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Prevent adoption? The balance between security and innovation in crypto

9 min reading

It seems like in the process of crypto development security reasons and innovation are clashing.

cryptocurrency https://www.freepikcompany.com/legal

The cryptocurrency space is moving so fast that there is a new trend every year: only a few years have passed from Initial Coin Offerings (ICOs) to irreplaceable tokens (NFT). In the face of such impressive innovations, crypto companies and regulators face a growing challenge: aligning security practices with new products and features. The approach of some companies is to act quickly and adopt new innovations as they become available, leaving security processes such as Know Your Customer (KYC) and Anti-Money Laundering Inspections (AML) as secondary objectives. Popular cryptocurrency exchange Binance appears to have used this strategy this year when regulators began investigating.

Binance's KYC guidelines allow users who do not fully verify their identity to download up to 2 BTC per day. Margin pairs listed for major fiat currencies allow leverage of up to 125x of their futures trading platform, but should reduce available leverage and eliminate margin pairs when reportedly introduced by the Internal Revenue Service in Justice. Since then, the exchange has followed a tailored approach to its business needs and has introduced a mandatory KYC process for "global users, for every function". This move resulted in the loss of about 3% of the total number of users.

While Binance has been forced to remove some of its offerings and reduce leverage on its platform, other exchanges are still offering consumers the same product. Yuri Kovalev, CEO of crypto trading platform Zenfuse, noted that finding regulations that allow eligible companies to compete is a challenge: "It's difficult to find a way to balance investor protection regulation and innovation, especially in an area where new funding proposals emerge every few months.

Steven Stoneberg, CEO of cryptocurrency exchange Bittrex, said that cryptocurrency regulations are now “quite complex” and handled differently in different jurisdictions. Stoneberg points out that customer safety should remain a priority as "more stable and clear regulations - as in the traditional financial sector - are needed to ensure the true security of client assets and data." For example, Stoneberg cites the Liechtenstein Blockchain Act, which "offers more security and clarity on how exchanges should cover new customers and protect customer assets".

Regulatory clarity is seen by some industry players as a must, because its innovation can be eliminated. In a recent blog post, Nasdaq-listed cryptocurrency exchange Coinbase found that its plans to launch a lending program had been halted by the U.S. Securities and Exchange Commission, who threatened to sue them "without even telling them." Coinbase said it tried to "do productively" with the SEC but never received any clarification on the SEC's motives or how it could modify the product to make it compatible. The suggested alternative is to turn off the controls on the side. Commodity Futures Commission (CFTC) Commissioner Brian Quintenz advocated this alternative and once called for cryptocurrency exchanges to self-regulate, reflecting the mood of many in the industry.

Three distinctions to look forward to:

  • Is self-regulation a viable alternative?
  • Are decentralized exchanges a threat?
  • Basic crypto rights

Is self-regulation a viable alternative? 

The concept is not new: organizations such as the Financial Industry Regulatory Authority (FINRA) have helped implement security investor protection initiatives with brokerage and broker-dealer firms. In Japan, a self-regulatory body has been established for the country's cryptocurrency exchange sector, the Japan Cryptocurrency Exchange Association (JCEA). Stoneberg doesn't think the answer lies in self-regulation, given that "the complexity of this digital ecosystem makes regulation difficult". For him, self-regulation means “developing” all the hard work that has been done in the field of crypto regulation and “recomplicated the regulatory environment, implementing blockades”.

The pseudonym founder of decentralized financing (DeFi) platform Flare Finance CryptoFrenchie said that he believes in "the ability of decentralized platforms and centralized platforms to provide a self-regulated environment that is effectively responsive (or responsive to the need) to go beyond regulatory requirements. modern."

The founder of the DeFi project added that the current system "has proven unable to meet the needs of the current financial system," adding: "Applying the same system to a faster environment like cryptography could be more stifling than it could potentially be." Alexander Lutskevich, founder and CEO of crypto exchange CEX.IO, suggested that self-regulation could be an option, saying that in the company's experience, self-regulation is the answer "when no regulatory framework is in place". Speaking about his company line, Lutskevich said:

“While the cryptocurrency framework has not yet been formalized in some countries, we have taken a self-regulatory approach using best practices from other leading financial institutions. Both centralized and decentralized cryptocurrency platforms should "aim to analyze their own systems and develop modules specifically tailored to the needs of today's regulatory systems," CryptoFrenchie said.

Read also: How to increase DeFi security?

Are Decentralized Exchanges a Threat?

While the debate about self-regulation continues, others have grown about decentralized trading platforms and their impact on markets. Memoryless decentralized exchanges allow users to trade directly from their wallets, often without signing up with an email address. Some critics argue that decentralized exchanges (DEXs) make the efforts of a centralized platform useless for KYC and AML because bad participants can carry out their illegal activities through these platforms. Others suggest that a DEX, even if managed by a Decentralized Autonomous Organization (DAO), could increase its visibility to help blockchain detectives and law enforcement agencies uncover illegal transactions.

According to Jeff Dorman, chief investment officer of digital asset investment firm Jeff Dorman, decentralized applications (DApps) and other projects can contribute to the security of the cryptocurrency space. Dorman said the industry needed to set the standard, adding: "Companies and projects need to understand the importance of creating a transparency management board, and analysts from across the industry need to roll up their sleeves and do the dirty work of ensuring transparency on projects that don't do it themselves.

Bittrex's Stoneberg said that "the best way to cover up illegal activity is not with cryptocurrencies, but with old-fashioned money." The CEO added that blockchain-based transactions are "more traceable than any other financial activity". Stoneberg said that he believes decentralized exchanges should develop guidelines for AML and KYC that they can implement, but added that the industry is "still in the early stages of seeing how decentralized exchanges perform". Lutskevich suggested that one day decentralized exchanges could use tools that can trace the origins and past history of crypto assets to keep illegal funds off their platforms. He noted that "basic information can be tracked" on the blockchain, even though the data is "far from what the Financial Action Task Force's guidelines for centralized exchange collection require". Lutskevich added:

“Decentralized mechanisms are currently being investigated and developed that can use smart protocol protocols to prevent illegal origin funds (money laundering, ransomware, hacking) from entering the DEX. Lutskevich concluded that decentralized platforms could use KYC and AML techniques to address the concerns of regulators. He noted that implementing KYC on its own may not be enough to prevent illegal activity and protect consumers.

Raj Bagadi, founder and CEO of traditional banking bridge DeFi and Scallop, said that the growth of the decentralized finance industry is a regulatory challenge but suggested that the solution could be a "regulated blockchain". Regarding the product under development, Bagadi said: “We can ensure that the blockchain wallet goes through a KYC/KYB process. This means that account holders are identified and all funds in the chain can be traced – ultimately creating a hostile environment for illegal activities and preventing them in the first place. 

Read also: Building multi-chain is a new need for DeFi products

Basic crypto rights

Binance seems to have recently weighed in on the issue by releasing so-called “basic rights for cryptocurrency users”. The stock exchange argued that everyone "should have access to financial instruments" that "enable greater economic independence". He also noted that “responsible crypto platforms have a duty to protect consumers from bad customers” and use KYC to “prevent financial crime”. Commenting on Binance's insistence on crypto rights, Lutskevich hinted that the move was an "advertising campaign" by a company that "just started promoting these values," making it more of a "marketing strategy".

Through a website dedicated to the basic rights of cryptocurrency users, Binance urges industry leaders, regulators, and politicians to “shape the future of global finance together”. The exchange added that they believe that "it should be up to the politicians of each country and their voters to decide who should oversee the industry." Crypto, writes Binance, belongs to everyone. While the stock market believes regulation is unavoidable, any politician who regulates space has a monumental job to do, because so far keeping bad actors away without stifling innovation has been a challenge.

The strategy that cryptocurrency companies seem to agree on is based on working with regulators to find solutions that won't discourage consumers from accessing the currency or innovative digital services that have been created in their ecosystem. Lawsuits against major crypto companies seem to show that only one country likes to cooperate.

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