Crypto’s Growing Pains: Security, TradFi Embrace

Crypto, which was born during the 2008-2009 financial crisis, is about to see how it handles the next one.

That’s something Michael Gronager, CEO of blockchain computing firm Chainalysis, finds very interesting, he recently told PYMNTS.

“The idea was basically to build this very transparent value transfer network – non-censorable, everyone had access, very open and so on,” he said. Fourteen years later, he added, “here we are again.”

The first cryptocurrency, bitcoin, was largely a response to the sub-prime mortgage crisis and what its anonymous creator, Satoshi Nakamoto, saw as the corrupt behavior of the traditional financial system and the purported complicity of government and regulators. monitor them. The very first bitcoin block mined on January 3, 2009 had a note attached that quoted a headline from that day’s Times of London as a kind of time stamp – it was clearly about a British bank bailout.

Gronager, whose firm specializes in tracking cryptocurrency transactions along the blockchain, often for law enforcement investigators or companies chasing stolen funds, said that “the initial thoughts around crypto were that this behaves like gold, digital gold.”

That argument was widely embraced for several years, until it became clear that bitcoin and the broader crypto market followed the stock market — especially tech stocks — and were “driven by a lot of the same mechanics,” Gronager said.

“So, when the market took a correction on its traditional financial side, we also saw correction in crypto, which to me almost indicates that it wasn’t really a crypto crash, it was just a market crash,” he said. If crypto was hit harder, he suggested, part of it was that people who had both needed liquidity quickly, and crypto provided it.

Gronager also said that looking at the crypto market will show that while small retail traders may be selling, “traditional large holders, they’re actually buying the dip. People who have been long in crypto and still have high conviction, and they’re actually buying more.”

Maturing markets

One big difference, he added, is that the crypto market is much more mature than during previous bear markets, such as 2013 and 2018.

The crypto market had many problems at the time, Gronager noted, “There was hardly any proper compliance. There was concern about criminal activity. The companies in the area were relatively small” and there was very little participation from traditional financial firms.

“If you look at it today, you’ll find that big payments companies have entered the space” like Block and PayPal, even traditional financial firms like Bank of New York Mellon, Gronager pointed out. “It’s a big, big change – a lot of the problems that needed solutions have been solved in the last 10 years or more specifically in the last couple of years.”

At the same time, he added, crypto is now seen as not just a payment instrument that competes with credit cards and NFC payments, he said.

“What people have realized is that there are so many other opportunities in the crypto space in terms of building other financial instruments … it’s more likely to be an area of ​​growth than in the payments industry,” Gronager said. “I still think payments are important, and I would probably say the most important payments where crypto is used today is clearly in remittances and cross-border transfers, where there’s a lot of friction.”

Stablecoins now

Still, the problem with crypto payments, Gronager said, is that if you’re a retailer and you want to buy things or get paid wages, you’re likely to have an instrument tied to how you pay taxes — a national currency.

“Basically, you want to use a stablecoin or CBDC,” he said, referring to the central bank’s digital currencies. “There really aren’t many use cases that aren’t being solved” by these digital currencies.

That said, a big difference between the two is that stablecoins have been among the fastest-growing and most traded assets in the crypto space, while CBDCs don’t really exist yet, except for a few small startups, he said. (Although the eventual launch of China’s digital yuan will change that.)

As for stablecoins, Gronager said he sees them as “tokenized dollars,” which both makes them very strong and “paves the way for tokenization of other assets.”

While stablecoin regulation has become a central focus of governments, regulators and elected officials over the past couple of years, it’s something, he said, that the crypto industry “has been longing for.”

By regulating something, Gronager said, you support it. “You’re basically saying this is accepted,” he added. “This is something we do, this is how we do it, and these are the common rules” so that companies “know what they can do and how they can best operate.”

Gronager pointed to New York’s BitLicense – which was highly unpopular in the industry due to the difficulty of meeting the requirements – and said it nevertheless made New York “the biggest center for crypto worldwide”.

A long hitting page

As for US regulation, Gronager hinted that he thinks it could take longer than some in the industry hope, despite talk of a comprehensive cryptoregulatory framework next year.

“I was part of a lobby group around the Fifth Anti-Money Laundering Directive” in the EU, he said, noting that the construction of a proper regulatory framework started in 2015. “It took four to five years before anything actually happened law and rolled out.”

One of the areas that needs the most regulatory clarity, he said, is whether cryptocurrencies are securities and how that classification is defined. It has been a major bone of contention, with the US Securities and Exchange Commission (SEC) saying that almost all cryptocurrencies except bitcoin are a security, and the industry arguing that they are more like commodities.

“It’s still a bit of a gray area and it’s something that needs more clarity,” Gronager said, adding that from his perspective “if you look at underlying protocols like bitcoin, like ethereum, like other things, I would definitely call them commodities more than securities.”

But it very much depends on the underlying use cases of tokens associated with a particular project, he added. Which is exactly what the broader crypto industry is saying, and what the SEC currently disagrees with.

Solving that question “isn’t close,” Gronager predicted, saying it hasn’t meant much in traditional finance because there weren’t “a lot of securities that were, I would say, available to a large amount of investors,” in the way that cryptocurrencies is.

Another big area of ​​regulatory focus is and must be decentralized finance, or DeFi, he said.

Follow the money

Gronager’s firm recently called 2022 the biggest year yet for cryptohackers, noting that more than $3 billion has been stolen — the vast majority of it from “bridging” projects designed to facilitate cross-blockchain payments.

These bridges, he noted, automate the process of changing one cryptocurrency into another without having to trade it on an exchange. They do this by locking crypto in a wallet that allows users to withdraw another cryptocurrency for a specific transaction, then return it in exchange for their original tokens.

North Korean hackers have particularly exploited bridges, he said, noting that they are believed to be behind more than $1 billion in thefts.

“Obviously what’s happening here is that there’s new technology being rolled out” mainly in 2021 “when the market was growing like crazy,” Gronager said. “When things grow very, very quickly, people become very focused on getting things to market very quickly.”

When that happens, “the risk of making mistakes, not having revised the code enough, not having thought [the project] through good enough” increases, he said. “Of course you want to see hacks.”

What’s needed, Gronager said, is not just better security for these projects, but “better ethics around making sure that security is high.”

Say Freeze

At the same time, he said, with proper investigations of these cases, freezing of stolen funds is possible.

Chainalysis is usually “able to reach out to our network of crypto exchanges when hacks happen and freeze funds,” he said. “When funds are frozen in an exchange, they can actually be given back to the project from which they were stolen. And at the same time it disables the hackers from actually [off-ramping] the funds.”

Pointing to the $625 million Ronin Network bridge hack in March, Gronager said about 10% has been recovered and paid back to the victim.

“The majority of the funds have still not been laundered,” he added. “They’re still sitting on the blockchain and can’t be moved because we’re in the loop. If they move into a central, they can be frozen. So it’s very difficult for the hackers to move them from there. So things are being done in this area to prevent it, but it has been a bad year.”

At the same time, he pointed several decades back to the rollout of Windows 95, which was on almost all computers.

“If you just opened an email — not even opening it, just looking at the preview of the email, your computer could be hacked,” Gronager said. “Suddenly your computer could be taken over, some of these hacks could actually destroy your hard drive, they could steal important information.”

What it didn’t do, he added, was prevent the growth of the Internet.

“As the Internet grew, many companies built security,” such as antivirus scanners, he said. “Today, operating systems are far more stable, far more secure than they were in the late 90s and early 2000s.”

That’s where the crypto industry is today, Gronager said.

“The technology is young,” he said. “It’s less than 10 years old for the most part. And it’s still hardening every day.”

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