Code can be better than law.
Most of the conversation about policy in Web3 has centered around what crypto pioneer Nick Szabo calls “wet code” – in this case, the laws that govern human institutions. The world of crypto offers an alternative – “dry code,” or computer code – to protect investors and users, which may be a more efficient approach by literally encoding rules in verifiable, permissionless and self-custodial protocols.
It is an approach that relies on incentives and the transparency of the technology itself.
Why regulations matter
Let’s take a step back and consider the stated reason for financial regulation. Regulations are important because they can promote orderly and efficient markets and protect investors from those who may take advantage of them.
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Take the problem of leverage, i.e., when people trade on margin, or borrowing money they have to pay back. Without going into detail, the math behind leverage is such that gains and losses increase linearly while risk increases quadratically.
In other words, if you have 5x leverage you only gain or lose 5x against a given price movement, but your risk of being liquidated increases by 25x. Leverage, by its nature via math, sets the house up to win.
Couple this with the fact that exchange operators act as central clearing houses performing the settlement of trades. Historically, large institutions have filled this role, being willing to take the other side of a trade and eat the losses in the case a trader defaults.
To catch up: You have investors with access to leverage taking risks that increase quadratically, and centralized exchanges settling the results of their bets.
Exchanges also have access to information regarding liquidation prices that the rest of the market does not have, and an incentive to manipulate the market for their own gain.
You can see why regulators are interested in this arrangement and are needed to prevent exchanges from trading against their customers.
Regulations have a defined role and clear mandate to oversee centralized entities that, for the most part, can operate opaquely as far as clients having access to their inner workings.
