As Bitcoin continues to soar and institutional investors pour over $20 billion into crypto ETFs, a fundamental shift is taking place in digital asset markets. The appointment of Paul Atkins as SEC Chair, known for favoring market-driven solutions over heavy-handed enforcement, fueled optimism that crypto could finally balance regulatory change.
But the crypto industry faces a stark choice that no amount of regulatory flexibility can overcome: either sacrifice the unlimited programmability that makes these systems revolutionary, or accept that their compliance from an anti -money laundering regulation perspective cannot be fully automated or built into the system. This is not a temporary technological limitation regarding one system or another – it is as fundamental as the laws of mathematics.
Automating Market Integrity
To begin to see why, we can think about an economy where shells are money. If we pass a law that no one can transact more than 10 times per day or hold more than 10% of the shells, we have an enforcement problem. How do we know who holds the shells when? Information asymmetry prevents compliance and adherence to a surveillance challenge.
Blockchain technology solves that problem. If everyone can see where all the shells are at all times, then the implementation works. We can build compliance into a system and reject illicit transactions. Here, transparency from the blockchain enables automated compliance.
But Web3’s long-held premise is to automate stock exchanges and vastly more complex interactions. Doing so requires moving beyond shells to a system where users create their own assets and upload their own programs. And unauthorized access to publish these complex programs poses a problem for users who may be exposed to malicious programs or scams, the system which may be overcrowded, and regulators who care about preventing financial crimes.
The main challenge lies in what computer scientists call “undecidability.” In traditional finance, when regulators impose rules such as “no transactions with sanctioned entities” or “maintain adequate capital ratios,” banks can enforce these requirements by their existing control systems. But, in a truly decentralized system where anyone can deploy sophisticated smart contracts, it becomes mathematically impossible to verify in advance whether a new piece of code might violate these rules.
JPMorgan’s recent rebranding of Onyx to Kinexys illustrates this fact. The platform now processes over $2 billion in daily transactions, and participation is by participants who meet regulatory criteria before joining. Unlike typical cryptocurrency platforms where anyone can write and deploy automated trading programs (known as smart contracts), JPMorgan’s system maintains compliance by restricting what participant.
This approach has attracted major institutional players like BlackRock and State Street, which together have more than $15 trillion in assets under management. Many crypto enthusiasts see such restrictions as a betrayal of the technology’s promise. These compromises are not just practical choices – they are necessary for any system that aims to guarantee regulatory compliance.
The Securities and Exchange Commission’s mandate to protect investors while facilitating capital formation has become increasingly complex in the digital age. Under the leadership of Gary Gensler, the SEC has taken a strict enforcement approach to crypto markets, treating most digital assets as securities that require strict supervision. While the prospective approach based on Atkins principles may seem more helpful, it cannot change the underlying mathematical constraints that make automated compliance impossible in permissionless, fully programmable systems.
The limitations of fully automated systems have become painfully clear with MakerDAO, one of the largest decentralized lending platforms with over $10 billion in assets. During the market turmoil in March 2024, when the price of Bitcoin skyrocketed by 15% in a few hours, MakerDAO’s automated systems began to trigger a cascade of forced liquidations that threatened to bring down the entire platform.
Despite years of refinement and over $50 million spent developing the system, the protocol required emergency human intervention to prevent a $2 billion loss. Similar incidents at Compound and Aave, which together hold another $15 billion in assets, underscore that this is not an isolated case. This is not just a technical failure – it demonstrates the impossibility of programming systems to handle every potential scenario while maintaining regulatory compliance.
Towards the Next Crypto
The industry now faces three paths forward, each with unique implications for investors:
First, follow JPMorgan’s lead by developing permission-based systems that sacrifice some decentralization for transparent regulatory compliance. This approach has already gained significant traction: six of the top ten global banks have launched similar initiatives by 2024, collectively handling over $2 trillion in transactions. The rise of regulated crypto products, from ETFs to tokenized securities, further validates this path.
Second, limit blockchain systems to simple, predictable operations that can be automatically verified for compliance. This is the approach adopted by Ripple with its newly launched RUSD, which is designed to comply with the standards of the New York Department of Financial Services based on limited purpose trust company framework. While this stifles innovation due to the restricted action space that users can take, it enables decentralization within carefully defined boundaries.
Third, continue to push for unlimited programmability while accepting that such systems cannot provide strong regulatory guarantees. This path, chosen by platforms like Uniswap with more than $1 trillion total trade volume in 2024facing increasing challenges. Recent regulatory actions against similar platforms in Singapore, the UK and Japan suggest that this strategy’s days may be numbered in developed markets.
For investors navigating this evolving landscape, the implications are clear. The current enthusiasm in the market, largely driven by regulated products like ETFs, indicates that the industry is moving towards the first option. Projects that recognize and address these key constraints, rather than combat them, are likely to thrive. This explains why blockchain initiatives by traditional financial institutions, despite their limitations, are seeing remarkable growth – JPMorgan’s platform reported a 127% increase in transaction volume in the year this.
The success stories in the next chapter of crypto will likely be hybrid systems that balance innovation with practical constraints. Investment opportunities exist in both regulated platforms that provide clear compliance guarantees and innovative projects that carefully limit their scope to achieve verifiable safety characteristics.
As this market grows, understanding these mathematical constraints becomes important for investors’ risk assessment and portfolio allocation. The evidence is clear in the performance of the market: regulated crypto platforms have delivered an average return of 156% over the past year, while unrestricted platforms face increased volatility and regulatory risks.
An approach based on Atkins’ principles may offer more flexibility than Gensler’s prescriptive rules, but it does not negate the fundamental limitations of automated compliance. Just as physics constrains what is possible in the physical world, these mathematical principles set immutable boundaries in financial technology. The impossible dream isn’t cryptocurrency itself – it’s the notion that we can have unrestricted programmability, complete decentralization and guaranteed regulatory compliance all at once.
For the crypto industry to deliver on its revolutionary potential, it must first recognize these immutable obstacles. The winners in this next phase will not be those who promise to overcome these mathematical limitations, but those who design clever ways to achieve them.
