The Great Crypto Farm in the Sky
With fintech and crypto firms outlaying tens of millions during the 2022 Super Bowl [3][4][5], we’re reminded that nothing has so clearly defined the zeitgeist of the 2020s as the ascendancy of crypto. The consumer appetite for crypto related products is at an all-time high and a new wave of fintech platforms riding high on the retail investing hype cycle has made this new family of digital products accessible to an unprecedented mass of hobbyist investors, raising questions about knock-on volatility and financial stability [6][7][8]. We question whether consumers are able to appreciate and successfully negotiate the complex financial and legal risks inherent in the cryptocurrency space, and whether regulators and the current legal system are adequately equipped to protect them.
From the cybersecurity perspective, the crypto-asset world has always been fraught with exceptional and unique risks. Evoking comparisons to the “kongbucks” in Stephenson’s anarcho-capitalist dystopia [15], cryptocurrencies have long served as a pseudo-anonymous value exchange system within dark web black markets, as the hard-to-trace currency of choice for extortionists running ransomware schemes, and a favored direct target for cyber theft. Unreliability, disrepute, and ephemerality have been persistent pernicious undercurrents in this space, and many large crypto-exchanges and even entire tokens have disappeared overnight for reasons ranging from outright fraud and rug pulls to large scale hacks — the digital equivalent of bank robberies — that have left coin vaults empty [9][11]. Dozens of crypto-exchanges have been hacked with crypto heists tripling in the last year to mete out USD 4 billion in losses to companies like BitMart, Liquid, and AscendEX [12][13]. While this is a drop in the bucket compared to the about USD 2 trillion in crypto market cap, it does present a source of non-trivial risk, as many of these compromised exchanges have been unable to recover the stolen currency or return coins to depositors [10][14].
Against this backdrop, we see that the application of financial custody laws to crypto-assets during a liquidation event has often been non-intuitive from the consumer perspective. While commercial crypto-exchanges promise fidelity of token ownership, matters are often complicated by opaque wallet/key segregation schemes and ill-defined staking rights agreements that blur the legal lines between custodial and debtor-creditor relationships. Depositors often find themselves at the back of a queue behind venture capitalists and other creditors of a newly bankrupt crypto-exchange, and sometimes entirely without a legal claim to their deposited tokens. A recent article by a Georgetown law professor delves into the applicable US laws, reviewing the legal nature of custodial relationships and finds a less than rosy picture for consumers in a crypto-exchange bankruptcy [1]. The outcomes in these cases are often further complicated by both international jurisdictional variances as well as the heterogeneity and lack of standards across exchanges as explored in this 2020 review by the Coin Telegraph [2].
It is clear is that as consumers, nations, governing bodies, and legal systems all grapple with the new normals of decentralized finance, they are often inadequately equipped to reason about the complex inherent risk landscape. While regulatory bodies are rushing to bring structure to these new unsecured currency markets, existing legal frameworks are often ill-equipped to protect consumers from catastrophic losses, and this presents an existential reputational risk that threatens the sustainability of the blockchain enterprise. There is a clear need and present opportunity for firms that can step up to innovate, provide leadership, and drive the adoption of robust and dynamic technical, cybersecurity, and risk management practices that inspire consumer and regulator confidence — the firms that do will be poised to join the vanguard that defines the metrics for success in the next chapter of the DeFi story.