The United States is ushering in a new era of crypto reforms. Only a few days ago, Mark Uyeda, the acting chair of the Securities and Exchange Commission (SEC), announced the formation of the Crypto Task Force to be spearheaded by Commissioner Hester Peirce. As the new administration develops measures to address gaps in the oversight of cryptoassets, it must balance several tasks. While focusing on economic efficiencies and innovation, it must also consider economic gains as well as possible negative externalities, investor protection, and risks of the technology.
In a new article, I explore these critical issues and offer solutions while contrasting the structure, microstructure, and transaction costs of cryptoasset (also “digital asset”) markets with those of legacy markets. The article addresses the risks and benefits of blockchain-enabled markets, discusses how they promote innovation, and argues for a well-organized and formal self-regulatory framework covering centralized and decentralized intermediaries and ecosystems.
Blockchain technology promises to revolutionize financial markets by enabling trading and markets bypassing traditional intermediaries. Yet, the new market’s structure has produced new intermediaries called “crypto-exchanges.” There are centralized (CEXs) and decentralized (DEXs) exchanges, which facilitate trading, brokering, and clearing transactions with digital assets.
In an ideal world, CEXs could vet cryptoasset issuers and asset information and provide trading efficiencies from streamlined operations, while DEXs could rely on blockchain-native solutions to lower trading costs. The former, however, may be suboptimal and mired in conflicts of interest, and the latter may be insufficient. Both CEXs and DEXs may externalize the trading costs to investors and the market at large.
CEXs are organized firms that bring together buyers and sellers of cryptoassets. Trading typically takes place on an off-chain limit order book with bundled transfers thereafter recorded on-chain. CEXs also often function as custodians of digital assets. They are the primary market gatekeepers for most retail investors and various parties listing digital assets. As such, CEXs may generate efficiencies by combining the functions of several legacy intermediaries, including underwriters vetting assets, brokers and market makers facilitating trading, exchanges listing assets for secondary market trading, and clearinghouses clearing and settling transactions.
Over recent decades, CEXs have faced criticism for their lack of transparency and susceptibility to market manipulation, conflicts of interest, insider trading, and inefficient governance. The global nature of cryptoassets has added competitive pressures on CEXs that may limit CEXs’ incentives to self-regulate and may even introduce incentives to manipulate information and cook exchanges’ books. Since CEX trading often does not run on blockchains, it is not controlled through blockchain-native methods. Despite their traditional market functions, CEXs are typically regulated as money transmitters and money services businesses, i.e., a regulatory framework unsuitable for trading and markets.
Under these conditions, why should CEXs be trusted to optimize trading costs, oversee market participants, ensure transparency and information provision, and address adverse selection? Today, CEX-based trading is built on trust in private firms located both in the United States and abroad, largely unregulated, competing with one another, and listing identical digital assets. It is unclear, at best, if these firms have sufficient incentives to maintain fair and efficient markets without better regulation, technology-enabled or otherwise.
Arguably, DEXs may limit some of the risks of CEXs. DEXs operate through smart contracts and decentralized applications built on blockchains. Their inherent advantages are automated execution, autonomous operations, transparency, and the virtual absence of custodial risks. Many DEXs are automated market makers (AMM) where buyers and sellers transact against liquidity pools in a decentralized trading environment. A DEX does not have intermediaries but facilitates transactions between users and smart contracts built directly on a blockchain.
Yet, AMMs and other DEXs generate novel risks involving the quality of the code of the underlying smart contracts and decentralized applications, as well as their developers’ influence over governance and protocol operations, which could be on-chain or off-chain. Blockchain-native mechanisms may not fully control these activities and may even introduce new risks. For example, blockchain-native intermediaries, including “validators” and “block builders,” may earn a substantial abnormal profit from DEX trading. They may change order execution while putting together blocks to be added to the blockchain to finalize settlement. Like legacy intermediaries, such as broker-dealers, block builders and validators can front-run or back-run transacting parties (a “sandwich attack”) and reorder submitted transactions to maximize their profit. Unfortunately, these profits may come at the expense of cryptoasset traders and the integrity of blockchain-enabled ecosystems. Such opportunistic behavior is typically called “maximal extractable value” (MEV). It is illegal for broker-dealers, but in blockchain-enabled transactions, opportunistic activities are addressed primarily through protocol and application design. The effectiveness of these methods remains imperfect.
Among other issues are fragmented liquidity and price slippage. AMMs, for instance, may offer fragmented liquidity, generate losses from inefficient prices, and distort price formation by referencing compromised external data sources (“oracles”). Separately, DEXs expose traders to the risks of fraud and mistakes in an environment where erroneous or fraudulent interactions with smart contracts powering DEXs are irreversible.
In sum, DEXs may avoid the quagmire of conflicts of interest, agency costs, and custodial risks of CEXs but have their own problems. Even if DEXs seemingly offer the same functions as legacy trading systems or CEXs, they approach trading differently, creating and managing risks and costs in novel ways. In addition, as court cases against DEX developers have illustrated, DEXs may bypass vetting digital assets they make available for trading, leaving investors with worthless assets and no identifiable defendants.
How to resolve these problems and make sure the digital asset market operates efficiently? As I suggest in the article, voluntary compliance and private self-regulation will not resolve these problems due to negative incentives, international competition, global price formation and arbitrage, trading spillovers between unregulated and regulated CEXs and DEXs, and information barriers among hundreds of CEXs and DEXs operating across borders. Legacy regulation is also unable to address the major concerns of the new markets. Instead, reforms are urgently needed.
Drawing on Friedrich Hayek’s insights into decentralized knowledge, my article suggests that a formal self-regulatory framework offers an appropriate solution, leveraging the expertise of market participants and retaining regulatory oversight. A suitable prototype to achieve these objectives—i.e., to combine industry expertise with regulatory decision-making at a fast pace—is already in place. It is the uniquely U.S.-specific expert SRO model. Digital-asset-focused SROs overseen by the SEC and CFTC could approximate decentralized markets by receiving direct inputs from market participants. They would submit rules for approval to the regulators and relay updated and aggregated market information. A positive externality of this rule approval process would be educating the agencies and improving their market expertise. Regulators would receive current information packaged, assessed, and processed by innovative entities within their jurisdiction.
I propose a two-tiered self-regulatory model that builds on the previous research of Jackson and Massad and Yadav:
- Crypto-Exchanges as SROs: Under this model, CEXs would adopt formal self-regulatory functions, including setting listing standards, implementing anti-manipulation measures, and monitoring insider trading. These exchanges could be required to either register with existing SROs, such as the Financial Industry Regulatory Authority (FINRA), or form new ones tailored to digital assets.
- A Policy-Level SRO: To address the problem of DEXs and improve information sharing among all crypto-exchanges, a policy-level SRO is needed. This SRO could oversee the broader policy framework for cryptoassets and ensure uniform standards across markets. Through that comprehensive SRO, developers could gain access to enhanced resources and knowledge on law and compliance. Such guidelines should send a strong signal to future DEX developers, nudging them to follow the standards. Formal best practices and principles could also reinforce the efforts of the developer community to design technological solutions to broader transactional and regulatory problems. In turn, lists of compliant DEXs could produce a verifiable signal about their quality. In an ideal scenario, a separating equilibrium could form between the platforms that followed the best practices and those that did not, draining liquidity from the bad venues as traders moved to safety.
Structurally, the new SROs could enter into agreements with legacy SROs to exchange information, assist in enforcement, or provide other material assistance. In the alternative, SROs such as FINRA and the National Futures Association could create a joint task force working across digital-asset markets, including commodities, securities, and derivatives. So long as the new self-regulatory model accumulated the necessary market expertise and processed it into effective self-regulation, it would be irrelevant whether there were new SROs or a new joint task force of existing SROs.
While the proposed model offers a promising path forward, I acknowledge its potential challenges. Critics of legacy SROs often cite their susceptibility to capture by powerful market participants, conflicts of interest, constitutional issues, and under-enforcement. To address these concerns, reforms must incorporate the mechanisms ensuring SRO independence, transparency, and robust oversight. Reformers also need to leverage market expertise, embrace the decentralized nature of digital asset markets, and tailor self-regulatory frameworks to mitigate their risks while fostering innovation. The future of digital asset markets depends on their ability to evolve into transparent, efficient, and trustworthy ecosystems. These goals can be achieved through collaborative efforts between regulators and industry participants.
This post comes to us from Yuliya Guseva, professor of law and director of the Fintech and Blockchain Research Program at Rutgers Law School. It is based on her recent article, “Decentralized Markets and Self-Regulation,” published in the George Washington Law Review and available here.