The demise of FTX is a story as old as financial markets and does not reflect a failure of blockchain technology, but the lack of regulation around the “point of trust” – where money is exchanged on the promise of a future return, Goldman Sachs (GS) said in a research report Friday.
Recent crises in the crypto market follow a well-trodden path, the report said: “A highly volatile and relatively new asset creates the potential for instant riches, drawing in many unsophisticated investors looking for the opportunity to make millions.”
New financial instruments are lightly regulated because they are not covered by existing rules and regulators have yet to identify the potential for harm, the note said. That’s the reason the crypto bubble of recent years involved more widespread fraud than the dot-com boom at the turn of the century, which happened in the well-regulated equity market.
“Regulation is needed at the point of trust, where money is exchanged on the promise of some future return, because it is the time component that creates the opportunity for fraud,” analysts Jeff Currie and Daniel Sharp wrote.
To access the market, investors must go through a gatekeeper, such as a crypto exchange like FTX, and speculative investors are willing to give money to these institutions in the hopes of getting rich quickly.
Despite the crises of 2022, Goldman says cryptocurrencies are likely to flourish, and the key to their success depends on rulemakers correctly identifying what to regulate.
In crypto, it’s “the point of trust, not the trustless blockchains themselves,” Goldman said. Once the financial features of digital assets are sorted out, regulators should not interfere with the blockchains themselves, the bank added.
When a token is used as a financial instrument, as when Terra’s UST stablecoin was lent out on Anchor for a 20% yield, it should be regulated like other securities, the report said, and until regulators can classify which tokens fall into this category, the “opportunity for fraud in crypto will persist.”
Goldman notes that decentralized financial (DeFi) lending systems, in which financial applications are carried out on a blockchain, don’t pose the same counterparty risk as traditional banks. In DeFi lending, collateral is visible to all members of the pool and is automatically liquidated if the value approaches the value of the loan. Collateral can be retrieved without the need for court proceedings or at a discount to the loan, by using smart contracts.
“This resolves the question of trust, the very thing regulation to safeguard investors would be intended for,” the bank said.