neutral technology, and unfortunately there are bad people in this world and they're going to try to use them for bad purposes. But I think if we have well-funded law enforcement, training and tools, we can get ahead of these and I think we can do better in a crypto world than we do in the TradFi world.

Where do we stand currently on what is and isn't a security in the US?

That is a question that is being heavily debated in courts. It's a question that's posed one way or another in the Ripple case, the Coinbase case, the Kraken case, the Binance case, the Legilex case out of Texas. This is something that is very actively being litigated and will hopefully be resolved as these cases move through the courts or if Congress passes thoughtful legislation.

Does it get decided in the courts or by legislation first?

That's a good question. We're dual-tracking it. Both of those can take a very long time. I think it depends on if some of these cases get kicked up to the Supreme Court or not.

There's certainly a lot of legislative activity in Congress this year but there's a very good chance that that carries over into the next Congress and is something that will really be resolved in 2025 or 2026.

Is it only US law that matters here? Because I never hear about what is and isn't a security in Europe or Japan or something.

This is an issue that's unique to the US because of the way "investment contract" is defined here. Europe, through the MiCA legislation, has put a framework in place. Other jurisdictions have been able to move quickly and that's usually because they have a single financial agency or regulatory agency and they don't have this quirky securities definition like we do in US securities laws.

Are there any big-picture implications to the conviction of the Tornado Cash developer Alexander Pertsev on charges of money laundering?

We're going to have to see how the courts play out, but it's super disappointing to see software developers being held accountable for other people's actions with a tool that they built. There've been a couple different Tornado Cash cases here in the US and we filed an amicus brief in one of those but, yeah, I think it certainly has a chilling impact on the industry. Put simply, technology is just a tool. It's like Ford being held liable if somebody runs a red light in one of their cars.

Is the Tornado Cash developer Roman Storm also likely to be convicted?

I certainly hope not, but, no, I don't have a prediction on that.

Has there ever been a case where a regulatory body has gotten as much public attention as the SEC does on crypto?

There are a lot of industries right now that are upset with the SEC. If you talk to the hedge funds, some of the banks, the private funds, there are a lot of folks that are challenging the SEC.

But the crypto industry has been uniquely strong in pushing back due to the fact that we feel like we've been treated incredibly unfairly by this agency. When we showed up with ideas, we've been willing to meet, we've been willing to discuss, and all of those efforts have been dismissed by the SEC.

Do you feel like all the public attention it gets is helpful to crypto's cause?

I mean, this is not the ideal way we want to work, right? But I think it's great that crypto is fighting back and being strong. Crypto is politically powerful right now and that's because of the crypto voter, the crypto advocate and a really strong crypto industry. We wish it could be a smoother path, but this is the path that it is, so we're here to push back and fight for what we believe in.

Do you think that crypto could swing a presidential election?

I do. DCG did some polling with Harris last month that said one in five voters in swing states believe that crypto is an important issue in the 2024 election.

You have incredibly close races, so to have one out of five voters care about crypto, I think a candidate's crypto position could indeed swing which way a race might go.

Last question: I imagine there must be easier ways to make a living than defending the crypto industry. Why do you do it?

I have always been interested in the policy-making process and I think that the questions facing the crypto industry are some of the most important problems facing the policy-making world. I have always been very passionate about the development of the internet, I've been passionate about the rights of individuals and crypto brings together a lot of things I care very deeply about.

I'm very happy to be doing this and I will be here until we come away with a win.

And then I will do something way easier!

— Byron Gilliam

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