Coinbase CEO: My vision for crypto regulation

Overview: One of the most common questions I’m asked in the regulatory governance and policy space is what regulatory clarity looks like. In this article, I outline a realistic and actionable blueprint for ensuring we have regulatory transparency for centralized entities and a level playing field between exchanges, while preserving the decentralized crypto innovation that will bring tremendous benefits to the world.

After the FTX debacle, I thought that giving a blueprint of where I thought the industry was headed would help restore trust and start a new chapter.

These are fairly simple measures, but they will require the joint efforts of all of us, including companies, policymakers, regulators and customers. We should strive to pass new legislation as early as possible and in a relatively easy way, rather than waiting for a comprehensive and complete set of bills.

I will describe most of this in the context of the United States, but similar measures need to be taken in all major financial markets around the world, as well as in other countries in the G20.

1. Create clear supervision for centralized entities

Over the past decade, I have had hundreds of meetings with policymakers on how to achieve regulatory clarity in the cryptocurrency space. While some meaningful progress has been made, I am hopeful that the FTX debacle will be the catalyst we need to finally pass new legislation.

It would be best to establish clear regulation around the centralized entities of crypto (stablecoin issuers, exchanges, and custodians) first, as this is where we see the greatest risk of consumer harm, and almost everyone would agree that this is the right thing to do. Regulation in traditional finance is organized around ensuring that intermediaries operate fairly and reasonably, and the same principles make sense when there are intermediaries in the crypto industry. Decentralized organizations (DAOs, DeFi, etc.), on the other hand, do not involve intermediaries and have their own (in some ways superior) set of protections, which I will discuss later.

Stablecoins

Regulating stablecoin issuers is a good place to start because there is broad interest in Washington and we can get some momentum quickly. We don’t need to do anything fancy or specific to a particular cryptocurrency; stablecoins can be regulated under standard financial services laws, such as a state trust charter or an OCC national trust charter.

You don’t have to be a bank to issue a stablecoin, unless you want to do fractional reserve lending. Banks are the most regulated because you need a license to make loans with customer funds. But for many stablecoin issuers, being required to hold 1:1 assets and only allowed to invest in high-quality assets such as government bonds is not a big deal.

So, what would a reasonable stablecoin law stipulate for stablecoin issuers:

• Register for a state trust or OCC national trust license.

• If you want to do fractional reserve lending or invest in riskier assets, you might as well be a bank. Otherwise, you can only invest in high-quality liquid assets, such as U.S. Treasuries.

• Conduct rigorous annual audits and provide clear rules to hold client funds in appropriate reserve assets, separate from the firm's cash.

• Establish reasonable management and control mechanisms and board governance.

• Achieve basic cybersecurity standards such as SOC compliance.

• Establish blacklist functionality to meet sanctions requirements.

Hopefully we can achieve these in the first half of next year.

Exchanges and Custodians

Once we have clarity on stablecoin regulation, a set of rules for centralized exchanges and custodians can help prevent bad behavior while keeping innovation in place. Many ideas can be borrowed from traditional financial services, so we don’t need to reinvent the wheel.

Here are some potential regulatory changes for centralized exchanges and custodians:

• Implement robust Know Your Customer (KYC) and Anti-Money Laundering (AML) policy procedures.

• Create a federal licensing and registration system where you can get a license to serve the entire country (or license an entire region, like the EU). In a place like the US, it's fine to keep states' rights to issue their own licenses, but there should also be a federal option to make the US a single market.

• Strong consumer protection rules are needed, such as risk disclosure and transparency around fees and conflicts of interest.

• Establish effective minimum standards for protecting client assets.

• Market manipulation, wash trading and other forms of market misconduct are prohibited.

Commodities and Securities

Perhaps the most complex point that requires clarity is which crypto assets are commodities and which are securities. The Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) have been arguing over this issue for years in the United States, but unfortunately, they have not provided any clear information to the market.

At this point, it seems clear that Congress needs to step in to pass legislation. This could be done through an updated version of the Howey test that applies to crypto tokens that may fall under investment contracts.

The Howey Test for cryptocurrencies might now look like this:

• Do you have funds to invest?

If the crypto asset issuer is not selling the asset for project construction, then it is not a security.

• Is the investment in an ordinary enterprise?

For a crypto asset to be a security, it must be controlled and operated by a centralized organization such as a company. If a project is decentralized enough, then it is not a security.

• Are there any profit expectations?

If the primary purpose of a cryptoasset is some other form of utility (voting, governance, incentivized action by the community, etc.), then it is unlikely to be considered a security.

• Do profits come primarily from the efforts of others?

If the expectation of profit comes primarily from participants unrelated to the issuance of the asset, then the project is sufficiently decentralized and would not be considered a security.

It is important to note that for an asset to be considered a security, all four of these criteria need to be met. Meeting just a few of them is not enough. For example, people invest in gold or Picasso paintings with the expectation of profit, but these are not securities because the expectation of profit does not come from ordinary businesses (or the efforts of others).

We also need to establish a legal precedent for what constitutes “sufficient decentralization.” One attorney (not myself or Coinbase) told me that they consider “5-15% of token supply distribution” to be a general consensus before an issuer begins secondary sales of an asset. But this has not been tested in court, and we will ultimately need to see case law develop.

In the absence of clarity from the SEC and CFTC, Coinbase performs a detailed legal analysis of every asset we consider listing, and we can only list commodities at this time. I would like to make this analysis public (currently under discussion) to see if it can help lead to a self-regulatory standard and save other crypto companies huge legal costs. We would prefer that the regulators come to the table, after which we may need to update our analysis, but until then, we are happy to show our work to see if it can help.

Right now, the crypto industry is primarily focused on trading crypto commodities, but the U.S. should also have a robust market for registering and issuing crypto securities, which could be a real improvement over traditional securities issuance methods. Under current regulations, this would require a broker-dealer and an independent national securities exchange, both of which are licensed by the SEC to conduct crypto securities trading. But these regulations now seem out of place. While the SEC can amend its own rules to ensure that customers are truly protected, Congress may need to act to make it happen.

Congress should also require the CFTC and SEC to clearly publish the top 100 crypto asset classes by market cap within 90 days of the enactment of the above legislation, declaring whether each asset is a commodity, security, or "other" (such as a stablecoin). If asset issuers disagree with the analysis, the courts can decide edge cases, but this will serve as an important labeled data set for the rest of the industry to follow as millions of crypto assets are eventually generated.

2. Enforce a fair competition environment

Gaining regulatory clarity would be a good first step, but if we fail to enforce these rules evenly at home and abroad, we have lost our way forward.

One challenge is that regulators and law enforcement only focus on the domestic market. In most cases, they do not have international authorizations and do not have the ability to regulate/investigate offshore companies. If the entity is not registered, where do they send legal notices? Which door do they knock on?

This creates a negative incentive for crypto companies to serve the world from offshore favorable jurisdictions, while companies that try to follow domestic rules are penalized. FTX.com is a good example, based in the Bahamas, but due to weak KYC controls, it serves customers in many countries, including US citizens. In my opinion, the FTX.US entity is partly real, but also partly a front to distract US regulators from its main business.

It is an open secret that there are still a few questionable players in the crypto industry that do not follow the above rules. We will continue to see various problems in the crypto field until clear regulation is formed and fair competition is enforced.

What does it mean to enforce a level playing field? It means that if you are a country that is going to issue laws that all crypto companies must follow, then you need to enforce those laws not only domestically, but also against overseas companies that provide services to your citizens. Don't take the overseas companies' word for it. Really check to see if they are targeting your citizens, but they claim they are not. If you don't have the power to stop these activities, then you need to work with international law enforcement. Otherwise, you will inadvertently incentivize companies to serve your country from overseas. Countries have lost tens of billions of dollars in wealth over the past few years by not realizing this, and now millions of customers are being hurt by the FTX crash.

3. Achieve innovation in the decentralized encryption industry

The above list is a good set of measures to regulate centralized entities in the crypto industry. But as cryptocurrencies become more decentralized, we have the opportunity to create stronger consumer protection mechanisms.

First, self-custodial wallets allow customers to store their own cryptocurrency in a way that doesn’t require trusting anyone. Advances in technologies such as multi-party computation and social recovery will make it easy for anyone to securely store their own cryptocurrency without having to trust any third party.

Second, the smart contracts that power DeFi and Web3 applications are public and open source by default. This means that anyone can audit the code to see if it actually does what it claims to do. This is the ultimate form of disclosure. In addition to "don't be evil" (Google's famous corporate value), we can also achieve "can't be evil", where you can trust the laws of mathematics instead of humans.

Third, as more organizations use DAOs and smart contracts to build "on-chain", we will see the emergence of on-chain accounting. You should be able to view the solvency, financial statements, tax status, etc. of any fully on-chain organization in a completely transparent manner.

This is the future that self-custody, DeFi, and Web3 can provide, but to achieve this future we need to maintain crypto’s potential for innovation. Self-custody wallets should be treated as software companies and not regulated as financial services businesses because they never take possession of customer funds. Similarly, creating a decentralized protocol or hosting a website on IPFS should be equivalent to publishing open source code, which is protected by free speech in the United States. People can send money through web browsers or Internet protocols, but we do not regulate them as financial services businesses, and the same concept applies here.

The role of financial regulators should be limited to centralized entities in the cryptocurrency industry, and more transparency and disclosure is needed. In the on-chain world, this transparency is built-in by default, and we have the opportunity to create stronger protection mechanisms. With the Internet, we have achieved better regulation through Uber’s star rating system than taxi rewards. Crypto has the potential to further this idea by encoding trust on-chain in a cryptographically provable way.

in conclusion

With clear regulation of centralized entities, enforcement of a level playing field, and continued innovation in decentralized crypto, the crypto industry can bring tremendous benefits to the world. There are too many bad actors causing harmful interference right now, and we all need to take responsibility for improving this situation. I am optimistic that we can make significant progress on the above fronts and pass crypto legislation in 2023.

• 1. Objectively speaking, KYC and AML programs have largely failed in their ability to deter criminal activity. The United Nations estimates that only 0.2% of illicit funds are seized, while this study estimates that “compliance costs are over 100 times greater than the criminal funds recovered”. These programs also compromise customer privacy, result in customers being charged higher fees, discourage entrepreneurship/innovation, and hurt financial inclusion. Despite these issues, a complete elimination of KYC and AML rules does not appear to be on the table, so the most likely path is that KYC and AML rules apply to centralized crypto exchanges and custodians, while decentralized crypto wallets and protocols represent the forefront of innovation, bringing tremendous value and protection to consumers.

• 2. Frankly, the biggest obstacle to resolving the commodity vs. securities issue is politics. Some regulators do not want clear regulation of cryptocurrencies because they are actually trying to restrict the development of the industry. Harsh rhetoric and enforcement regulation, without clear rules for everyone to follow, has pushed most of the industry out of the United States, causing damage to American investors and businesses.