As Bitcoin continues to rise and institutional investors pour over $20 billion into crypto ETFs, a fundamental shift is occurring in the digital asset markets. The appointment of Paul Atkins as SEC Chair, known to favor market-driven solutions over heavy-handed enforcement, has spawned optimism that crypto can finally balance innovation with regulation.
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 perspective cannot be fully automated, or be built into the system. This is not a temporary technological limitation of some system – it is as fundamental as the laws of mathematics.
Automating market integrity
To begin to see why, we can think of an economy where shells are money. If we pass a law that no one can trade more than 10 times a day or hold more than 10% of the shells, we have an enforcement problem. How do we know who has which shells when? Information asymmetry prevents compliance, and compliance turns into a monitoring challenge.
Blockchain technology solves that problem. If everyone sees where all the shells are at all times, then enforcement works. We can build compliance into a system and reject prohibited transactions. Here, the transparency from blockchain enables automated compliance.
But the longstanding premise of Web3 is to automate exchanges and countless complex interactions. Doing so requires moving beyond the shells to a system where users create their own assets and upload their own programs. And permissionless access to publish these complex programs causes problems for users who may be exposed to malicious programs or fraud, the system which may face overload, and regulators concerned with preventing financial crime.
The core challenge lies in what computer scientists call “undecidability”. In traditional finance, when regulators impose rules such as “no transactions with sanctioned entities” or “maintain capital adequacy ratios”, banks can implement these requirements through their existing control systems. But in a truly decentralized system where anyone can implement 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 reality. The platform now processes over $2 billion in daily transactions, and participation is by participants who meet regulatory criteria before signing up. Unlike typical cryptocurrency platforms, where anyone can write and implement automated trading programs (known as smart contracts), JPMorgan’s system maintains compliance by limiting what participants can do.
This approach has attracted major institutional players such as BlackRock and State Street, which together have more than $15 trillion in assets under management. Many crypto enthusiasts see such restrictions as betraying the technology’s promise. These trade-offs are not just pragmatic choices – they are necessary for any system that aims to guarantee compliance with the law.
The Securities and Exchange Commission’s mandate to protect investors while facilitating capital formation has become increasingly complex in the digital age. Under Gary Gensler’s leadership, the SEC took an enforcement-heavy approach to crypto markets, treating most digital assets as securities that require strict oversight. While Atkins’ expected principles-based approach may seem more accommodating, it cannot change the underlying mathematical constraints that make automated compliance impossible in permissionless, fully programmable systems.
The limitations of fully automated systems became painfully apparent at MakerDAO, one of the largest decentralized lending platforms with over $10 billion in assets. During March 2024’s market turbulence, when Bitcoin’s price fluctuated 15% in hours, MakerDAO’s automated systems began triggering a cascade of forced liquidations that threatened to collapse the entire platform.
Despite years of refinement and over $50 million spent on system development, the protocol required human intervention to prevent a $2 billion loss. Similar incidents at Compound and Aave, which together handle another $15 billion in assets, underscore that this was not an isolated incident. This was not just a technical error – it demonstrates the impossibility of programming systems to handle all potential scenarios while complying with the law.
Mod compatible crypto
The industry now faces three paths forward, each with distinct implications for investors:
First, follow JPMorgan’s lead by building permission-based systems that sacrifice some decentralization for clear compliance. This approach has already gained significant traction: Six of the ten largest global banks have launched similar initiatives by 2024 and together handle 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 Ripple has taken with its recently launched RUSD, designed to comply with New York Department of Financial Services standards based on the limited trust business framework. Although this limits innovation due to the limiting scope of action that users can make, it enables decentralization within carefully defined boundaries.
Third, continue to seek unlimited programmability while accepting that such systems cannot provide strong regulatory guarantees. This path, chosen by platforms like Uniswap with its over $1 trillion in total trading volume by 2024, faces increasing challenges. Recent regulatory actions against similar platforms in Singapore, the UK and Japan suggest that this approach’s days may be numbered in developed markets.
For investors navigating this evolving landscape, the implications are clear. The current market enthusiasm, mainly driven by regulated products like ETFs, indicates that the industry is moving towards the first option. Projects that recognize and address these fundamental limitations rather than fighting them are likely to thrive. This explains why traditional financial institutions’ blockchain initiatives, despite their limitations, are experiencing dramatic growth – JPMorgan’s platform reported a 127% increase in transaction volume this year.
The success stories of crypto’s next chapter are likely to 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 security properties.
As this market matures, understanding these mathematical limitations becomes critical to investors’ risk assessment and portfolio allocation. The proof is already evident in market performance: regulated crypto platforms have delivered average returns of 156% over the past year, while uncapped platforms face increasing volatility and regulatory risks.
Atkins’ principles-based approach may offer more flexibility than Gensler’s prescriptive rules, but it cannot override the fundamental limits of automated compliance. Just as physics limits what is possible in the physical world, these mathematical principles set immutable limits on financial technology. The impossible dream isn’t the cryptocurrency itself—it’s the notion that we can have unlimited 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 limitations. The winners in this next phase will not be those who promise to overcome these mathematical limits, but those who design intelligent ways to work within them.
