Will regulations divide crypto?

You’ve probably come across the following tweet by Brian Armstrong the CEO of Coinbase:

Last week we heard rumors that the U.S. Treasury and Secretary Mnuchin were planning to rush out some new regulation regarding self-hosted crypto wallets before the end of his term. I'm concerned that this would have unintended side effects, and wanted to share those concerns.

— Brian Armstrong (@brian_armstrong) November 25, 2020

To summarise, the US Treasury seems to be working on new regulations concerning self-custody wallets (i.e. cold storage such as Ledger Nano S/X). It currently seems that such regulation will require crypto-companies such as exchanges to verify the ownership of a wallet before a withdrawal can get through.

This would sort of de-anonymise a big portion of the blockchain that interacts with centralised exchanges and other financial institutions. The goal this achieves is identity information collection which can reduce fraud.

Is it reasonable, will it limit the growth of this new space or will create two different crypto worlds (regulated & non-regulated)? Let’s explore together.

The Issues Crypto Solves

Let’s go back to the roots of what this new financial looks like: “Control in the hands of users”.

Banks have always been seen as sort of problematic by the public. One of the issues with external custody of funds is that you’re not really in control and the bank can choose to freeze your funds, shut down your account and you could do little about it.

The second problem that arose from multiple banks from the around the world is unwise decisions which led to trust issues. Banks are a business, the main way they bring in profits is by lending out a big portion of the capital deposited into the bank in the form of loans and collecting interest on those loans. In the US, the minimum reserve requirements used to be 10% which meant a bank with $1 Billion in deposited capital could lend out as much as $900 million to collect interest. But what if (for whatever reason) a group of people owning $200 million in that bank come by and ask to cash out? Well the bank simply cannot do that as not all loans have been repaid and they’re only required to maintain 10% on hand. This phenomenon is called a bank run and is not uncommon (you can check the list here).

Self Custody

This is where a trustless system and self custody come in. Users keeping their own funds, holding their private keys, gives them full control and also full responsibility.

Assume the regulation passes where users must verify ownership of an external wallet by signing transaction with their private keys, how much does that change?

Not much to be fair, custody would remain the same and problems derived from fractional reserves would not be possible. The only limitations, which are currently present, come from centrally issued digital assets like most stablecoins. Because USDT and USDC are issued by central firms, they have the full power to reverse transactions and freeze addresses. This has previously happened at the request of authorities.

These laws are already applied in Switzerland and Singapore, so they aren’t entirely new.

Proposed Limitations

Two of the limitations Brian mentioned were “Many crypto users are sending crypto to smart contracts to use Defi apps. A smart contract is not necessarily owned by any individual or business who could be identified.” and “Many crypto users are also sending crypto to people in emerging markets, where it is difficult or impossible to collect meaningful "know your customer" information. Some of these individuals are living in poverty, and may not have any permanent address or form of government ID.”

It is unlikely that the majority of users would use a centralised exchange’s wallet to interact with DeFi protocols, most do that from self hosted wallets. As long as they own the cold storage wallet, users could withdraw from an exchange to their wallet and then interact with a DeFi protocol. The same can be said of the other limitation presented.

Crypto Segregation

There’s a notable section of individuals involved within the cryptocurrency space that value their anonymity, this does necessarily mean they conduct illicit activities and that’s a misplaced assumption people make. An owner of large sums, identified, can become a target and anonymity saves them.

Assuming this regulation, or a similar one, passes, there’s a big chance we see the crypto world divide into two:

• Compliant KYC world
• Anonymous world

Will there be bridges linking the two? Probable and that can become a new line of business we see emerge.

There’s already speculation that assets trading in the anonymous section would trade at a premium as they have an extra feature non-available elsewhere. The question becomes: how useful will those anonymous funds be in everyday life? Can they be spent if the user wanted to?