How to play in a (regulatory) sandbox

‘Sandboxes’ are all the rage with regulators since having been initiated by the UK’s Financial Conduct Authority in 2016. South Africa’s own Reserve Bank is in the process of establishing one which is expected to be operational in late 2019. Although regulators have a conservative mandate, it is also in their interests to encourage innovation. A ‘sandbox’ provides the regulator with insight into the types of innovation being explored by FinTech entrepreneurs, and the ability to provide guidance to them at an early stage. Here are my observations:

It’s not hard to create a sandbox

  • Regulators already have the authority to relax certain regulations – they don’t need to ‘ask permission’. 
  • However, the regulator should have a good grasp of the benefits they intend to obtain in the longer-term from establishing a ‘sandbox’.
  • This should not be seen as a PR exercise by the regulator, but as an important investment with a longer-term return to the regulator.
  • This return can be seen as deeper insight into the activities of disruptive innovators (as the regulator will typically not see the data from entities outside of their purview). This data can form the basis of policy decisions and changes to regulatory parameters. 
  • Writing new legislation is very challenging — takes years to develop the white paper and it reams of lawyers to review for consistency with other laws and regulation. A ‘sandbox’ can be a mechanism to fast-track that process.

Make friends

  • The regulator will be building relationships at a key stage with the founders of FinTech entities — some of which will go on to become systemically important.
  • The intensity of activity within a sandbox will quickly expose people’s true value systems and drivers. Malicious and selfish intent will become obvious, as will goodwill and generous behaviour.
  • The shared experiences will build bonds between the participants in the sandbox. These relationships will foster respectful interaction between them over the remaining course of their careers, which in many cases will be in large regulated financial institutions. 

Encourage diversity in your sandbox

  • Regulators must also invite the incumbents (large banks, insurers) into the sandbox — so that their own internal innovation units can also experiment.
  • FinTech entrepreneurs from neighbouring countries should be encouraged to participate. They are typically solving similar problems for a similar customer base.

Kids have differences

  • A ‘sandbox’ is intrinsically discriminatory against the incumbents. Relaxing a regulation for a set of participants inside the sandbox gives them an advantage against the incumbents using the existing regulatory ‘straightjacket’. 
  • However, this is a necessary action to ‘level the playing-field’ for new entrants, as they do not have the array of market advantages that the incumbents enjoy (balance-sheet, credibility, customer base, tech capability, low marginal costs, etc).

Not everyone can play

  • Both entry and exit criteria for access to the sandbox need to be established. Entry criteria must be relevant to a start-up (i.e. no financials, limited corporate documents), but it is fair to ask that they are domiciled in the regulators’ jurisdiction. 
  • Exit criteria are very important — at what scale must the sandbox participant now be forced to comply with regulations, and how is that process enforced?

Play must be supervised

  • A sandbox does not provide freedom from rules, just a (temporary) relaxation of some regulations. Participants in a sandbox must still adhere to basic corporate governance and general law.
  • Customers will be used as ‘guinea pigs’ and the regulator must still ensure that they are not exploited or harmed by the activities of ‘sandbox’ participants. 
  • It is essential that the regulator dedicate a team of people to manage the sandbox. They need to have this as their primary responsibility and they need to understand that this is not a short-term assignment, but effectively a new division of the regulator. This team must consist of a variety of skills and experience-sets.
  • A sandbox intrinsically cuts across the organisational boundaries of the regulator. Therefore it needs sponsorship and executive support from the very top of the regulator, to resolve these organisational politics.

Sharing is caring

  • The regulator can also play a role in sharing practices identified from within the sandbox, to the incumbents it oversees. These practices can improve the technical competence of these incumbents — thereby minimising systemic risk to the regulator.
  • Entrepreneurs often copy innovative solutions from the international market into the local environment. By observing solutions being built in the sandbox the regulator can gain insight into these international best-practices and offerings.
  • A valuable benefit the regulator can provide to ventures in the ‘sandbox’, is direct access to knowledgeable people inside the regulator. These people often have many years of experience in the industry and would provide a very valuable resource to entrepreneurs. Access to these resources is actually a unique selling proposition of a ‘sandbox’ to entrepreneurs…

Be messy

  • Entrepreneurs don’t play by the rules, and the regulators must expect that activity in the sandbox will not be linear and predictable, but organic and chaotic. Do not expect monthly progress reports or even project plans.
  • A sandbox may also include an ‘incubator’ capability, which could be an office environment for entrepreneurs to work from. My own view is that there is a surplus of incubators, and the regulator often does not have the most attractive premises for start-ups.

Don’t hurt others

  • As disruptive innovators often exploit process weaknesses and ‘arbitrage’ regulation, insights from the sandbox can help the regulator identify these ‘problems’. This can help them to either resolve these issues or guide the entrepreneurs towards ‘safe’ solutions.
  • FinTech entrepreneurs operate in a very stressful environment, and naturally, emotions will be high. Expect occasional jubilation and also despair as funding runs out and closely-held ideas get proven incorrect.
  • A key role for the regulator is to protect those inside the sandbox (often throwing sand) from the ‘grown-ups’ outside the sandbox. The regulator needs to persuade the incumbents of the longer-term and industry-wide value of FinTech innovation.
  • The regulator will also be called on to protect the entities within the sandbox from each other. There will often be more than one participant working on the same problem, and the protection of IP may become a challenge. A smart regulator will help these businesses to see opportunities to collaborate together.

Take personal responsibility

  • The success of participants in a sandbox is directly attributable to the skills and passion of the participant. There is no-one else to blame and ‘politics’ is pointless. 
  • The regulator will typically not have funds to provide to entrepreneurs as seed funding/acceleration and would tie themselves in red-tape trying to fairly allocate that. 
  • The provision of seed funding and acceleration capabilities (cloud computing facilities, legal and accounting services, etc) should best be provided by the existing FinTech ecosystem. 
  • The regulator could perhaps lobby the tax authorities for tax credits/benefits for small FinTech firms, or for the VC firms that supply them with capital — perhaps a tax rebate for angel investors who provide capital to VC firms or direct to FinTech firms?
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Stablecoins Will Fall Over. Here’s why:

I recently read a post by Seshree Govender on stablecoins. In case you’re new to crypto, stablecoins are crypto assets which are backed by the value of a ‘stable’ asset. For example, the cryptocurrency Tether (USDT) is linked to the US dollar and Facebook’s Libra will be backed by a basket of real-world assets including bank deposits and short-term government securities.

The classic approach to evaluating a cryptocurrency is to measure it against the three primary attributes of money: a medium of exchange, a unit of account and a store of value. Some cryptocurrencies have attracted significant attention and investment and have a market cap that indicates that they are perceived to have some permanent ‘store of value’ benefit. However, there has been significant volatility in their prices, relative to a range of fiat currencies.

Stablecoins are designed to minimize volatility. Although they do reduce the volatility experienced by many cryptocurrencies, this solution has some fatal flaws. I anticipate that these flaws will cause the stablecoin bubble to burst and that these projects will be abandoned. Although volatility in the price of cryptocurrencies will persist, I expect that this will moderate over time as regulation of cryptocurrency exchanges cools down speculative trading. Even extreme volatility is not problematic for properly-structured BitcoinSV merchant payment processing. A much more serious problem is high mining fees (such as those with BTC), which act as ‘friction’ for payments.

In my opinion, the fundamental reason that stablecoins exist is flawed. The argument is that without price stability, cryptocurrencies cannot be used as a medium of exchange or a unit of account. This argument may be based on old-school bank thinking, where the time difference between when a transaction is initiated and when the underlying funds flow could be hours or even days. A BitcoinSV transaction is ‘cleared’ and ‘settled’ (using banking terminology) simultaneously, so there is no volatility in price through the duration of the transaction.

Furthermore, simple mechanisms exist for merchants to price their goods and receive their payments in fiat currency, without having any exposure to cryptocurrency volatility. These mechanisms are inherent in the BitcoinSV ecosystem, without the need to build a complex and unnecessary stablecoin infrastructure on top of the cryptocurrency itself. The mechanism is simply that the merchant (or their processer) sells any BitcoinSV received as soon as they receive it. This function is provided by service providers (called Bitcoin Payment Processors) to merchants, analogous to the role bank card acquiring companies play in processing international transactions for bank customers.

Stablecoins also require merchants to create new tender-acceptance mechanisms for each stablecoin. As it is, merchants are very reluctant to introduce new tender mechanisms into their till-points, have barely started accepting Bitcoin, and will simply not be interested in accepting a host of new stablecoins. Without an ability to spend the stablecoin, it loses the ability to be used as a medium of exchange.

By definition, a stablecoin is not its own unit of account as it is tied to the price of another asset. It is merely a store of value. But if its value is tied to the value of another asset why not simply purchase that asset instead, without all the hassle of using a stablecoin cryptocurrency?

If owning a stablecoin is essentially the same as owning the underlying asset, then the regulations of that underlying asset will naturally accrue to that stablecoin. This means that a stablecoin will very likely be seen as deposit-taking by financial regulators, and the stablecoin issuers will quickly face the same regulatory and compliance burdens as a bank. Regulators will also require that moving that stablecoin across national borders will require ‘processors’ to validate that both the sender and receiver of those stablecoins have proven their sources of funds, have been checked against global anti-money-laundering and terrorist financing watchlists, and have their tax affairs in order.

People often see cryptocurrency as a measure to mitigate the systemic risks associated with fiat currency. Primary amongst these is inflation, as all fiat currencies lack tangible backing and are debt-based. Stablecoins are exposed to the exact same systemic and idiosyncratic risks as the underlying fiat currency, so can they really work as a store of value when compared to non-debt-based cryptocurrencies? I don’t think so.

In cryptocurrency, there is no counterparty against whom you can exercise your rights of ownership. This is an important concept. When fiat currency is created, a simultaneous sovereign debt obligation is created, exposing holders to risks such as political risk and the inadequacy of monetary policy. Under the theory of Relative Purchasing Power Parity, the difference between countries’ rates of inflation and the cost of commodities drive changes in the exchange rate between them. Why would you choose to own an inherently depreciating stablecoin when you could own negative-inflation cryptocurrency as a real store of value instead?

In my opinion, all the infrastructure required to operate a stablecoin is unnecessary and wasteful. Validation of the fiat currency resources backing the stablecoin must be transparent, be done diligently by independent auditors and be an on-going process. Currently, there are absolutely no regulations or compliance in effect and no consequences if the company behind the stablecoin isn’t actually doing that. The recent accounting concerns around the stablecoin Tether should be noted. The opportunity for fraud and scams in stablecoins is very lucrative. It doesn’t take much to manipulate the fiat treasury – an easy thing for insiders to do and hard for outsiders to detect.

This leads me to the fatal flaw of stablecoins: they are massively centralized. It is intrinsic in their design that a single organization issues the stablecoin, acquires and manages the fiat-currency reserves, and releases that back to the sellers. This also raises governance concerns, such as where the issuing company is domiciled, the strength of local regulation, who the appointed auditors are and the standards to which they adhere. Again, no-one has oversight of this and it is completely unregulated. Due to the financial risk, this function is centralized to the original management team. This requires all users of the stablecoin (holders and merchants) to place full faith in a single central point. Why even adopt a blockchain mechanism when the most efficient technical solution would be a simple database operated by the founders?

An argument is often made that stablecoins are better for cross-border remittance than ordinary cryptocurrency, as the backing asset is well-known on both sides of the remittance corridor. Although that may be true, remittance end-users (typically a poor person in an emerging economy) still convert that stablecoin to local fiat currency, as that stablecoin is not legal tender in the receiving jurisdiction. As a stablecoin is typically less liquid than the major cryptocurrencies, this increases the total cost to the receiver. It has been noted that the primary use case for stablecoins is to act as a ‘cash account’ for cryptocurrency traders closing out positions – thereby fueling speculative trading and price volatility!

Facebook’s proposed Libra is actually a pseudo-stablecoin, in that it is not stable against any single fiat currency but pegged to a basket of major currencies. That is probably a natural response to the fact that Facebook has a global customer base but this ‘efficient’ solution will actually disappoint every customer. Ordinary people do not measure their wealth against a basket of currencies, but against a single fiat currency – that of the country where they live. The problem is that Facebook is so big (2 billion users) that they have the financial muscle and captive customer base to keep investing in and promoting this completely flawed idea. The only upside to the Facebook Libra idea is that regulators will be forced to take a more proactive stance towards regulating cryptocurrency, something that I support.

There has been some speculation about a Rand-based stablecoin. The South African Reserve Bank successfully demonstrated through Project Khokha that they are interested in innovative technology to improve payment system operations. In principle, this sounds like a good idea, but in practice a Rand-based stablecoin suffers from all the flaws I’ve pointed out in this post. In addition, a Rand-backed stablecoin would be limited to a single country. This offers no benefits to the many millions of people in South Africa who remit billions of rands annually to recipients across our borders while paying some of the highest fees in the world.

The classic characteristics of money are durability, portability, divisibility, uniformity, limited supply and acceptability. All of these characteristics are embodied in the original vision for Bitcoin as described by Satoshi Nakamoto’s whitepaper. Currently, the only cryptocurrency that is built according to the original whitepaper for Bitcoin is BitcoinSV (BSV). The multitude of variations on the original bitcoin idea, including BTC, ETH, XRP and stablecoins are an illusionary diversion. Cryptocurrencies still have a long way to go, but the focus should be about building useful services on top of the existing stable protocol.

Angus Brown

Monday 22nd July 2019



Tether Accidentally Minted $5 Billion of Its Stablecoins, Then Deleted Them

Facebook Libra Risks to Financial Stability Demand ‘Highest’ Regulatory Standards, Says G7

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Why regulation will help grow Bitcoin adoption

Money is a fundamental part of the way any society operates, and governments have controlled how it is created and used. I have spent the majority of my professional life either working for, or building, banks. They are actually quite fragile financial entities, as the 2008 global financial crash reminded us. They pose systemic risk to the fabric of society, and historical bank crashes have set entire countries back by decades. Central banks were created to try and control these risks, however, like any government-run business, they have a patchy record.

I was a founding member of a team that launched, the world’s first bank-backed digital currency, in 2000. We were heavily influenced by the thoughts of “The Sovereign Individual” (Davidson & Rees-Mogg), “The Future of Money” (Lietaer), “Maverick” (Semler) and the books of Neal Stephenson. Our original vision was to create an entirely new digital currency that could be used to transact freely on the internet. We had some interesting conversations with the South African Reserve Bank about that! Years later, I was fascinated by Satoshi Nakamoto’s Bitcoin whitepaper as I recognised the same spirit and intentions. Bitcoin is one of the critical financial innovations of our time.

In 2016, I took a giant leap of faith and co-founded a Bitcoin payments startup, Centbee. We provide an app that makes Bitcoin the easiest way for people to pay each other. My co-founder, Lorien Gamaroff, and I have been invited regularly to provide advice and education to central banks across the world. We’re extremely fortunate to be based in South Africa, a nation that has one of the most robust and innovative banking systems in the world. We have a healthy relationship with the South African Reserve Bank, which has a relatively open view towards cryptocurrencies.
In June 2018, I was invited to address the South African Reserve Bank (SARB) and it may have surprised some in the audience when I said, “The Reserve Bank is letting us all down by not providing enough regulation. ” Failure to regulate creates an opportunity for public abuse and deception. SARB have engaged constructively with many participants in the cryptocurrency ecosystem and recently published a Consultation Paper to which Centbee has submitted a detailed response.

People often think of regulation as meaning ‘establishing controls’, but it also means ‘to make regular’ – to bring order to a situation. Regulation helps to bring the chaotic to the mainstream. Although early adopters typically have a high risk appetite, most people shy away from disorder, especially when it is associated with illegal activity. For many, the word ‘crypto’ is largely synonymous with ‘hacking’ – and that’s not a good thing! If we truly want Bitcoin to succeed, it needs to be owned and used by hundreds of millions of people. To achieve that, Bitcoin has to be perceived as safe, easy-to-use and easily available. We must recognize that regulators, as the agents of government, are the gatekeepers.

In his book “The Great Degeneration”, historian Niall Ferguson noted that ‘highly regulated‘ is not always synonymous with a sound and safe financial system. New regulations always have some unintended consequences as the marketplace adapts. This is not to suggest that cryptocurrencies should be entirely unregulated, rather a call for regulation should be seen by policymakers as an ever-adapting process. Regulatory design should strive to have ‘anti-fragile’ outcomes (as coined by Nassim Nicholas Taleb) – where systems improve the more they are stressed.

Modern financial systems are possibly the most complex, non-deterministic creations of humankind. Governments are challenged by Bitcoin because they have a very limited ability to control the technology. They face a paradigm challenge whereby they license a specific product in a specific jurisdiction and must now deal with a technology that is borderless. Not only does this pose problems to regulators attempting to provide a harmonized national policy approach across different product types and fiscal domains, but they have to address the issue of services provided across borders. The market of cryptocurrency users is a global audience. Although some cryptocurrencies are currently viewed as alternative assets by speculators, it must be emphasized that the original vision (and likely longer-term outcome) is that Bitcoin is a protocol.

At Centbee, we believe it is more fruitful to regulate apps and use-cases than to attempt to control the cryptocurrencies themselves. When confronted with a paradigm-busting concept, it would be prudent to consider metaphors outside of financial services – perhaps to consider how digital music or photographs are created and shared? Interestingly, most customers today choose paid-for services like iTunes and Netflix over pirate sites.

When consulting with regulators, here are some of the points we make:

  • A cryptocurrency address is not the same as a bank account: A fundamental attribute of cryptocurrency is that the technology platform is the ledger – it is not maintained and controlled by third parties. A cryptocurrency wallet provider (such as Centbee) does not exercise control over the address to the same degree that a bank does over an account. Non-custodial wallet providers have not actually accepted funds from the public. They are merely software service providers, performing some intermediary functions. They only exist because they perform a useful function – protecting customers and providing access to services.
  • A cryptocurrency address is not the same as a bank account: A fundamental attribute of cryptocurrency is that the technology platform is the ledger – it is not maintained and controlled by third parties. A cryptocurrency wallet provider (such as Centbee) does not exercise control over the address to the same degree that a bank does over an account. Non-custodial wallet providers have not actually accepted funds from the public. They are merely software service providers, performing some intermediary functions. They only exist because they perform a useful function – protecting customers and providing access to services.
  • Countries are not closed financial ecosystems: Central banks correctly identify the threat of cryptocurrency to their right to control the money supply. However, in reality every economy is tightly integrated into the global financial system. All entities in a country have access with differing degrees of freedom to global assets, where effective monetary policy is the aggregation of all actions by all central banks.
  • The Role of the bitcoin payment processor: Merchants need assistance in accepting and processing cryptocurrency payments. These entities which I term the bitcoin payment processors are contracted to merchants and provide acceptance, settlement and reconciliation services for a fee. They remove the complexity of blockchain technology for the retail ecosystem and ensure that retailers receive fiat settlement safely and reliably. Standards (such as BIP21/70) have already been created by the cryptocurrency community to facilitate interoperability successfully and make Bitcoin payments operational. Bitcoin payment processors connect the cryptocurrency settlement mechanism to the national payment system.
  • We need exchanges: All interaction between the fiat economy and cryptocurrency relies on crypto-fiat exchanges whose function should be segregated properly from Bitcoin payment processors and wallets themselves. In time, central banks may consider setting up cryptocurrency payments clearing houses (using the archaic term), where designated and licensed exchanges may agree operating mechanisms to reduce liquidity risk. As a central part of the payment system, they pose systemic risk to a country’s economy and should be regulated like other financial exchanges and marketplaces.
  • Registration and licensing: We support the registration of cryptocurrency wallet providers, Bitcoin payment processors and exchanges with the local central bank. In recognition of this transparency we request that the central bank provide a ‘letter of no objection’ to all successfully registered entities and encourage the banking sector to not apply discriminatory practices against registered firms. The regulator should determine the most material ecosystem participants and establish a fit and proper assessment to operate as part of the national payments infrastructure. Existing regulations should be extended or clarified to encompass these entities. This would provide comfort to merchants and banks as to settlement finality.
  • Pay your taxes: It is unrealistic to expect the state to help the needy and maintain base infrastructure without all citizens contributing as they are able. Dodging taxes is not just illegal but is effectively stealing from your fellow citizens. Any technology can be exploited to hide wealth however, we do poor service to Satoshi Nakamoto’s vision by avoiding our legally-owed taxes. Centbee is registered in the country where the founders live and we pay our taxes. We have also informed our tax authority that we will assist them if requested. We would turn away customers who intended to use Centbee’s services to avoid tax.
  • Merchants are not police: Over time, a large portion of the effort in policing anti money laundering (AML) activities has been transferred to the private sector, specifically, the banks. Merchants are not directly regulated by central banks and it is not practical or feasible to expect merchants to monitor, police or report on cryptocurrency transactions.
  • Legal tender clarification: Only central banks are mandated as the sole issuer of fiat national currency and designated legal tender. In the same manner that a central bank freely acknowledges the existence of foreign currency, we suggest that each central bank consider acknowledging cryptocurrency as a form of non-governmental foreign currency. There is a perception amongst retailers that accepting Bitcoin may be illegal, and that perception will hinder innovation in the payment system. We specifically request that the central bank clarify that merchants have the right, but not the obligation, to accept Bitcoin for goods and services.
  • Know your customer (KYC): Privacy is a fundamental human right enshrined in most countries’ laws. Unfortunately, we’ve seen far too many accidental and profit-driven data leaks and the pseudonymous nature of Bitcoin provides some innate protection against that. The Financial Action Task Force (FATF), the global advisory body to combat money laundering, recommends clearly classifying any entity providing a money or value transfer service as a financial institution and imposes an obligation to combat money laundering. Each cryptocurrency provider is welcome to adopt their own approach towards customer identification. Centbee has decided that each customer will be uniquely identified via a device token, IP address, and / or a mobile phone number. This is an intrinsic part of the ability to easily send money between friends, and an appropriate, risk-based approach towards deterring money laundering. In cases where the customer simply moves cryptocurrency around between various addresses, we don’t believe that any further KYC data such as name, address or national identity document should be required. Where a cryptocurrency service provider (an exchange or wallet) facilitates the exchange of fiat currency for cryptocurrency, it is reasonable to require customers to undergo a more diligent KYC procedure. The specific KYC protocol of the jurisdiction where the customer resides should be applied. Simply purchasing or using cryptocurrency should not be considered a high-risk activity by itself.
  • Fighting money laundering and terrorist financing: Bitcoin has some potential for money laundering and we recommend that AML transaction monitoring be conducted for all cryptocurrency transactions. Suspicious transactions should be reported to the local investigative agency. All cryptocurrency enthusiasts should support efforts to stamp out money laundering and terrorist financing. However, the effort and impact on customers should be proportionate to the actual risk posed, and we should note that it is impossible to completely deter all illicit activity.
  • Fighting illicit activity: An important principle of money is that ‘taint does not transmit’, and that the consequences of an illicit act must flow to the person committing that act. We do not burn the money recovered from a theft – but return it to the bank to be lent out again. Centbee absolutely condemns illicit and illegal activity and will actively support regulators and police in prosecuting any such acts.
  • Customer protection: Unfortunately, there have been cases of people being enticed into speculative or fraudulent investments in cryptocurrencies. In these cases, the fault generally lieswith human nature rather than the technology itself. Regulators can assist by providing warnings to the public, and establishing white-lists of reputable, registered cryptocurrency firms in their jurisdiction.
  • Foreign exchange controls: As a developing nation, South Africa has a relatively fragile trade balance and the Rand is a highly liquid emerging market currency. Monitoring and control of capital movements out of the country are important to the fiscus and economic planning of the nation. Cryptocurrencies do pose a risk for illicit and unmonitored capital flows. These balances are effectively externalized the moment they are created, and as such, the effective border control mechanism is the point of conversion from fiat to cryptocurrency. Existing legislation typically empowers authorities to request detailed data from cryptocurrency firms to assist any investigation. At this time, I think it would be inappropriate to apply the conventional authorized foreign exchange dealers licensing framework and requirement on crypto exchanges.
  • Innovation follows regulation: Regulators prefer to be technology neutral and often claim that they will regulate only after the innovation spark. However, we must recognize that in the financial domain, innovation without adoption is just an experiment and adoption is largely controlled by the incumbents. I believe that regulators need to take a more proactive stance towards innovation.

I am confident that a transparent and respectful approach towards regulators will help them develop enabling legislation. Regulation can help customers and existing financial institutions gain more comfort in cryptocurrencies and drive the adoption of Bitcoin. I welcome dialogue with my cryptocurrency colleagues across the world and recognize they may have different political and social views. They may also have had different experiences with regulators in their local jurisdictions. Part of Centbee’s vision is to make Bitcoin simple and easy. We welcome constructive criticism and look forward to driving debate and development in the cryptocurrency industry.

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