After BitMEX: Regulation Must Change for the Digital Age

Being a policymaker or regulator these days is harder than ever. What policy objective to prioritize: digital innovation and economic growth or prudent operation of the existing markets? Privacy, confidentiality and other civil liberties, or the radical transparency that is required to aid in the prevention of financial crime and terrorism? 

It is also hard being a disruptive financial services innovator in today’s world. Do we just launch a global alternative financial system that is more secure, faster and cheaper, or do we first ask for permission to operate incrementally in each jurisdiction? The former gives us a shot at glory. The latter, follower status.

Policy objectives are often like liquid flowing through communicating vessels: You need to trade off higher impact in one area for lower impact on another area. So are business objectives, as the recent shakedown of bitcoin derivatives exchange BitMEX teaches.  

BitMEX appears to have broken every possible applicable rule, allegedly, in both the financial crime and prudential domains. And all in plain sight. It’s rather unbelievable that such seemingly smart and tech-savvy innovators were so misguided as to completely ignore the regulatory compliance aspects. 

Perhaps it was its high-risk appetite, but BitMEX should have known better that the U.S. has one of the most sophisticated regulatory apparatuses in the world, one of the heaviest-handed enforcement attitudes and the farthest-reaching jurisdictional reach. 

There will, hopefully, be lots of lessons learned here. Not only by the market as to the regulatory obligations applicable to financial players, but by governments with respect to their long-term innovation policy objectives, too. 

It’s not easy to balance prudence, control and market stability with innovation and progress. It’s actually really hard. But the emergence of blockchain technology and crypto networks has created a one-in-a-lifetime opportunity for both industry and policymakers to jointly rethink and redefine, first, how financial services could be reinvented with these new technologies and, second, what regulatory safeguards should apply to financial services that run on these new technologies.

But the fact is that all BitMEX seems to have done is operate out of compliance, not damage the market in any way. And for that it will pay a hefty price.

Take for example the regulatory framework for commodity derivatives, which is relevant to this case. This framework involves a highly prescriptive set of rules intended to mitigate the multiplicity of risks posed by the various specialized participants. These rules are tailored to the structure of the market as it has existed for decades. 

With blockchain and crypto networks and other cutting-edge technologies, however, both the nature of the assets themselves and the market infrastructure are changing. It’s now possible to clear and settle a native digital asset simultaneously. That was impossible five years ago. 

When innovating in the world of finance there are bound to be lots of technical violations of existing regulatory obligations, as seems to have been the case with BitMEX. The U.S. government regulators had a point when they explained they “can’t allow bad actors that break the law to gain an advantage over exchanges that are doing the right thing by complying with our rules.” But the fact is that all BitMEX seems to have done is operate out of compliance, not damage the market in any way. And for that it will pay a hefty price.  

Honest question: While law enforcement and prudential regulators continue to do their jobs, is anybody redesigning regulation for the 21st century? Or is that too lofty a goal?

Some believe that by shooting down a trail-blazing innovator that was leveraging cutting-edge technologies to offer investment products under a new technological paradigm, the government has prioritized protecting the U.S. market. I don’t want to speculate on the potential geopolitics of such a move, but enforcement actions like this may have the unintended consequence of slowing down the pace of innovation both in the U.S. and around the world.

A design principle embraced by modern, nimble and resilient organizations is that in order to optimize the system we need to suboptimize the subsystems. Perhaps that is what governments and industry should be working together to accomplish in this increasingly fast and digital twenty-first century.

We can continue applying the square peg of old regulation to the round hole of new assets and markets, or to rethink and reshape our regulatory frameworks to the new decentralized financial products and services that are rapidly emerging across the world. It is our choice.