The U.S. is gearing up for some big changes in regulation. But finding the right balance between decentralization and compliance is a major challenge, according to Ben Charoenwong and Jonathan Reiter.
As Bitcoin’s price goes up and institutional investors pour over $20 billion into crypto ETFs, we’re seeing a major shift in digital asset markets. The recent appointment of Paul Atkins as SEC Chair has sparked optimism. He’s known for supporting market-driven solutions rather than heavy-handed enforcement. This gives hope that the crypto industry can finally blend innovation with regulation.
However, the crypto world faces a tough choice. It can either give up the limitless programmability that makes these systems unique or accept that compliance with anti-money laundering laws can’t be fully automated. This isn’t just a temporary tech issue; it’s as fundamental as math itself.
To understand this better, think about a scenario where shells are used as money. If we pass a law that limits transactions to ten per day or restricts ownership to 10% of the total shells, we run into enforcement problems. How do we track who has which shells at what time? This information gap complicates compliance and turns it into a surveillance issue.
Blockchain technology offers a solution. If everyone can see where all the shells are at all times, enforcement becomes straightforward. We can integrate compliance into the system, blocking any banned transactions. Here, the transparency of blockchain allows for automated compliance.
The core challenge comes from something called "undecidability." In traditional finance, when regulators set rules like "no transactions with sanctioned entities," banks can implement these requirements through existing systems. But in a truly decentralized setup, where anyone can create complex smart contracts, it becomes mathematically impossible to know in advance if new code will break those rules.
JPMorgan's recent rebranding of Onyx to Kinexys illustrates this point. The platform now processes over $2 billion in daily transactions, and only those who meet regulatory criteria can participate. Unlike typical crypto platforms, where anyone can write and deploy automated trading programs, JPMorgan’s system ensures compliance by limiting what participants can do.
This approach has attracted major institutional players like BlackRock and State Street, which together manage over $15 trillion in assets. Some crypto enthusiasts see these restrictions as a betrayal of the technology’s promise. But these compromises are not just practical choices; they are necessary for any system that aims to comply with regulations.
The SEC’s role in protecting investors while promoting capital formation has become more complex in today’s digital landscape. Under Gary Gensler, the SEC took a strict enforcement approach to crypto markets, treating most digital assets as securities that require tight oversight. Although Atkins’ expected principles-based approach might seem more flexible, it doesn’t change the fundamental issues that make automated compliance impossible in permissionless, fully programmable systems.
The limitations of automated systems became clear at MakerDAO, one of the largest decentralized lending platforms with over $10 billion in assets. During the market turbulence in March 2024, when Bitcoin’s price fluctuated by 15% in just hours, MakerDAO’s automated systems began triggering a wave of forced liquidations that nearly led to its collapse.
Despite years of refinement and over $50 million spent on development, the protocol needed emergency human intervention to avoid a $2 billion loss. Similar issues at Compound and Aave, which manage another $15 billion in assets, show that this wasn’t an isolated incident. It highlights the challenge of programming systems to handle every potential scenario while ensuring compliance.
Now, the industry faces three possible paths, each with distinct implications for investors:
First, follow JPMorgan's example by creating permission-based systems that trade some decentralization for clear regulatory compliance. This approach is gaining traction, with six of the top ten global banks launching similar initiatives in 2024, handling over $2 trillion in transactions. The rise in regulated crypto products, from ETFs to tokenized securities, further supports this direction.
Second, limit blockchain systems to simple, predictable operations that can be automatically verified for compliance. Ripple has taken this route with its newly launched RUSD, designed to meet New York Department of Financial Services standards. While this approach restricts innovation, it allows for decentralization within defined boundaries.
Third, continue pursuing unlimited programmability while accepting that such systems can’t guarantee strong regulatory compliance. This path, chosen by platforms like Uniswap, which had over $1 trillion in total trading volume in 2024, faces increasing challenges. Recent regulatory actions against similar platforms in Singapore, the U.K., and Japan suggest that this approach may struggle in developed markets.
For investors navigating this evolving landscape, the implications are clear. The current market enthusiasm, largely driven by regulated products like ETFs, indicates a shift toward the first option. Projects that recognize and address these fundamental constraints, rather than resisting them, are likely to succeed. This trend explains the significant growth in traditional financial institutions’ blockchain initiatives, with JPMorgan’s platform reporting a 127% increase in transaction volume this year.
The success stories in crypto’s next chapter will likely be hybrid systems that balance innovation with practical limitations. Investment opportunities exist in both regulated platforms that provide clear compliance guarantees and innovative projects that thoughtfully limit their scope for safety.
As the market matures, understanding these mathematical constraints will be crucial for investors’ risk assessment and portfolio management. The evidence is already apparent in market performance: regulated crypto platforms have delivered average returns of 156% over the past year, while unrestricted platforms face increasing volatility and regulatory risks.
A principles-based approach from Atkins might offer more flexibility than Gensler’s strict rules, but it can’t change the fundamental limits of automated compliance. Just as physics sets boundaries in the physical world, these mathematical principles impose limits in financial technology. The real challenge isn’t cryptocurrency itself; it’s the belief that we can have unrestricted programmability, complete decentralization, and guaranteed regulatory compliance all at once.