Like much of the financial world, Carolyn Wilkins, a former deputy governor of the Bank of Canada, was dismayed at the governance failures that led to the collapse of the FTX crypto trading platform. However, while there is much to be said about the specific missteps of those connected to this company, she said that the incident is reflective of broader governance problems affecting the entire cryptocurrency sector.
"Crypto itself is suffering from governance issues of its own that are causing trouble [since] they're not resolved. This will erode trust even further and lead to generalized financial stress if crypto were to become more prominent," she said, speaking to the audience at the Governance, Regulation and Accounting for Digital Assets Forum at New York University's Stern School of Business.
For one, a lot of the products that come out of this world are "inherently fragile." She pointed to the fact that FTX used unbacked cryptocurrencies as collateral in loans on its own platform, Alameda, which she said was a surefire path to runaway risk and conflicts of interest. This was especially the case when considering Alameda's further use of customer funds from FTX.
"The fact this can go on undetected for long enough to have a lot of lawsuits — at minimum there are some big questions about audits and controls … . It reminds me of Arthur Andersen and Enron in terms of due diligence," said Wilkins, who is currently a senior research scholar with the Princeton Griswold Center.
But with this observation comes questions about the companies that invested in FTX as well. Where was their due diligence, she wondered. She noted that entities like the Ontario Teachers' Pension Plan, Fidelity and others with a lot of investment experience were caught in the fallout, too. This shows that the governance problems within the cryptocurrency world can also extend outside of it, with negative effects for the entire financial sector.
Another issue, she said, is that distributed ledger technologies and smart contracts are intentionally designed to resist formal, centralized control. Wilkins said this is not an inherent problem, noting that there are ways to establish decentralized governance in a smart and efficient way. With the right safeguards and enough transparency, such a structure can spur growth by framing decisions as a game where participants all have something at stake, which can promote engagement and allow more to have a say.
However, based on what she has observed, this is not what has happened. Not just in terms of the ideal ways of setting up decentralized governance, but in being decentralized at all. She noted that, despite what people may think, massive centralization can still emerge, with Bitcoin as one example. Due to the vast amounts of required computing resources needed to produce new tokens, about 50 entities control about half of its mining capacity.
Part of this is due to Bitcoin's existence as a "proof of work" system which favors those with the most raw computing power. The idea of a "proof of stake" system, which is built more on the idea of system capacity, was meant to be at least a partial corrective to this, but Wilkins pointed out that this has its own issues with concentration. For one, voting rights over proof-of-stake systems are not widely held, with top validators dominating the platforms. More insidiously, proof-of-stake systems can be vulnerable to governance attacks where, say, a hacker uses a flash loan to get governance tokens that allow them to manipulate the system and steal tokens. Wilkins did concede that players in this space are well aware of this issue, and some have taken mitigating steps, like mandatory waiting periods or making governance tokens non-transferrable.
But even a properly decentralized system will still have to contend with other governance issues. One is that the average layperson's understanding of just what it is they're investing in is far less developed than that of the experienced coders and engineers with deep understanding of the underlying architecture. And while the glib response is, "Well, just get that understanding," doing so takes time and energy that most simply do not have.
"The fact is most people have little idea how the protocol works if you have any of these entities. And you could vote, [but] do you really understand the math and all the weeds about what is going on? Probably not," she said, though she added it may not be necessary to do so if the outcomes still align with one's interests.
While crypto market governance is difficult, she said that there are lessons from traditional finance that can be employed. For one, there are things like advisory groups, such as the Treasury Market Practices Group. There could also be a global ethics code signed onto by major players, similar to the one established in the partnership between central banks and market participants from 20 jurisdictions around the world that formed in response to manipulation of the foreign exchange market.
Another possibility is to inculcate strong expectations for transparency. She conceded that public blockchain transactions do contain an element of this, but said it is not enough because of the aforementioned information asymmetry, among other issues. What is needed, she said, is something similar to what is expected of public companies today.
"The likely remedy lies in similar governance that supports transparency in traditional finance, which I think is possible in the crypto space. It's standardized comparative reporting, sharing information, sharing how system funds are evolving, sharing where there are conflicts of interest and related parties (that would have been helpful for FTX), regular audits of code, disclosures of how rights to change the code are determined, etcetera," she said.
She noted that all of these things could be undertaken privately, between players in the space.
"Shared rules of the road [can achieve things] in a way that regulation, telling them what to do, will never achieve: them coming up with something themselves," she said.
Wilkins said that the sector needs more than self-governance, saying there must also be more clarity to the current laws and regulations, particularly with regard to who enforces them. Overall, though, she said that there must be constructive dialogue between the regulatory and cryptocurrency world to build effective governance structures that safeguard consumers while allowing the innovation to grow.
"It's hard to get our arms around that, but there's some pretty sensible places where you can make progress. We may not get to a final perfect solution, but it will be better than where we are today," she said.
