19 July 2023

Separated, Integrated, Regulated: What the SEC’s Actions Mean for the Digital Asset Community

By Sameer Shalaby, Founder, President & CEO, VersiFi

The digital asset space is in the midst of a crisis. In the last year alone, we’ve witnessed a series of seismic events that have called into question the future of this asset class. The turmoil reached a crescendo earlier this month, when the SEC filed charges against industry titans Binance and Coinbase – just the latest sign that there is something dreadful in the state of crypto. Unless things change quickly, the industry conversation may shift from a question of safety and security to one of survival.

This may feel like a stunning reversal from the momentum and excitement that have long been present in the space – but in reality, it was inevitable. Digital asset markets are defined by deep-seated infrastructure issues and a lack of distinction between the various market participants and service providers, putting investors’ assets at constant risk. It was only a matter of time before those shortcomings led to disastrous results.

To achieve its full potential as an asset class, with widespread institutional adoption and secure transacting for all stakeholders, the digital asset industry must be open to an array of reforms, both structural and regulatory. And it needs to happen fast – otherwise, institutions will continue to focus on other asset classes and regions where they feel they can transact more safely. Just look at MiCA, the EU’s new framework for digital assets, which makes clear distinctions between the various service providers.

While it may seem at odds with crypto’s libertarian roots, the best way to bring about this evolution is for digital asset firms to embrace all the lessons that traditional markets have to offer. Let’s explore how.


Swimming in Their Own Lanes

Traditional markets are a case study in the value of segregated services. By sticking to specific core duties, all parties do their part to create a secure, transparent and efficient ecosystem where everyone is protected and counterparty risk is minimized. This separation is particularly important when it comes to three key functions: exchange trading, prime brokerage and custody.

Imagine a world where Goldman Sachs and NYSE were one company, or where JP Morgan and Nasdaq merged. The markets would become rife with conflicts of interest – overconcentration of risk would increase the odds of mismanagement and magnify the impact of market occurrences, while exchanges would have perverse incentives to give privileged access to their prime brokerage clients. We saw some of this play out in the FTX/Alameda Research debacle, where a conflicted operating model led to billions in lost assets.

For institutions to fully dive into digital assets, better boundaries are needed. How can traditional finance players – often deep-pocketed and risk-averse – justify adopting a new, unfamiliar asset class that has proven to be anything but lucrative for thousands of defrauded investors, especially when there are safer jurisdictions out there? This isn’t just an academic, long-term issue – with the disappearance of crypto-friendly banks like Signature and Silvergate, the need for institutions to provide on- and off-ramps and partner with digital-native custodians is more dire than ever.

By focusing on the core responsibilities of their highly specific, well-defined roles – swimming in their own lanes, so to speak – digital asset players can make a collective effort to attract institutional interest. Under such a model, they would not recklessly play with client funds as collateral, and they would not manage client accounts while being conflicted by proprietary investments. Instead, there would be a stable symbiosis among exchanges, liquidity providers, prime brokers, lenders, custodians and the buy/sell relationships. Exchanges and liquidity providers would focus only on matching buyers and sellers. Custodians would focus only on holding client assets. Prime brokers and lenders would focus only on supporting their clients with trading, financing and lending.

Ultimately, this would create a market structure very similar to what we have in traditional finance: separated, yet integrated. Entities from across the ecosystem would interact as needed to offer an array of distinct yet comprehensive services to clients. Under this model, technology providers could serve as the connective tissue, offering institutions an easy, single point of access to these segregated services. Everyone wins.


The Regulatory Ramp-Up

The SEC’s recent moves against Binance and Coinbase have underscored the need for this clear separation of responsibilities. The Coinbase charges are particularly relevant here – the SEC is alleging that the firm intertwines the functions of an exchange, broker and clearing agency, creating profound conflicts of interest. This comes on the heels of its February proposal to expand current custody rules to digital assets, which would effectively require digital asset exchanges to give up custody of client assets to qualified custodians.

The message is clear. The SEC is repudiating the firms that seek to be all things to the entire market and stressing the importance of defined roles. We have a long way to go before we have true regulatory clarity, but institutions looking for an indication of the direction we’re heading need look no further.

In this way, there is a dual incentive to bring about a separated, integrated digital asset ecosystem. Institutional investors want this model both for their own risk management processes and to prepare for the emerging regulatory framework. Firms in the industry must deliver. The future of the digital asset space – from the pace of adoption to its ultimate winners and losers – could depend on it.

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