Transcript | Future of Crypto Innovation and Regulation

Hello. This is Kevin Donahue, senior director with Protiviti, welcoming you to a new edition of Powerful Insights. In this episode, Michael Brauneis, a managing director with Protiviti, and global leader of the firm’s financial services industry practice, interviews Liz Mathew from ConsenSys, along with Maryann Kennedy and Lata Varghese from Protiviti.

Good afternoon. I’m Mike Brauneis. I’m managing director with Protiviti, and the leader of the firm’s global financial services industry practice. I’m very excited today to be able to moderate an outstanding panel we have of experts, both within Protiviti and our friend, Liz Matthew, of ConsenSys, to talk about developments in the digital assets, blockchain, and cryptocurrency industry. It seems like every week in these days, every day, there’s new news about both innovation happening in the market, as well as challenges in financial markets, asset values, and definitely increased interest in regulation in the space. So, we’ll cover all of that during our podcast today, and again, excited to hear the views of the terrific panelists who have taken the time to join us on this discussion.

With that said, the past year, we’ve seen a lot of discussion, there’s one company, especially one crypto exchange after another has declared bankruptcy or gone through issues of fraud, security breaches, et cetera. A lot of headlines and clickbait about the death of crypto. I think it’s interesting when you really analyze what’s happening, and the bulk of the damage so far has been existing force impacted a fairly narrow slice of the industry. So, I think a few questions related to that, and maybe, Lata, I’ll start with you. If you look at what’s happened within the crypto exchange market specifically, what do you think are some of the key steps for the remaining participants in that industry to reassure the public and rebuild market confidence, that there is a sustainable business model to be found there?

Sure. Thanks, Mike. I think just what’s happened, the industry should expect much tighter regulations and rules, and if you're an intermediate reenabling the trading of crypto assets or safekeeping customer assets, they should expect to comply with all of the rules that would apply if you were managing assets or any other asset. Just because you're trading in crypto assets, it doesn’t mean the same rules and regulations that are applicable in current financial industry don’t apply to you. So, I think it would come with being transparent and working with regulators to comply with the rules and proactively engage with the regulators, and new rules, as you said in the intro, Mike, are coming in as we speak, and just the openness to comply with those rules, and work proactively and engage with regulators, I would say.

Great. Thanks, Lata. It’s also interesting to see a lot of what’s happening, a lot of the challenges these firms are facing aren’t so much it seems like caused by any features that are unique to cryptocurrency or to the blockchain. Their basic issues of capital, liquidity standards, information security, and data protection. So, it seems like one path forward to sustainability is relearning some of those basics that we’ve seen, whether driven by regulation or not, just good risk management practices for any financial institution that are in those kinds of businesses. So then, maybe at a more positive or forward-looking light, again, there’s been a lot of news in the past year, a lot of the news has been negative but, Liz, I’ll maybe turn to you for perspective on do you see real innovation happening, and use cases starting to gain traction that are maybe being drowned out or not getting the positive attention they should, given everything else that’s happened over the past year.

Yes. Thanks, Mike. So, we at ConsenSys tend to focus on building the tech. We’re not an exchange or crypto bank or a custodian, and so we tend to spend all of our time thinking about how might we build on the technology and really focus on the infrastructure layout, as well as the gateway for users to access Web3. Most of what I see in terms of noise that has affected the industry is in some way, in our world, not crypto at all, and if we had to make somewhat of a poor analogy, traditional markets, I liken the centralized exchange, the centralized custodians, the platforms segment of the ecosystem to be like structure products that might have been linked to underlying that might have been crypto by definition. Whereas the true Web3 to be likened to sport market.

So, you might have some systemic risk that has built up in the structure product market that may have knocked out certain structured notes that were linked to – I’m making this up – dollar-BRL, right? That might create a lot of volatility in the market for structured bond holders of bonds that were linked to dollar-BRL. Does that impact dollar-BRL underlying? Maybe if the proportion of BRL holders tend to have gotten access through the structured bond market. But in most asset classes, the structure of product market is a subset, a small subset of the otherwise underlying risk profile, and we’ve seen this very much play out in the last 12 months, where you’ve had actors that are somewhat new in the industry when you think about in the context of other exchanges or fiduciary agents acting in the capacity as custodians or exchanges.

So, you’ve had these entities that may or may not have leaned into getting the necessary licenses and having the necessary disclosures, but I think it’s important to make the distinction that was the equivalent to a structured product that was linked to the underlying, whereas there are several companies that are focused on the underlying. It’s somewhat of a weak analogy because really, this technology, it’s not an underlying asset at all. So, we stay very much committed to making sure that the technology is accessible, both for developers and users, be it individual or institutional, that won’t have access to Web3.

I would say it’s still very early days. I don’t believe the used cases are emerging, but that’s where the forward-thinking organizations in all sectors that are taking a closer look at this and are experimenting with the technology, doing the POCs, learning from that and then figuring out how that technology might fit within their business models or use cases or communities is so vital right now, and we see that not having skipped a beat at all in what’s [Audio Gap]

Yes, that’s a great point, and I go back - I’ll probably date myself here, but you go back to the dot-com boom and bust of the late ’90’s and early 2000’s that in some ways, it took a hype cycle, ending in a lot of the less viable business models getting wiped out, to really see a healthier foundation for growth in the industry emerging. Still early days, to your point, but hopefully, that’s the stage of maturity that we’re now entering into in this area as well as. So, Lata, maybe one question back to you on this topic of what comes next after the great washout. We talked a lot about cryptocurrencies, digital assets, but maybe shifting gears a little bit to blockchain and distributed ledger technology, its elements of infrastructure. We’ve also seen some higher profile projects or experiments in those areas be deprioritized or scaled back a bit recently. So, I’m curious to your thoughts as to where we go from here on the blockchain front.

Sure. As someone who’s been engaged on the enterprise blockchain space, so to say, from 2015 succeeding or so, I think there’s just been way too much hype in blockchain’s potential to create a decentralized financial system, with too much focus on the technology and just not enough dialogue around what are the other legal, regulatory, other aspects that need to be sorted out to get the touted benefit. So, I think just beyond the tech, which is, first of all, is very complex, and then all these other host of issues, and that’s just taking a new paradigm of technology, which is primarily decentralized, and applying it to enterprise use cases and getting the same use cases sort of worked out between multiple participants who have to work through all of the different challenges to get these things scaled is just too disruptive, too transformational to take a new paradigm of technology and apply it to an existing use case, which maybe working inefficiently, but enterprise has gone just to invest in technology and scale just because it’s a little better way of doing things.

Then more fundamentally, I think there was just too much hype, and analysts were very quick to project that - all the cost saves that would happen, all the legacy institution, the death of intermediaries, I think the technology got way ahead of the other things that need to come. And I think what you're seeing with all the enterprise blockchain is the difficulty of taking something and making it work is way more than just that. I think that’s what you're seeing play out. And I think similarly, if I have to draw with Web3 and the whole - the threat narrative in the earlier case was around the product infrastructure is ready, the threat narrative that all intermediaries will be dead, and now, it’s like Web3 and decentralization, and that is dominating the dialogue about how it will be a completely new internet, without paying attention to what – ultimately, businesses will have to be built on top of this infrastructure when it’s ready, and what are all the different aspects that businesses need to be able to interact and safely provide new products and services that people care about? Because at the end of the day, nobody cares about decentralization, any of these, as much as they care about a better quality product and service. At least I want to say for a vast majority of users. So, I think it's a way of saying that enterprise blockchain was overhyped, and that’s what you're seeing play out.

Well, I think it’s a really critical point too, than a lot of cases, the technology itself is not the limiting factor, right? You look at a simple example conceptually, like property recording and why are we still walking into [Unintelligible 00:11:48] offices, and pulling paper every time there’s a real estate or mortgage transaction. So, the technology would very quickly be there to replace that entire architecture infrastructure, but the intermediaries have vested interests as well, right? And thinking about getting every city, every county, every state in the country, even just within the US, to pivot to a brand-new model like that, that’s a very specific barrier, and I think a much bigger barrier than the technology being there. There’s probably thousands of other examples like that, where those solutions are still waiting to be found beyond just the tech itself.

So, shifting gears a little bit, we all talked about the wave of regulation that’s likely coming, given everything that’s happened in the past year. So, Maryann, a question for you. Over the past five years, we’ve seen around the world, but I think specifically within the US, a number of state and federal regulators, maybe I’d say dip a toe in the water of innovation in this area, offering special or limited purpose charters to digital asset providers and other fintechs. Given everything that’s happened though, and a few of – now, even regulated banks that have been more prominent in the space, now facing safety and soundness concerns, what do you think that means in the next six to 12 months, at least for regulators’ appetite to continue experimenting or supporting flexible charters in this area?

Well, I think, Mike, you're absolutely right. If we go back several years, and I go back 2016 as having been part of the OCC, there were both federal and states that were interested in chartering, in some instances, invited it for fintechs. Again, back in ’16, we weren’t talking crypto, but there was a lot of conversation about – in fact, the applications were encouraged. The COPB even had their own sandbox capabilities where firms were invited in to try things out without reprisal, without - for any regulated financial institution violations were not being cited. For myself and the OCC, we really started our journey in March of 2016, and the reason I bring this up is I’d like to just draw some parallels to what Lata was talking about, those fundamentals. So, I think we all know that the OCC did a whitepaper of responsible innovation in March. Right after that, we invited the industry in to have some forums to discuss, “How do we make this work? Why does this work? What are the primary principles that we as regulators need to abide by, and what is the symbiotic relationship that a fintech can have with the bank or as a separate bank charter?”

The OCC laid out that framework. They laid out principles, and interestingly, the cornerstone of this principle, there’s seven or eight of them, but I’ll say the two most fundamental had to do with encouraging responsible innovation that provides fair access to financial services, and fair treatment of consumer’s check. The next one, further safety and soundness operations through effective risk management, and again, we didn’t define that, we're just saying effective risk management. The purpose of those two things was to be able to have a level playing field with other chartered institutions, particularly *1525national charters. After the messaging went out to the industry, as they say, we had a lot of meetings, a lot of forums, a lot of discussions. Everyone was onboard. Enthusiasm across the board in terms of what we could charter, but even though a lot of these firms listened, heard, read, and acknowledged, they really still didn’t allow it to absorb.

So, I was involved with a lot of conversations with, again, not so much crypto at that time, but fintechs that were coming in and saying, “We like to have some exploratory conversations about applying for the charter,” and the conversations basically went like this, we laid out basic risk management, capital requirements particularly risk-based capital; governance, more capital planning and what that planning look like, consumer compliance and fair access, and the list went on, and after we got done, it was like, “Really, that’s what’s needed? Well, we don’t think we’re going to be able to deal with that.” So, while the OCC did have some charter approvals, there weren’t as many as those exploratory meetings that we had in those days. So, where are we now? That fundamental framework that we laid out in that whitepaper hasn’t changed, and I just really think it’s going to be more difficult. There may be some out there that have really – weren’t able to get to a place where they can effectively have a charter, but it’s still unknown territory. We really don’t have a lot of rules right now to regulate against. Congress has said that’s one of their big priorities, is to be able to put something out more formally about around crypto, but again, regardless of the industry or how you want to approach it, the fundamental principals have to be there, and I have to tell you, again, I’m going to date myself, I can remember we were chartering some things in the ’80’s – now, again, I was more on the cleanup side where there were special purpose charters that had maybe a singular asset on the balance sheet. Those things did not do well, and for the same reasons, basic risk management, concentration risk management, liquidity, which is right now, very high on the interagency list, with that most recent liquidity risk management guidance that was just put out.

There’s too much uncertainty both the general economy, uncertainty about where regulation is going to go, et cetera. Do I think there’s a future? We’ve got some big players that are in crypto. I’m looking at other things. I think they too need to be reminded what the basic risk management around those are, though I think there are some that do it pretty well and cautiously. Do I think there’s a future? Yes, and I’ve talked to some of my former colleagues in the regulatory world, and those exploratory conversations are still going on. Some of the guidance has been, “Do some homework.” But then, what was written back in 2016, and how can you glean some of those really gold nuggets out of there? Take a look at handbooks, read the guidelines. If you want to meet with regulators that’s even a better way to sit down and say, “How can we get to where we need to be?” or think for an existing financial institution, “Here’s what we’re thinking in terms of some innovative products or services, both new and existing.” So, those are just some of the things that quickly come to mind. I don’t want to say crypto is dead, I just don’t think the regulatory environment is one now that can easily embrace it as we approach some potential for a lot of new rules and regulations, and people that aren’t learning from the past with respect to what needs to be done to form a solid foundation of risk governance and risk management practices.

Now, those are all great points, and I think in some ways, it’s disappointing to see when there are other countries around the world that have been – you can kind of say, at a high level, more crypto friendly or more crypto forward at least than the U.S. has been. But maybe ironically, or maybe not surprisingly, those countries have had fewer issues with safety and soundness, right?

That’s true.

I think that anyone who feels like this just proves the SEC needs to crack down harder. I think we clearly need more regulation, we clearly need more supervision. But personally, my view is the model of existing regulations written 80 years ago cater perfectly well for crypto, and companies just need to figure out how to navigate within that. I think so far, the global results that we’ve seen doesn’t support that view. I think we do need clear prescriptive guidance that all players in the market can interpret and operate against within a level playing field

I don’t disagree with you, Mike, and even to the extent – I mean, that was one of the reasons I think that regulators took a hard look over the past five years to say, “Wait a minute, we’re seeing this happening globally. How can we get our financial markets where they need to be so that we can be competitive?” Certainly, our mega banks need to be able to do that because they do business, globally. They have to be able to do these things. But again, when some of these firms come to the table – a recent example I just heard where you have, say, three legal entities under a holding company, and with a straight face, “Yes, we understand governance, but guess what, we have three directors on each of the legal entities. They're all the same people, and they're internal directors.” Well, you’ve just blown the whole notion of what governance should be at the board level, and it’s hard to have a conversation then with, “Are you really viably thinking about this in the context in which you should be thinking about it?” Maybe a silly example, but one that shows just some of the research and knowledge and thought that needs to go in as you start to think about these things for any firm that’s interested in moving in the space, or like I said in the beginning, getting a charter, which I think is going to be very difficult right now.

Yes. Great points.

Mike, if I could chime in there, right? There are some forward crypto – not crypto, but infrastructure that’s seeing the potential of DeFi public infrastructure that have some pretty heavily regulated financial intermediaries that have actually taken - done the work to conduct compliant institutional grade, cross transactions using public blockchains and DeFi protocols, et cetera. Obviously, the legal and regulatory uncertainties need to be figured out, but if you to your point, on your comment, if you take rules that were written for a different paradigm of infrastructure and just apply it to this new infrastructure, it doesn’t apply it. So, yes, regulation for the same activity, same risk, same regulation but new sets of rules depending on the type of - nature of the infrastructure, also requires that regulators that are lesser more informed about infrastructure and technology and be working rather than just like slapping on the same rules, which may or may not be required in the context of digital assets, which are written to ledgers, which are

not centrally maintained and subject to tampering and so forth and so on. So, there’s a nuance there too.

Yes, absolutely. Thanks, Lata. Last question, and maybe, Liz, this would be a good one for you to address. There’s been this great debate around born-digital, crypto-native startups versus TradFi or legacy financial institutions, and I think a lot of reasons why a number of traditional institutions have been either maybe hesitant to get into the space or felt like the playing field wasn’t level with the kind of regulation that they’ve already been subject to. So, looking forward to a world where everyone is more regulated and more capital will be required, et cetera, I actually think this could open up a bigger opportunity for TradFi firms to compete more effectively. So, just interested in your thoughts with the infrastructure and technology work that ConsenSys is doing. Are you seeing more interest or more investments being made in this area among traditional institutions, or do you still think it’s going to be more of the next generation of matured born-crypto firms that takes us to the next stage?

Yes. I would hope it’s hope, right? [Laughter] But certainly, we strongly believe in the ethos of leveling the playing field in the sense that the new entrant into the market has the same tools that enable their ability to compete for resources and liquidity against the incumbent. So, keep in mind, I would actually think of it almost the other way around. Like part of what this technology is trying to do is in fact, reexamine the cost of regulatory compliance across various different industries. Because the cost to compliance has, in a way, made the barrier to entry a lot higher. Be it healthcare, be it manufacturing, be it banking, or capital markets. So, we're really talking about, “Can we now be more efficient with the use of technology, with distributed ledger technology so that we don’t need to trust, right?” We can build systems that can be verified without blind trust. So, we hope that what we build is actually leveling the playing field so that the new entrant can sort of come in and offer their goods and services in the way that an incumbent traditionally enjoys.

That being said, I will say three years ago, if I have to take a specific example, we didn’t have tools out there to be able to readily even view your risk across different blockchains, your exposure across different trade strategies, for example. Even for the early adaptor venture capital fund or hedge fund, prop money that can arguably move the quickest, we still had them using their own spreadsheets.

There just weren’t any tools out there that gave them a standardized way to think about real-time monitoring and reporting. That’s changed now. So, one of our earliest products within ConsenSys is MetaMask Institutional, which enables the ability to be able to add a very basic level, have access, but then also hand in hand, think about access in a regulatory compliant way, thinking about being able to adhere to the governance policies that you need, the definition of roles and responsibilities within the team, and to have a real-time monitoring capability.

So, much has changed, the counterparts that we speak to that would potentially use the tool have graduated from bringing the single portfolio manager, to being multipronged in terms of thinking about how would the custodian or the fund admin or the auditor access this information? How would the operations team think about this? It’s not just one trader with a spreadsheet trying to do something on his own or on her own. So, I do see a maturity in even among the earliest adaptors that are looking at this at the nonindividual level. So, I am optimistic. But, yes, I’m still rooting for the newer entrant [Laughter] and giving them the same tools to be able to take on incumbents, not just in markets, across different sectors.

Yes, those are great points. It has been encouraging, I think, to see the progress the industry has made in at least starting to solve some of the inherent underlying challenges, right? Now, I look at things like anti-money laundering and financial crimes, that there’s that cynical view of the main use of bitcoin as a tool for money launderers and ransom payments, et cetera. If you peel behind that a little bit and you look at some of higher profile cases and prosecutions that have actually been brought, we’re seeing now exactly, I think to Liz, your point, the technology has evolved to where there is now a way to monitor for money laundering on chain, and I think some of the inherent features of immutability and transparency, et cetera, they're showed in some cases, it’s actually easier to catch money launderers transacting on chain and bitcoin than other traditional ways of illicitly moving money. So, still a long way to go in that regard, and that problem is not solved, but that’s a great example, I think, to wrap us up where we started this discussion of a lot news in the past year. A lot of that news is negative, but I think maybe unfairly, is masking some of the real progress that the industry has made, and some of the sustainable value that we're starting to see emerge from that.

So, before I wrap up, I’ll just ask the panel any final closing thoughts or other topics that you’d like to address in a bit more detail?

Well, I was just going to say, Mike, even though my comments might have seem negative, I really do hope, and I think that we’ll get to a place where we can have some new entrants, or regulated financial institutions can compete along with the rest of the world, and I think it may take – I don’t know if this has taken as much time perhaps as we think, because I think innovation is out there. There are some very smart people out there both working within our financial institutions, as well as outside of it. And there are some smart regulators too that understand that the United States needs to be part of that playing field.

If I want to chime in on that doubt too. I’d like to say that it is important to have first principal thinking on how we can build better services on new infrastructure. Equally, it is also not okay. I mean, there’s a reason why a lot of existing financial rules exist. Kind of both sides working together to build the future, because otherwise, if something develops in a parallel world, it doesn’t come to the masses, then the whole potential of the space is sort of lost. So, it’s not this or that, it’s both working together. And hopefully, a lot less hype and tech push, and more about services that truly benefit people who need to use them and live better lives. Because who cares about just [Audio Gap] you care about the product or the service.

Great. This has been a terrific discussion, and so much more to unpack in this area. I want to thank Liz, Maryann, and Lata for joining. Great insights, and thanks so much for your time this afternoon.

Thanks for having me.

Thanks.

Thank you.

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