Recently, the CEO of a crypto exchange in Canada died, and with him went the crucial password that he had used to secure crypto assets of his customers on an offline storage device.
This event has brought to the fore the question of regulation with respect to these new forms of digital assets.
In traditional financial markets, customer funds are always protected through regulatory frameworks enforced by the Central Bank such that whenever banks collapse, for whatever reasons, the customer’s funds are recoverable.
Of course in the crypto-currency world as demonstrated by the bitcoin crypto, this regulatory or governance role is decentralised and distributed amongst peering nodes owned by anyone who is willing to download, install and run the bitcoin protocol.
The governance rules are coded within the protocol that simply runs checks for each transaction request that wants to move funds from one account to the other.
Each of the participating nodes check to see if the user wishing to send one crypto from an account to another account actually has sufficient funds. Additionally, the protocol checks if the same crypto is not being simultaneously sent to two parties in what is known as a ''double-spend''.
There is no central node doing these automated checks but instead there are multiple nodes independently doing the checks and subsequently coming to a consensus that indeed the transaction is valid and should subsequently be accepted into the financial ledgers.
To incentivise the majority of the nodes to do the right thing by not cheating or colluding to accept fraudulent transactions, the bitcoin protocol offers them a challenging race to resolve a mathematical puzzle.
The mathematical puzzle is sufficiently difficult and requires that the nodes expend some significant energy or computational effort to resolve.
The node that is the first one to correctly validate the transaction request and resolve the puzzle ahead of the rest automatically gets rewarded or compensated beyond the energy or computational effort expensed.
The nodes that missed out on the reward cross-check and confirm that the solution proposed by the winning node is correct and subsequently accept the transaction in their ledgers.
Immediately there after, they start processing the next set of transactions with a view to resolving the next puzzle and claiming the associated reward.
This process of digital asset exchanges and validations continues autonomously as long as there is a good number of people or nodes incentivised enough to join the race to process transactions.
This new scheme of regulatory framework tends to clash with the traditional centralised framework which has actually worked like clockwork over the last ten years, the lifespan of the bitcoin network.
Many pundits assumed that the recent event of the CEO dying with passwords meant that the bitcoin or crypto ecosystem had finally found its waterloo and collapsed.
The reality however is that the bitcoin network is still quite stable but the downstream services like crypto-exchange are full of challenges.
A crypto-exchange is very much like a forex exchange, but accepts crypto currencies like bitcoin and exchanges the same into other currencies, including dollars.
If one or two forex exchanges collapse due to poor internal processes, this is by no means the end of, say, the Central Bank. Similarly, the crypto-exchange that died with its owner has no impact on the stability or otherwise of the bitcoin network.
It however does remind us of the need to provide strong regulatory frameworks around new start-ups that want to experiment with digital assets within the financial technology space.
In summary, we should expect two often-conflicting forms of regulation working in tandem but at different levels.
The decentralised governance framework will keep the core and the bitcoin or crypto nodes running autonomously while the traditional centralised governance framework would keep the downstream services like crypto-exchanges in proper check.
This would ensure that customer funds do not disappear because someone dies.
Mr Walubengo is a lecturer at Multimedia University of Kenya, Faculty of Computing and IT.
Email: [email protected], Twitter: @Jwalu