Crypto & Regulation

Regulation was a hot topic at the 2022 Bitcoin conference in Miami a few weeks ago. For many in the pro-crypto court, they believe that regulation is a key blocker to helping unlock the next wave of adoption. With clearer Do's and Don't's from regulators both investors and builders in the space will have clearer guidelines to move forward on. But there is also the need for regulation to clean up some of the current mechanics in the crypto space which are...less than transparent. Let's dive into why.

So a lot has been made over the last 2-3 years of using tokens as part of a private sale to raise capital for certain projects. Solana, Ape Coin, Fantom, and others have all used this tactic to raise capital from investors in a private offering before their token is listed on an exchange for the public to be able to buy and sell.

Now startups have been raising private capital for decades and there is nothing wrong with this process. Private, early-stage investors are there for a reason and provide a vital function in the overall capital stack to invest in high-risk, high-reward companies that often have a promising product or technology, but little to no traction at that point in time.

For a lot of crypto/blockchain startups, this has involved a private token sale. These early investors often get to purchase large chunks of the company's native cryptocurrency at a steep discount during these private sales. 

Now we need to change course a bit and learn about another characteristic of cryptocurrencies, perpetual futures. In equity markets, particularly stock markets we have options. Options are a contract between two parties in which one party borrows shares from another party via a contract in which you are stating that you believe the stock price will go up or down. If you guess right, that contract has a price at which you can buy those shares and then immediately sell them at the current price, and you get to take the delta between the actual price and the option price of those shares. If you guess wrong, the person you borrowed the shares from gets to keep the money you spent on borrowing the shares and the option expires (yes they have expiration dates).

So what is a perpetual future or option? In crypto-world, they are essentially a never-ending option contract in which you either go short (think the price is going to decrease) or go long (think the price is going to increase). You open a position, someone takes the opposite side, and as the price of a token goes up or down there are rates set by which one side must pay the other as the price of the token moves. Similar to the options, just in a more fluid and dynamic environment.

So what is the concern here? Well in public markets, the public has access to what are called "insiders" and institutional investors lists. That is those private investors who buy in large chunks. Why is that? Well, insiders and large shareholders often have the ability to move the price of the stock if they begin buying or selling in large chunks. Options orders also have a public book and that is to prevent an insider or institutional shareholder from using an option contract to impact the price of the stock. If you saw a firm that owns 10% of a company opens a long call option at a higher price people might see that and think "the price is gonna go up" and buy into the stock which will then drive the price up. This is a no-no for obvious reasons, but how does it come back to crypto and perpetual futures?

Well, remember those private token sales? In crypto there are not similar reporting requirements, so an investor can hold 5% of the supply of a token from a private sale and you or I have no idea. Say they bought that token at $0.05 in the private sale and then that token gets listed on major exchanges for $0.50. There is a ton of marketing and hype about this token and the project and retail traders are eager to buy-in. Well first, the private investors already got a 10x bump on their investment. For most, that is a nice return and so they might want to sell some tokens on the initial influx at the listing.

This is where things get a bit, dishonest. That same investor might go to the perpetual futures market and take out a short position. Knowing that they intend to dump their tokens on the open market, even if retail traders are excited the % that insiders hold and can dump is enough to depress the price even if retail traders come in and buy. And not only are they selling tokens for a profit as the price slides, but if they have a short futures contract they are making a profit over there from the price decline which they are able to directly and materially impact from their stake.

Not a great setup for a system that is meant to be transparent and build public trust. It actually by design allows those in the know to do the exact thing we have spent decades trying to build rules around for our public markets. And this is why crypto, in my humble opinion, needs regulation sooner rather than later. 

I know what crypto folks will say in response to this, that it is "all on-chain and transparent so why would someone do this, they would be exposed". And to that, I want to say that there is a huge difference between transparency and a system that is built to be transparent. Ever tried to figure out what your health insurance covers? Yeah me too, it's a complicated web that is part of the system that is designed to confuse and take advantage of that confusion but they get to say "it is all laid out in your plan".

Crypto feels like the health insurance industry right now. Yes, technically it is transparent and everyone is provided the same information. But to those in the know, they have a far greater advantage. Rarely do I see crypto folks (just like health insurance companies) trying to educate folks on how to read the on-chain data. Thought leaders in the space typically focus on all the merits of the technology and never bother to help try and teach people how to read and understand the data involved in these networks. Sure it is "public", but if you don't know how to interpret it then it might as well be a fixed game.