How to regulate exchanges: Learn crypto from Biden's SEC chair pick, part 2/3

This is the second in a three-part series based on Gary Gensler's extensive prior public statements on crypto. Here are parts 1 and 3.

Gary Gensler will likely become chairman for the U.S. Securities and Exchange Commission, or SEC, in the coming days. A professor at the Massachusetts Institute of Technology, or MIT, Gensler knows his way around crypto and blockchain, evident in his leadership of a class on the subject at MIT’s Sloan School of Management. 

While teaching the Fall 2018 semester, Gensler gave a wealth of insight into crypto regulation. In 2018, U.S. regulators were very much struggling to get a grip on the industry. But between the Bitcoin bull market that ended 2017 and the subsequent surge in initial coin offerings, it had become a top priority among the financial regulatory apparatus. Gensler's thinking was reflective of many broad trends that has since come about.

Crypto exchanges as the regulatory chokepoint

One element of crypto regulation that Gensler gives particular attention to is exchanges. A paper that Gensler authored with several of his colleagues at MIT around the time laid out their centrality to regulators:

“As most jurisdictions around the globe do not yet have specific regulatory regimes governing cryptocurrencies, ICOs or related tokens, exchanges are a critical gateway to protect against illicit money transmissions.”

Which largely remains true. Also called “fiat on- and off-ramps” in legalese, crypto exchanges function as centralized intermediaries in a largely decentralized economic system. The U.S. government thus pressures exchanges first in the crypto industry. Gensler's team argued that the situation was untenable:

“In the US to date, the only regulatory safeguards have been through state-administered money transmission regulations. This approach — regulating exchanges’ custodial duties in the same manner that Western Union and MoneyGram are regulated — has not been satisfactory.”

 The paper elaborated on the need to treat exchanges like exchanges, which register nationally: "To better protect the investing public, though, crypto-exchanges will need to be regulated more akin to traditional exchanges." 

Unaudited exchange data

Gensler also noted a few interesting points on crypto exchanges and opaque information on trading volumes. He used an October 2018 report from CryptoCompare on the most prevalent digital asset trading platforms to discuss a lack of clarity around exchange numbers:

“We don't know if these numbers are accurate. They are what CryptoCompare collects from 140 exchanges. But it doesn't mean they are accurate. One way they can be inaccurate is an exchange can just outright lie. And if there's no rule or law against it. They can do that.”

Gensler also mentioned market manipulation efforts, such as wash trading, as different methods of dishonestly producing exchange output data and prices. Other areas lacking data included the number of users on any given exchange, as well as those users’ activity levels.

Wash trading remains a huge issue in many global exchanges, with crypto being especially vulnerable. The situation has improved remarkably since 2018, but data quality from many exchanges remains a contentious subject. Crypto exchanges based in the U.S. are subject to much more aggressive auditing measures than those outside the country. For a long time regulators didn't really know who was accessing which exchanges, which led to the subsequent push for more user verification.

Few crypto exchanges had KYC protocols

Crypto exchanges are typically the front line for know your customer, or KYC, and anti-money laundering, or AML, laws in the U.S. Platforms have to gather a certain amount of information on their customers to operate in the U.S., although the exact degree is always a subject of debate.

As of 2018, 25% followed "partial” KYC, and 28% observed “absolutely none.” Gensler added: “I hope none of those 28% are operating in the US. But they might be.”

The U.S. has cracked down on crypto companies in the years since 2018. A large number of crypto exchanges now block customers residing in America, with Binance’s 2019 departure being a particularly notable example. U.S. regulatory bodies went after major derivatives exchange BitMEX in October 2020, in part citing a lack of KYC compliance that allowed U.S. persons to access investments that are not allowed in the country.

Predicting the regulatory crackdown

The crypto industry, as of 2018 at least, struggled with a lack of protective parameters, according to Gensler. He also predicted tougher incoming U.S. regulatory oversight in the U.S., which has indeed come true.

“They'll bring down a heavier footprint — bring down the hammer, if you wish — in 2019 or 2020,” he posited. “I don't think that it’s going to be in 2018.”

Various regulatory authorities have in fact come down on the crypto space since 2018, with the U.S. playing a particularly hawkish role worldwide. This is evident in examples like the SEC’s numerous cases against ICOs, the CFTC’s action against BitMEX or the DoJ’s seizures of illicit stockpiles. But contrary to popular belief, regulation in crypto is often good news for the industry when it provides a clear path forward. 

If Gensler takes the SEC chair, the crypto industry would gain someone who understands the crypto and blockchain space in depth. Producing rules and regulations based on an educated industry stance would likely help grow the space.