The Right Side of Crypto Regulation: Institutions Need to Avoid Thucydides’ Trap

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Source: AdobeStock / Роман Мартинюк

Anton Chashchin is a Managing Partner at the digital assets platform Bitfrost.io.

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The days when cryptocurrencies were reserved for the underground are fast becoming history. But the power dynamics in finance are all too familiar.

As cryptocurrencies edge into the mainstream – with global adoption up 881% in June 2021 compared with the year prior – opinions in the institutional world remain split. While some financial leaders – like MicroStrategy – are adding to their crypto holdings, the general support for adoption among the rank and file continues to be overridden by scepticism. The recent crypto crash has only exacerbated this, with many institutions backing out of the market and furthering the cynicism.

Older institutions, in particular, feel compelled to defend the foundations of traditional finances against the more radical characteristics of the crypto movement: decentralization, anonymity, and, in their eyes, instability.

Facing a challenge to the status quo, institutions now find themselves at a historically precedented fork in the road: Thucydides’ trap. 

The Thucydides Trap is a political theory describing a scenario in which a rising power challenges the dominance of existing power. The dominant power, when threatened, becomes paranoid and is likely to respond with war.

Although the original applied to Sparta and Athens of ancient Greece, this applies to the relationship between the crypto industry and financial institutions.

That sentiment is encapsulated by the comments of the well-known opponent of cryptocurrencies and the embodiment of traditional finance, Warren Buffett, who said in an interview with CNBC, “Cryptocurrencies basically have no value, and they don’t produce anything. I don’t have any cryptocurrency and I never will.”

This paranoia has grown as institutions have come to realise that the world of cryptocurrencies can create not just competition for them, but even a significant threat. The cryptocurrency markets are constantly expanding, both in size and sophistication.

Some have accepted the rise of crypto as inevitable. 52% of financial institutions now own cryptocurrencies and many have recently launched crypto capabilities, including investment banking giants like JPMorgan, asset management stalwarts like BlackRock, and infrastructure payments pioneers like Visa, as well as established Fintechs like Revolut.

But for those financial institutions that are preparing for war, they need not fall into the trap. Institutions that can lay their ego aside and open themselves to the opportunities inherent in crypto will be able to leverage the rise of digital assets to fuel their own growth. 

However, to encourage a fruitful relationship between institutions and the crypto industry, four key changes must take place.

1) Bolster knowledge with third-party expertise

Cryptocurrencies are fundamentally new and evolving assets, meaning institutions can find it hard to keep up with the latest capabilities – particularly newer entrants. Many are asking a lot of the same questions: what is Bitcoin? What is blockchain? Is it safe? How can they get involved? 

In response to a general dearth of crypto knowledge and capabilities among institutional investors, Wall Street has been amassing an army of crypto experts, with thousands of new crypto jobs at top firms since 2018. 

But the demand for knowledge far outweighs the supply. 

There is a lot to learn, and it’s hard to find the right talent to support pilot projects. Not all institutional investors have time to train their staff in order to successfully branch into the space. 

What’s more, the current market downturn is forcing many crypto companies to lay off employees – with the largest US crypto exchange, Coinbase, letting go of 1,100 employees. Top bankers are optimistic that this round of cuts will widen the pool of crypto talent available, resulting in many returning to banking, a sector that remains desperate for tech talent.

Additionally, to supplement a human resources-focused approach, institutions can call on external support from a number of third-party companies, which have emerged as institutional demand for expertise has grown. 

Such companies can support firms in building crypto services and integrating crypto into their business. In choosing reliable partners and hiring experienced consultants, institutions can realise their crypto ambitions.  

2) A robust, globally coherent regulatory framework

Prevailing suspicions among institutional leaders are, at least in part, motivated by a necessity to protect the customer at all costs. The recent volatility in the market has heightened suspicions that cryptocurrencies are a scam, or a bubble that could burst, damaging their clients, business, and the wider economy. 

Considering each move in crypto follows extensive risk assessment, business planning, and board approval, these concerns stall adoption, and go some way to explaining why some firms have yet to take their first steps. 

In many ways, it’s a legitimate concern. Cryptocurrencies do come with their fair share of compliance headaches, coupled with a general lack of governance.

 International regulation ranges from supportive but nascent – as in the case of the US Securities and Exchange Commission (SEC) and the UK Financial Conduct Authority (FCA) – to actively condemnatory – as in the case of China, which has banned digital assets outright.

On top of this, the crypto ecosystem is fast-evolving, making it hard for regulators to keep up. For example, most markets are still yet to implement policies on Bitcoin and Ethereum, let alone more recent digital phenomena like Non-Fungible Tokens (NFTs) and decentralised finance (DeFi). 

As traditional financial companies have both a responsibility to their clients and strict standards to uphold relating to investing and trading, they must remain compliant, which makes them nervous about volatile, undefined, and ungoverned assets like cryptocurrencies.

Although crypto may be perceived as a wild and unregulated asset – and perhaps even a dangerous one, given the recent crash in valuations – Russia’s recent invasion of Ukraine has shown the opposite, providing vital financial services to Ukrainians.

Nevertheless, despite the volatility and fears around a “crypto winter”, a recent report showed that the investor interest in the sector has not frozen – suggesting that the momentum of mainstream digital asset adoption is set to continue.

As client engagement grows, and the adoption of crypto assets continues, major crypto exchanges and other players in the space are already cooperating with lawmakers on sanctions and other monitoring tools. 

This already indicates the beginning of the formation of a common regulatory framework that can no longer be denied.

Rather than responding to ambiguities by avoiding cryptocurrencies altogether, institutions should be taking the reins in advocating for stronger protections and more robust regulatory frameworks that will allow them to launch into digital assets more confidently.

3) Addressing environmental concerns

Finance companies have a growing list of voluntary and mandatory environmental standards to uphold in a landscape that is increasingly ESG-focused. Many institutions, therefore, cannot invest in areas or work with companies that are not environmentally friendly. 

This is problematic from a crypto perspective in light of recent revelations surrounding Bitcoin mining, found to use the same amount of energy as a small country. 

Research from the European asset manager Candrium in 2021 has made the case that cryptocurrencies more broadly have a long way to go to satisfy ESG criteria.

But this is only the start of the story. Recognizing the need to reduce the carbon footprint of the technology, the market has already begun investigating ways to reduce energy consumption by making upgrades to the network or through other means, such as offsetting carbon use as some crypto mining companies have done.

Strides have been taken by some blockchains, like Ethereum, which is migrating away from the notoriously energy-intensive proof-of-work (PoW) model. The transition to the proof-of-stake (PoS) mechanism is set to make Ethereum’s carbon footprint over 17,000 more efficient than Bitcoin. 

While this should be championed, more needs to be done across the industry to offset crypto’s environmental impact.

In order to tip the balance of the ESG scale and allow for institutional involvement, greater investment as well as a regulator-led approach, is required in this space – and institutions can play a major role in driving this forward.

4) Greater awareness around crypto’s social benefits

While the environmental aspect is currently dominating conversations surrounding ESG, the social and governance aspects should not be forgotten, as they are areas where cryptocurrencies are superior to fiat money.

The fundamentally open source, borderless nature of the blockchain technology on which crypto is built means it has the potential to create more inclusive, democratic financial systems.

Institutions looking for a non-environmental leg up in the ESG space would do well to remember this. 

Time for a choice

Institutions have a choice to make: give in to the hubris of hegemons throughout history and push back against crypto, or form an alliance with the rising power. Many big financial firms have slowly come around, but there remains a level of Thucydidean paranoia.

As the market expands, and the solutions and surrounding regulatory ecosystems along with it, institutional confidence can and will rise.

By working with an established partner in the space, institutions can make the most of crypto’s new dawn and ensure they come down on the right side of history.

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