By Dawn Talbot and Ralph Benko
Felix Salmon, at Axios, recently summed up the consensus about the FTX debacle in his November 14th The Week the Crypto Dream Died: …
- “It now looks likely that SBF — arguably the most trusted man in crypto — will turn out to have been a crook who was embezzling his own customers’ funds.
- “If that’s the case, then lawmakers will have every reason to ignore industry pleas for special regulatory treatment. It might be many years, if ever, before crypto entrepreneurs have any hope they’ll be treated as though they’re responsible and law-abiding.”
The way to be treated as responsible and law-abiding is to be responsible and law-abiding. There is a way of doing that without crushing the blockchain sector’s ability to innovate. Follow along.
Even the most passionate crypto enthusiasts have been “whistling past the graveyard” on the FTX debacle. Meanwhile, there is a straightforward solution that can resurrect cryptocurrency from that very graveyard.
As we said in our book, Redefining the Future of the Economy: governance blocks and economic architecture (2020, The Websters’ Press), “The best oversight is insight.” What did we mean by that?
The lead co-author of that book and of this article has designed a mechanism that will prove a strong way to inhibit fraud … without the extreme compliance costs incurred from much SEC oversight. That mechanism is an algorithmic design derived from traditional broker/dealer practices devised to help firms comply with SEC regulations and to protect both customers and broker/dealers by suppressing incentives to collude.
If our claim proves out, this mechanism will meet both core criteria of President Biden’s executive order 14067 calling for the responsible development of digital assets. It would provide for both responsibility and development.
As we set forth in the book’s section entitled “The Best Oversight is Insight:”
“Accountability is essential to civilization itself. There are different ways to establish accountability. Some regulatory mechanisms may be inherent. We refer to these as “insight.” Others may be imposed by regulatory authorities. That’s “oversight.” Both oversight and insight are missing from current blockchains.
“Top-down oversight as provided by regulators is cumbersome and expensive in terms of compliance costs, latency, and lost resilience. Oversight tends to be scripted. It frequently ends up ‘fighting the last war,’ addressing problems that are no longer relevant and ignoring new problematic behaviors. Oversight (then) no longer involves discovery of perturbations in the system. It involves mere compliance with rules that may no longer be relevant or beneficial.
Oversight implies a legal mandate rather than a healthy, dynamic, process of market self-corrections. Economist Friedrich von Hayek might have called it ‘scientism.’
“While an accountability mechanism is essential, some oversight mechanisms in the regulatory world (such as those of the Consumer Financial Protection Bureau) are so clumsy and fraught with inefficiency that they are unlikely to achieve their mission and (potentially) impose onerous costs. Bad regulations inhibit commerce while doing a disservice to the very consumers they were, in theory, purposed to protect.
“Regulatory agencies also find themselves riddled with moral hazards including a chronic lack of accountability which the private sector would not tolerate.
“The best accountability comes from built-in, real-time feedback. ,,, An ongoing ‘real-time audit function’ would obviate the need for many cumbersome regulations and better protect the consumer.
“Consumer protection is both legitimate and important. The means at the regulators’ disposal tend to be insufficient. Good systems will emulate the human body. A well-balanced person drinks enough but not excessively. They do not require (tip-of-the-hat to William McChesney Martin) a chaperone to order the punch bowl removed just as the party was really warming up.”
What does this mean in practice?
Why do large scale financial scandals seem to plague US markets? Enron, Madoff, Lehman to name just a few. Now, FTX.
These scandals almost always require some insider collusion or conflict of interest. It is possible that in our march toward highly automated and faster processes some of the more subtle systemic check-and-balance mechanisms were tossed aside.
We contend this is exactly the case with crypto. And this can readily be cured by better code architecture.
The information flow of the original financial system, between six specific market participants, has been fragmented by “innovation.” This deficiency, and how to rectify it, was a major subject of Redefining the Future of the Economy: governance blocks and economic architecture.
We described the potentially negative impact of disturbing information flow within a system to automate portions of the system individually. Disintermediation without representation or advocacy can be more risky than traditional financial institutions. QED: FTX.
In our book we outlined a practical mechanism to require responsible behavior in FinTech, behavior consistent with regulatory and compliance guidelines. Our lead co-author introduced a combinatorial mathematics pattern that promotes cooperation to maximize profits while inhibiting collusion.
We condensed the interaction among market participants during an IPO to the Prof. Brown “schoolgirl” combinatorial mathematics problem. There are seven participants and seven steps (or blocks).
Three principals participate in each step. No two participants can work together on more than one step. Hence (7,3,1).
A multitude of “block design” patterns exist. The seven “players” in the IPO process include the banker, the analyst, the trader, the issuer, the investor, the exchange and the financial instrument itself.
Each participant or node performs its requisite function to originate a new financial instrument with the checks, balances and accountability required to normalize pricing. The information flow among participants becomes obvious when structured as blocks.
Add consensus at specific “blocks” — steps in the algorithm — and the resulting mechanism contains both a “form of democracy” and a “governance block.”
By this expedient, at any and every moment one can view the “form of democracy” and “state of capitalism.” Combining blocks and consensus brings us to what we have as “governance blocks” and “economic architectures.”
This mechanism, wherever adopted, will dramatically inhibit fraud.
Corporate governance primarily resides between the Board of Directors (BOD) and Chief Executive Officer (CEO). In the case of FTX there was little in the way of BOD oversight and, apparently, virtually no exercise of Board fiduciary duty.
Typically, a board sets the incentives whereby the CEO is rewarded for achieving specific goals such as serving shareholders, environmental causes, employees or customers. In the traditional financial compliance model both corporate bankers and analysts were and are tasked with monitoring these incentives. This is a good thing.
To reiterate, with FTX there appeared to be deceptive “virtue signaling” rather any actual accountability mechanisms. That’s a bad thing. Our “schoolgirl” combinatorial mathematics to the rescue! Combinatorial mathematics can inhibit or even, in theory, preclude market misconduct freeing up the regulators to focus their limited administrative resources on catching the most nefarious actors.
FTX contagion is an ongoing conundrum. This is due to the lack of transparency, a consequence of a lack of oversight or, even better, “insight,” i.e., programmed combinatorial math instructions that would inhibit and perhaps even avert fraud.
As noted above and bears repeating: “a combinatorial mathematics pattern … promotes cooperation to maximize profits but discourages collusion during the IPO process.”
Some form of self-regulating mechanism is no longer optional for FinTech, most especially for decentralized finance mechanisms. It is an existential necessity.
The industry tends to use decentralized loosely, without making the distinction between the technical architecture and the internal controls. Just because it’s on the blockchain does not make it inherently decentralized. If a principal has the power to impose his will via his self-deleting text system you have a potential single point of failure.
We propose this decentralized financial compliance/governance system as fully consistent with US oversight regulations and compliance standards yet with less compliance-cost friction.
Financial compliance may be distasteful to the highly independence-minded, largely libertarian, crypto sector. That said, built in compliance – insight, superior to oversight – offers an optimal balance between both the freedom of the sector’s innovators and the safety of the public.
Voluntary self-regulation is not foolproof. Yet it is indisputably good.
Nothing is foolproof. Never make the best the enemy of the good.
Such compliance, properly structured, encourages individual competition, multiple oversight entities and services consumers by providing fiduciary coverage from multiple perspectives (structure, liquidity, future outlook) while not imposing onerous compliance costs. The participants can only maximize their profit by cooperating without colluding.
The crypto sector has chronically tackled specific functions without a clear understanding of how structured information flow unites multiple functions into a robust system. We show how to avoid that fumble, thereby guiding crypto onto safe ground.
No current cryptocurrency has the seven qualities (6-perspective surveillance of one security) that we outline as “institutional quality.” Without all seven, the exchanges will never come close to the investor security provided by institutional grade financial instruments’ architecture in terms of transparency, liquidity, structural validation or valuation.
These seven perspectives baked into the chain may surpass the traditional standard of institutional quality, providing even higher levels of consumer protection than traditional finance has provided. Thus, both legitimate desiderata – “responsible” and “development” – can be served without exposing investors to undue risk and without imposing onerous compliance costs on innovators.
How? To reiterate: “There are seven participants and seven steps (or blocks). Three principals participate in each step. No two participants can work together on more than one step. Hence (7,3,1). … The seven ‘players’ in the IPO process include the banker, the analyst, the trader, the issuer, the investor, the exchange and the financial instrument itself.”
This can be baked right into the blockchain.
Insight is the best form of oversight.