Compliance Doesn’t Make Crypto Risk-Free

Compliance Doesn’t Make Crypto Risk-Free | Opinion

In the ever-evolving landscape of cryptocurrency, compliance with regulations is essential, but it does not guarantee safety from risks. Many crypto projects may adhere to legal frameworks and pass regulatory checks, yet they remain vulnerable to severe operational failures. This article explores the limitations of compliance in preventing losses, the current state of the cryptocurrency industry, and the need for a more robust risk management framework.

Key Takeaways

Compliance with regulations does not eliminate risks associated with cryptocurrency projects.
Many compliant projects face significant losses due to operational failures rather than malicious actions.
A focus on compliance alone can lead to a false sense of security among investors and users.
There is a pressing need for better risk assessment frameworks within the blockchain industry.
The development of a “Probability of Loss” metric could provide a clearer understanding of a project’s risk factors.

Compliance brings traditional market rules to crypto, but it doesn’t make the compliant project invulnerable or risk-free.

Regulatory Compliance and Its Limits

Despite spending large sums on legal advice and maintaining transparency, a cryptocurrency project can still fail dramatically due to simple mistakes, like a coding error within its smart contract. This highlights a critical aspect of crypto regulation: while compliance can help mitigate certain risks, it does not protect against all forms of failure.

Different jurisdictions have implemented various regulations to shield against money laundering, market manipulation, and the misuse of consumer funds. However, the fragmented nature of regulatory standards makes it difficult for all players to adhere uniformly. Many regulations are focused on protecting users but fail to enhance how market participants manage their operations effectively.

For instance, the EU Digital Operational Resilience Act (DORA) requires financial entities to vet third-party providers and monitor their security, yet these measures do not prevent actual operational failures. Cyber attacks can happen rapidly, often outpacing the ability of regulatory audits to catch issues in real time.

The Risks of Compliance as a Marketing Tool

Currently, compliance is often utilized as a marketing tactic in the crypto space, where regulatory adherence is mistakenly equated with safety. A basic Know Your Customer (KYC) process does not imply that a project is inherently secure, especially if there are underlying operational flaws.

The reliance on “checking the boxes” is flawed. Compliance is intended to deter criminal activities and bring projects into the regulatory framework but does not guarantee against failures. In the world of cryptocurrency, poor management can lead to losses far more significant than those caused by deliberate fraud.

Analyzing Financial Losses in Crypto

Examination of financial losses in 2024 reveals that compliant, well-established businesses, such as centralized exchanges and infrastructure projects, suffered greater financial losses compared to decentralized protocols. Notably, regulated exchanges like Japan’s DMM Bitcoin and India’s CoinDCX and WazirX were involved in significant financial losses not due to fraud but due to operational failures linked to malware in supply chain attacks.

The reality is that essential aspects like proper key management are often overlooked in compliance checks, which focus primarily on auditing code rather than assessing overall operational risk.

Bridging Compliance with Measurable Risk

There is a misconception that obtaining a regulatory license equates to operational safety. While compliance effectively keeps criminals away, it does not necessarily ensure that a project will function consistently or avoid going bankrupt. A project may adhere to Anti-Money Laundering (AML) laws yet still face severe threats from mismanaged operations.

We are still at the initial stages of establishing effective regulatory systems in the blockchain space. Expecting regulations to address all market complications is unrealistic, and therefore the industry must explore self-regulatory measures. One promising approach is creating a “Probability of Loss” framework, which provides a mutual understanding of risk assessment beyond compliance.

Hacken is developing a self-regulation platform currently in beta testing, which employs the Probability of Loss (PoL) metric. This metric acts much like a credit score for web3, offering insights into a project’s risk profile through a combination of indicators related to security and historical behavior.

Reevaluating Due Diligence in Crypto

The current trust model within the crypto industry relies heavily on superficial factors, such as notable endorsements and a regulatory license, which do not reflect a project’s true structural integrity. The fundamental question has shifted from “Are they compliant?” to “What is the likelihood of their failure?”

Moving forward, the market needs to price risk based on real-world factors rather than mere compliance appearances, fostering a healthier and more dependable cryptocurrency ecosystem.