Decentralized Markets and Self-Regulation

The United States is entering a new era of crypto regulation. Recently, SEC Acting Chairman Mark Uyeda announced a new Crypto Task Force led by Commissioner Hester Peirce. As the new administration addresses gaps in cryptoasset oversight, it must balance efficiency, investor protection, and the inherent potential of technological innovation while managing risks and maximizing economic welfare outcomes.

My recent article examines these issues by comparing the structure, risks, and costs of crypto markets with traditional markets. It develops a formal self-regulatory framework covering both centralized and decentralized digital markets to address their structural risks and tap into their efficiencies.

Current Market Structure

Blockchain technology promises to transform financial markets by enabling trading without traditional intermediaries—peer-to-peer trading. Yet, new intermediaries have emerged. They are typically called ‘crypto exchanges’ and can be either centralized (CEXs) or decentralized (DEXs).

CEXs perform several market functions. They bring together cryptoasset buyers and sellers. Trading often occurs on off-chain order books, with transactions later recorded on-chain. CEXs often serve as asset custodians. Today, they have become the primary gatekeepers for retail investors and combine the functions of multiple intermediaries, including underwriters, brokers, market makers, exchanges, and clearinghouses.

Many CEXs, however, have faced criticism for lack of transparency, market manipulation, conflicts of interest, insider trading, and poor governance. The intense and mainly global competition in this sector limits CEXs' incentives and even ability to self-regulate properly. In the extreme, the current system may encourage market manipulation.

Despite performing traditional broker-dealer, exchange, and clearinghouse functions, U.S. CEXs are typically regulated as ‘money transmitters’, which is an inadequate framework for trading platforms. Not surprisingly, there are concerns about the CEXs’ ability to maintain fair and efficient markets without better regulation. The countervailing concern is designing a regulatory approach encouraging innovation without superimposing outdated frameworks stifling technological development.

DEXs operate through smart contracts on blockchains. They promise automated execution, autonomous operations, transparency, and reduced custodial risks, ie., the risks that many CEXs struggle to control. Many DEXs function as automated market makers (AMMs), enabling users trade against liquidity pools without intermediaries.

However, DEXs introduce new risks associated with smart contract code quality issues, developer influence over governance, and new blockchain-native intermediaries (validators and block builders) who can manipulate transaction execution. Other concerns include ‘maximal extractable value’ (MEV) extraction through front-running and back-running trades. Many blockchain-native parties are not overseen through traditional financial regulation, even though practices such as front-running are already addressed in the traditional markets. Instead, the developer community is working on solving these problems through faster execution on Layer 2 blockchains and private mempools [a mempool is a holding area for unconfirmed transactions submitted by transacting parties].

Among other issues that may affect DEXs are fragmented liquidity and price slippage, reliance on potentially compromised external data sources, irreversible transactions with no recourse for errors or fraud, and inadequate vetting of tradable assets before listing. Because DEXs often, by their design, do not vet the assets they list, users can end up with worthless tokens and face the risk of fraud. In sum, while DEXs avoid some CEX problems, they create their own unique challenges. Both exchanges may thus externalize trading costs to investors and the broader market.

The Need for Reform

Several factors make these problems difficult to solve. In a perfect world, CEXs would efficiently screen assets, enforce compliance, and reduce trading costs, while DEXs would rely on transparent, blockchain-native solutions.  Yet, voluntary compliance and private self-regulation are often insufficient due to misaligned incentives. Global competition at the level of jurisdictions and among exchanges triggers regulatory arbitrage. Moreover, information and liquidity barriers may exist among hundreds of trading platforms, even though developers are actively working on solving these problems.

Comprehensive solutions, however, are needed given that price formation is global, with potential spillovers between regulated and unregulated markets. Unfortunately, conventional regulation often fails to address these novel concerns. One key issue is that rapid technological changes, especially when blockchain technology is combined with AI, outpace regulators’ capacity, expertise, and resources.

Proposed Solution: A Two-Tiered Self-Regulatory Model

In my research, I propose solutions by drawing on Friedrich Hayek's insights into decentralized knowledge. The proposed model outlines a formal self-regulatory framework to leverage market participants’ expertise while maintaining regulatory oversight. The U.S. has a strong tradition of self-regulation and stands apart from many other jurisdictions with different self-regulatory models. The expert self-regulatory organization (SRO) model of American financial markets can be easily extrapolated to cryptoasset markets.

I propose a two-tiered model that builds on previous research by Jackson, Massad, and Yadav:

1. Crypto-Exchanges as SROs: CEXs would take on formal self-regulatory functions, including setting listing standards, implementing anti-manipulation measures, and monitoring insider trading. They would either register with existing SROs like the Financial Industry Regulatory Authority and the National Futures Association (FINRA and NFA, respectively) or register as new individual SROs for digital assets.
2. A Policy-Level SRO: To address the problems of DEXs, which often have no central entity that can be easily subject to regulation, and to improve information sharing among all crypto exchanges, I suggest creating a comprehensive policy-level SRO. That SRO would oversee the broader and dynamic regulatory framework and develop uniform standards for cryptoasset markets. It would provide DEX developers with enhanced legal and compliance resources, establish best practices, and create whitelists of compliant DEXs. These measures would send quality signals to the market, informing investors which DEXs are safer than others. Clear information signals would create a separating equilibrium between good and bad actors and drain liquidity from low-quality DEXs.

Structurally, the new SROs could partner with legacy SROs to exchange information and assist in enforcement. Alternatively, existing SROs such as FINRA and NFA could create a joint digital asset task force spanning commodities, securities, and derivatives markets.

Addressing Potential Challenges

Critics of legacy SROs cite concerns about capture by powerful market participants, conflicts of interest, constitutional issues, and under-enforcement. I fully acknowledge that to succeed, reforms must incorporate mechanisms ensuring SRO independence, transparency, and robust oversight while leveraging market expertise and embracing the decentralized nature of digital asset markets, as well as the potential of blockchains to operate more transparently.

The future of digital asset markets depends on their evolution into transparent, efficient, and trustworthy ecosystems. These tasks can only be achieved through collaboration between regulators and industry participants.

Yuliya Guseva is a Professor of Law and Director of the Fintech and Blockchain Research Program at Rutgers Law School.

The author’s complete paper can be found here.