Traditional Finance and the Need for Crypto Regulation
This article is a full version of our latest series: “Traditional Finance and the Need for Crypto Regulation”
Part 1 — After the Terra Crash —
“Depression-era bank runs occurred in a number of ways, but the most common was a sharp drop in investor confidence — as we might see with today’s algorithmic stablecoins.”
Last month in May 2022, the crypto industry experienced a shocking event that wiped out nearly $30 billion from the ecosystem, the Terra UST de-peg event. This event is fundamentally similar to a bank run which has happened numerous times historically and it is important to understand why bank runs happen and why regulations were created.
In this blog post, we will take a deep dive into historical bank run events and how regulators were instrumental in addressing the problems.
On December 10, 1930, a Bronx businessman visited his local branch of Bank of United States, which sounds like a government entity, but was actually one of the country’s largest commercial banks at the time.
In need of cash, he wanted to sell his stock, but the bank manager refused, reportedly telling him it was a good investment. As he stormed out of the bank, the businessman warned all those waiting in the branch that the bank could not afford to make pay-outs as promised.
Depression-era bank runs occurred in a number of ways, but the most common was a sharp drop in investor confidence — as we might see with today’s algorithmic stablecoins.
Americans were understandably anxious about their money after the massive stock market crash of October 1929. The wealthy began shrinking their investments and consumer spending fell sharply. In 1929, some 650 US banks failed.
The next year the number doubled and confidence in US financial institutions collapsed. Finally, when a sizable number of depositors withdraw, or request to withdraw, their funds from the same bank around the same time, the financially devastating snowball has been kicked downhill.
Banks, let’s not forget, do not hold all of the deposits of all their clients in-house at any one time, but lend them out to borrowers or use them to build or buy assets. This brings to mind perhaps the best-known example of a bank run — which did not actually happen.
“You’re thinking of this place all wrong,” George Bailey pleads with a crowd of unruly depositors at the Bailey Brothers’ Building and Loan in Frank Capra’s classic It’s a Wonderful Life. “As if I had the money back in a safe. The money’s not here. Your money’s in Joe’s house, and in the Kennedy house, and Mrs. Macklin’s house — and a hundred others.”
After a few sizable withdrawals, a bank might have limited reserves on hand. If a word starts to spread about the bank’s limited ability to pay out, anxiety is sure to follow, spurring still more withdrawal requests. Bank officials might then quickly move to recall loans and liquidate assets at emergency prices, but often there’s just not enough time. Amid high financial anxiety, the mere appearance of being unwilling to pay out can tip the scales.
Whether or not the Bronx businessman’s accusation was true, word spread, and within a few hours, some 2,500 people were lined up outside Bank of United States looking to liquidate. By the end of the day, they had withdrawn some $2 million. This sparked a domino effect and bank runs hit other lenders in the Bronx and in Brooklyn. The next day’s New York Times announced that the Bank of United States — with over $260 million in deposits — had closed its doors and the state had taken control of its finances.
The bank’s downfall likely began two years prior, in 1928, when it started selling shares to depositors to raise funds. Possibly taken in by the bank’s name, which suggested powerful backers, immigrants and working-class locals were the bank’s primary clients. Today, we might call them “the unbanked,” as most found it difficult to access financial services in New York City on their meager incomes and savings. Immigrants likely viewed an account at Bank of United States, not to mention stock holdings, as a step toward financial stability and respectability.
The bank promised that the stock would hold its value and that it would be willing to buy back shares on demand. “For banks that hold illiquid assets,” finance professors from Brandeis and NYU wrote in 2020, “these promises of liquidity on demand are the key source of vulnerability.”
Even so, the bank’s clients likely felt confident that the Federal Reserve system would protect them in the event of collapse. “Few of these working-class depositors appreciated, however, the bold risks the bank had taken with their assets when it merged with other banks, bought and sold first and second mortgages and offered loans to anyone with an account,” Columbia University professor Rebecca Kobrin wrote in 2019.
The established member banks of New York’s Federal Reserve system, which had been created for just this sort of crisis had, in previous years, joined forces to bail out several troubled financial institutions. However, the ethnicity of this bank’s patrons and leadership — the president and vice president were Jewish — is widely thought to have played a role in the member banks’ decision to not step in and save Bank of United States.
Few would view today’s crypto investors as akin to the immigrants and Jews of a century ago, who were among the more maligned minorities. Yet, it may not be much of a stretch to argue that the dominant traditional financial institutions of our era have a similar bias against crypto.
The up-and-comers not only pose a threat to their industry and status — a twist on replacement theory — but they tend to be seen as “new money” arrivistes, untrained in the ways of modern finance and undeserving of the riches so many of them flaunt. Thus, it would come as little surprise to learn that some of these institutions, hearing of their drowning crypto brethren, might have decided against throwing out a lifeline.
This may even apply to the greatest crypto collapse thus far. One of the leading theories for what happened to Luna centers around Anchor Protocol, a savings vehicle on the Terra ecosystem that promised ridiculous 20 percent annual returns for those who deposited their UST there. Anchor helped drive the rapid growth of UST, which became the third-largest stablecoin by market cap just 18 months after its September 2020 launch.
Some promotional sleight-of-hand may have played a role. “Terra used all the right language to imply low risk,” Peter Yang, product lead at Reddit and web3 advisor, tweeted after the collapse. “UST is a STABLEcoin. Anchor is a SAVINGS protocol. Anchor’s 20% APY was one of the most recommended DeFi entry points for beginners.”
But in early May, UST deposits in Anchor fell 20 percent in a single day, from $14 billion to $11.2 billion. Suddenly the criticisms that UST relied too heavily on Anchor seemed legitimate; it began to fall and soon lost its peg to the dollar. This in turn led to the collapse of Luna, which UST, an algorithmic stablecoin, relied on to maintain its peg.
Rumors have swirled that a top investment firm, leading market maker and crypto exchange worked to precipitate the collapse. All of them have denied the charge, and we may never know exactly what happened with Terra. But whether or not the collapse was intentionally engineered is largely immaterial. What’s clear is that a major pull-out from Anchor shook investor confidence, kicking off a domino effect.
“If a large number of a bank’s depositors simultaneously assign the same high probability of potential loss to the bank’s assets, the bank will experience large simultaneous requests for deposit withdrawals,” analyst George Kaufman wrote for the Cato Institute in 1988. “That is, the bank will experience a run.”
It’s largely about investor confidence, or the lack thereof, and regulatory support can provide a sturdy backbone. Without it, anxious investors might be left with nothing more than hopeful encouragement.
“We can get through this thing all right,” George Bailey urged the panicky crowd at the Building & Loan. “We’ve got to stick together, though. We’ve got to have faith in each other.”
Part 2 — Financial Crises and Regulations —
Each major collapse led to both broader economic difficulty and invaluable regulations. All of which brings us back to Luna, and the collapse that has shaken crypto.
Following the collapse of Bank of United States, similarly devastating bank runs continued into early 1933, when Franklin Roosevelt was inaugurated as president. He soon declared a national bank holiday, during which all banks would be closed until passing federal solvency inspection.
Roosevelt began his series of fireside chats that March with a solemn vow: “We do not want and will not have another epidemic of bank failures.” He called on Congress to devise banking legislation to support the country’s ailing financial institutions and, in June, signed the Banking Act of 1933 into law.
That landmark bit of legislation, also known as the Glass-Steagall Act, separated commercial and investment banking and created the Federal Deposit Insurance Corporation. Among other regulatory duties, the FDIC was tasked with insuring all deposits in eligible banks in the event of bank failure. Meant to end bank runs and restore financial confidence, the FDIC is widely considered a major success.
To be clear, the FDIC was not an absolute success as more than 2400 depository institutions failed just from 1986 to 2007 — it means the government has been able to manage and mitigate the risk of bank failures. There have, however, been two major hiccups.
Twenty years before Bank of United States’ implosion, two Midwest banks merged in 1910 to form the Continental Illinois National Bank and Trust Company. Despite conservative roots, its management implemented a rapid-growth strategy in the 1970s, and by 1981 Continental had become the US’ largest commercial and industrial lender, with $40 billion in assets.
An analysis by Salomon Brothers that same year described Continental as “one of the finest money-center banks going.” The next year, however, the ground began to shift.
As with Bank of United States, “it became clear that the bank had made some risky investments,” according to a Federal Reserve history article. These included $1 billion in energy-related loans from an Oklahoma bank that failed in July 1982 and developing country investments that struggled through the debt crisis brought on by Mexico’s default the next month.
In the first quarter of 1984, the bank’s nonperforming loans jumped $400 million to $2.3 billion. On May 10, rumors of Continental’s insolvency sparked a massive run and depositors pulled out more than $10 billion. The next day the bank borrowed $3.6 billion from the Federal Reserve of Chicago. A few days later Continental accepted a $4.5 billion line of credit from a group of the US’ largest banks.
Still the run continued, and regulators began to fear a massive spillover if the country’s seventh-largest bank were to collapse. “The FDIC estimated that nearly 2,300 banks had invested in Continental Illinois, and nearly half had invested funds greater than $100,000, the deposit insurance limit,” says the Federal Reserve history.
On May 17, the FDIC gave the bank a $1.5 billion infusion of capital. The next day it announced that it would extend its support to depositors with funds beyond its $100,000 limit. Continental Illinois had become insolvent, the largest bank failure in US history up to that point, but governmental support, a sort of soft nationalization, enabled it to survive in a lesser form.
In July 1984 the FDIC said that it had failed to find a buyer and would provide permanent assistance, starting with the purchase of $4.5 billion of the bank’s bad loans. Stockholders were largely wiped out, but the FDIC protected bondholders and depositors, as promised. [The government pulled out of Continental Bank in 1991, and Bank of America purchased it in 1994.]
In Congressional hearings on Continental’s collapse, Congressman Stewart McKinney echoed recent press reports and uttered a phrase we know all too well today. “We have [created] a new kind of bank. It is called too big to fail. TBTF, and it is a wonderful bank.” The data bore out the sneaking suspicion that bigger banks, because of the broader risk to the economy, had begun receiving preferential treatment.
Since 1950, the FDIC has had a menu of three responses to failing banks: liquidate and pay insured depositors; find a buyer; or provide federal life support. In the late 1980s and early 1990s, the average asset value of FDIC-liquidated banks was $65 million, while the average size of banks that were sold or propped up was $200 million.
The larger the bank, the greater the risk of financial spillover, and thus the greater likelihood of significant governmental support. The problematic impact of this has been that financial institutions, grasping the advantages of size, will aim to grow as quickly as possible, potentially cutting corners and making more problematic investments en route. TBTF incentivizes over-sized banks, and possible risk-taking.
Congress sought to address this growth issue by limiting “too big to fail” rescues with the FDIC Improvement Act of 1991. The law limited the FDIC’s ability to protect creditors and the Fed’s ability to lend to troubled banks. Yet the other key issue raised by Continental’s failure — systemic risk, or the idea that one failure might ripple out, leading to other collapses and broader economic trouble — was left unaddressed for a quarter-century.
This despite the fact that C.T. Conover, Comptroller of the Currency, had warned of the likely outcome had Continental’s failure left depositors and creditors out to dry: “We could very well have seen a national, if not an international, financial crisis the dimensions of which were difficult to imagine.”
Enter Lehman Brothers, with $680 billion in assets, and its landmark bankruptcy filing in September 2008. Like Bank of United States and Continental, not to mention some crypto initiatives, Lehman embraced a high-risk model.
Relying on complicated financial products and presumed real estate growth, the firm needed to raise billions of dollars every day just to stay in business. It had invested heavily in subprime mortgages and, when these markets sagged, Lehman was unable to raise the necessary cash.
In March 2008, the US Treasury and Federal Reserve began looking for a buyer. Since it was an investment fund, the government could not nationalize Lehman as it done with Fannie Mae and Freddie Mac, not to mention Bank of United States. What’s more, Lehman lacked the assets to secure a massive government loan.
After Bank of America and Barclays pulled out of possible last-minute purchases, Lehman filed the largest bankruptcy proceeding in US history on September 15. The Dow Jones saw its worst one-day decline in seven years.
Two weeks later, after Congress rejected the Fed’s proposed $700 billion bail-out of troubled banks, the Dow experienced its largest-ever one-day decline to date. This came days after regulators had seized Washington Mutual (WaMu) and sold it to JPMorgan Chase for $1.9 billion. With $307 billion in assets, WaMu became the largest bank failure in US history, easily eclipsing Continental Illinois.
The economic crisis that followed became known as the Great Recession, a period that still today undermines the financial stability of millennials. They have less wealth, more student debt, and are more likely to live with their parents. As a result, they are more likely to take risks with their finances — a key reason behind the emergence of cryptocurrencies.
Lehman’s collapse also brought about the Dodd-Frank Wall Street Reform Act, the most far-reaching financial legislation since Glass-Steagall. Dodd-Frank, signed into law by Obama in July 2010, created the Financial Stability Oversight Council, which keeps an eye out for systemic risks.
If the FSOC determines that a bank has become too big it can turn it over to the Federal Reserve for inspection. The Fed can then force that bank to increase its reserve requirement to make sure it’s liquid enough to prevent bankruptcy. Dodd-Frank also made permanent the FDIC’s move to increase its maximum insurable investment amount from $100,000 to $250,000, providing greater security to a much broader swathe of investors and institutions.
To recap, the high-wire act of Bank of United States led to failure, spurring the creation of the US’ crucial financial oversight body, the FDIC; the problematic investments of Continental Illinois led to governmental stewardship, which created concerns about “too big to fail”; and the fall of Lehman and the resulting financial crisis paved the way for broader investor security and greater oversight of TBTF and systemic risk.
Each major collapse led to both broader economic difficulty and invaluable regulations. All of which brings us back to Luna, and the collapse that has shaken crypto.
“When a protocol that’s worth billions fails, it has a massive impact on the rest of the ecosystem,” Peter Yang said on Twitter in May. “This is the Lehman Brothers moment for DeFi. I think it will take many years to recover.”
Things may well get worse before they get better. But if history is any guide, it will be increased regulations that ensure a full recovery, and a bright future for crypto.
The FDIC is far from perfect, but it serves its purpose, providing a crucial safety net in choppy financial seas. That’s just one reason stablecoin issuers like GMO Trust keep 100 percent of their reserves in cash or cash equivalents.
Part 3 — Regulators Prepare —
Crypto is now facing its “Lehman Brothers’ moment”, and a sober, forward-thinking response is needed to ensure the future of DeFi.
Time for Crypto to Face the Music
About a year ago, US officials began laying out an aggressive approach to regulating cryptocurrency, starting with stablecoins. The market turmoil of recent weeks has accelerated these efforts, which is mainly a good thing for the industry.
The collapses of Luna and Celsius and the broader subsequent market trouble echo the bank runs and financial disasters of previous decades — and would, similarly, be best addressed via increased oversight and regulation. Once revealed, the problematic investments of Bank of United States and Continental Illinois made investors skittish and desperate to recoup their investments asap. Decades later, Lehman Brothers relied too heavily on subprime mortgages and its house of cards collapsed along with the housing market. In all three cases, regulatory responses added increased oversight, significantly reducing risk and increasing stability.
Crypto is now facing its “Lehman Brothers’ moment”, and a sober, forward-thinking response is needed to ensure the future of DeFi. In late June, after crypto markets had slumped more than $2 trillion, the head of the Bank for International Settlements argued that any form of money not backed by reserves funded by taxes lacked credibility. “You just cannot defy gravity,” said Agustin Carstens. “At some point, you really have to face the music.”
Regulators Prepare
What might facing the music look like for stablecoins? The best way to begin to answer that is to examine regulatory thinking and actions thus far. The first major signal appeared in October 2021, when the Financial Action Task Force (FATF), which combats money laundering (AML) and terrorist financing, issued new regulatory guidelines, amending its statements from the previous April after considerable pushback. The FATF did not introduce new regulatory changes for virtual assets, but rather made the industry and markets aware of the risks and future expectations. Virtual asset service providers (VASPs), such as crypto exchanges, were made aware that they would be accountable for conducting compliance steps, such as Know Your Customer (KYC). The FATF also made clear that DeFi companies are not VASPs, but their operators and creators — any entity with “control or sufficient influence” over the protocol — can be seen as such under certain conditions, which would require them to comply with all existing FATF requirements, including the KYC compliance DeFi has avoided with its user anonymity.
The FATF hinted that it might soon move to crack down on problematic exploits, which would be good news for the industry. “With decentralized exchanges and protocols suffering record hacks and scams (‘rug pulls’) worth hundreds of millions of dollars and being largely unregulated,” its guidelines explained, “this is creating fertile ground for bad actors to acquire significant funds to perpetrate ML/TF transgressions, which in turn places extra pressure on the FATF and other regulators like FinCEN to take action.”
In November, the US President’s Working Group on Financial Markets published a report on stablecoins that highlighted risks to market integrity and investor protection, including possible fraud, terrorist financing and money laundering, and trading misconduct such as market manipulation, insider trading and front running, as well as risks to the broader financial system. “If stablecoin issuers do not honor a request to redeem a stablecoin, or if users lose confidence in a stablecoin issuer’s ability to honor such a request, runs on the arrangement could occur that may result in harm to users and the broader financial system,” argued the report, peering successfully into the near future. The Working Group, the FDIC, and the Office of the Comptroller of the Currency (OCC) went on to jointly “recommend that Congress act promptly to enact legislation to ensure that payment stablecoins and payment stablecoin arrangements are subject to a federal prudential framework on a consistent and comprehensive basis.”
The report also encouraged legislation to be flexible yet comprehensive and complement existing authorities while aiming to minimize stablecoin user risk by requiring stablecoin issuers and any holding company or parent to: be insured depository institutions subject to supervision and regulation; require wallet providers to be subject to federal oversight; and enable the federal supervisor of stablecoins to require that any entities critical to the functioning of a stablecoin to meet certain risk management standards.
In March, President Joe Biden issued an executive order on ensuring the responsible development of digital assets. The order highlighted the remarkable growth of digital asset markets (from $14B to $3T in five years ending Nov 2021) and the implications for consumers, investors and businesses and risks to financial stability. “We must take strong steps to reduce the risks that digital assets could pose to consumers, investors, and business protections; financial stability and financial system integrity…US should ensure that safeguards are in place and promote the responsible development of digital assets to protect consumers, investors, and businesses.”
Biden also went into illicit finance and crime, including fraud, money laundering, terror financing, as well as the underbanked and privacy. The issue of money laundering has become more urgent for policymakers in the wake of Russia’s invasion of Ukraine, with officials fearing that Russia could use stablecoin and crypto tools to evade sanctions. This is an important concern, yet it’s largely beyond the scope of this post, which is focused on stablecoins and regulations that might limit the risks they pose to users, investors, businesses and the financial system. On that last issue, Biden smartly added that “We must reinforce United States leadership in the global financial system and in technological and economic competitiveness, including through the responsible development of payment innovations and digital assets.” Thus, smart, effective regulation for crypto will not only stabilize the industry but also help keep the US at the forefront of digital innovation.
Biden went on to outline his stance on a Central Bank digital currency. “My Administration places the highest urgency on research and development efforts into the potential design and deployment options of a United States CBDC.” Such a currency could strengthen the dollar and solidify its international position, which would in turn strengthen stablecoins linked to the dollar. As part of a “whole of government” approach to crypto, Biden’s Executive Order urged the Federal Reserve to outline a plan and required most government bodies — Treasury, State, Attorney General, Commerce, Homeland Security, Office of Management and Budget, National Intelligence and “other relevant agencies” — to submit, by September, a report on money and payment systems, digital assets, likely impact of a CBDC, the implications for the US financial system, and more.
The order also required these bodies to establish a framework for international adoption of global principles and standards for the trade and use of digital assets. This suggests that legislation momentum is likely going to build significantly in the fall. Senator Pat Toomey of Pennsylvania has already taken the lead, introducing in April the stablecoin TRUST act, which would establish a new federal license for stablecoin issuers — as of now it would be the world’s first — that would make stablecoins act like most other banks. Under this proposed regulatory framework, they would have to maintain reserves, disclose their holdings and submit to regular audits.
The US is far from alone in its plan to regulate. In June, Japan passed a new law allowing banks, money transfer agents and trust companies to issue stablecoins — the world’s first such regulation. The government will soon introduce a registration system to monitor the circulation of stablecoins and enforce anti-money laundering and terrorist financing measures. Essentially, the law bars tech firms and startups — which have spearheaded growth of this DeFi segment, and likely sparked its decline — from issuing stablecoins. Also in June, the Bank of England’s executive director for markets, Andrew Hauser, said that digital currencies did not represent any “red line” risks for central banks, but that a combination of stablecoins and CBDCs could significantly alter central banks’ control of monetary policy. Governments need to be prepared, he argued, to adjust to the changing markets.
Meanwhile, the European Commission is finalizing its landmark Markets in Crypto Assets Regulation (MiCA) law, and an internal paper leaked in May revealed that the commission appears to be in favor of a hard curb that would allow regulators to order issuers of larger stablecoins (exceeding 200M euros in value and 1M daily transactions) to halt issuances until those totals drop beneath the threshold. The European Parliament, on the other hand, favors a gentler approach under which stablecoins would be reclassified and subject to oversight by the European Banking Authority — a move that to some extent would echo US regulatory plans.
Finally, Singapore’s monetary authority in late June granted in-principle approval to leading exchange crypto.com as a payments platform. This has little to do with stablecoins, but it does suggest that some forward-thinking governments are beginning to view cryptocurrencies as clearing the regulatory bar for payments systems — a key step on the road to a broader embrace.
Part 4 — Crypto’s Response —
If DeFi has to take on elements of TradFi to survive and thrive, was all the attendant hope just hyperbole?
Crypto’s Response
The next key question involves the actions informed crypto firms are taking to help shape and begin to prepare for looming regulations. Some have been quick to act in advance of tighter regulations, thinking that if they are not ready to comply when regulations take hold they could face devastating consequences. Changpeng Zhao, founder-CEO of the top crypto exchange Binance, has been helping lead the charge. Appreciating the need for crypto players to reach alignment or consensus with regulators, Zhao has since spring been traveling from country to country meeting with treasury and finance officials. He also understands the importance of public messaging, signaled by sizable recent investments in Twitter ($500M), the newsy-est of social media platforms, and leading business news outlet Forbes ($200M).
In January, Aave launched what may be the first permissioned protocol, Aave Arc, which is closely aligned with KYC and AML compliance standards. With Fireblocks as its first active whitelister, the lending protocol works the same as Aave, but with its own separate liquidity pool in which all users have been vetted and verified. The motivation behind the creation of Arc may have the FATF’s so-called travel rule, which is likely to see more robust global enforcement soon. Fireblocks is also providing compliance and security for another major effort to bridge the gap between traditional finance and DeFi, Compound Treasury, a joint effort between Compound and Siam Commercial Bank.
“Permissioned DeFi is the future of institutional finance,” says Aave, and it may just be true. Tyron Lobban, digital assets head of JPMorgan, pointed toward just that sort of future at a June tech gathering. “We think tokenizing U.S. Treasuries or money market fund shares, for example, means these could all potentially be used as collateral in DeFi pools,” Lobban said at Consensus 2022 in Austin. “The overall goal is to bring these trillions of dollars of assets into DeFi, so that we can use these new mechanisms for trading, borrowing, lending, but with the scale of institutional assets.”
Uniswap has not added a permissioned protocol, but a year ago it delisted more than 100 tokens it saw as at risk of being classified as securities, including tokenized stocks, options tokens and insurance-based tokens. In its announcement, Uniswap suggested it may have motivated by growing regulatory pressure. While the delistings brought Uniswap more into compliance with AML standards, critics charge that it also brought its DeFi label into question.
Balancing DeFi and TradFi
Indeed, some say the same of Aave Arc. If being listed on a platform requires approval from a central authority, rather than a governance vote, than that protocol is technically not decentralized. This begs the question: If DeFi has to take on elements of TradFi to survive and thrive, was all the attendant hope just hyperbole? It’s a great question, and the answer is complicated — and perhaps best saved for a future post. For now I’ll just say that responding to these pressures is almost inevitably a trade-off: the main objective for crypto players at the moment needs to be giving traditional institutions a greater level of comfort when participating in a lending protocol, and getting there is worth the risk of upsetting DeFi zealots. I’m confident that Aave, Uniswap, Binance and Compound are all better positioned for coming regulations than they were a year ago. Another sign of crypto’s greater openness to TradFi thinking is Celsius, days after its recent crash and trading freeze, hiring Citibank to advise on possible solutions and purchase offers. This budding romance between crypto and TradFi augurs well for the industry.
The main objective should be to build a secure ecosystem while maintaining a balance between regulation and innovation. Like Zhao, the more forward-thinking firms and leaders have opened a channel of communication with government officials and have a voice in figuring out the optimal framework. SEC Commissioner Hester Pierce regularly seeks to engage the crypto industry on regulatory issues, such as taking part in an online forum moderated by Aave last August. As an NYDFS-regulated trust, GMO Trust has also been proactive in reaching out to regulators and providing insights on operations and sound stablecoin maintenance, including cybersecurity, AML control and reserve management. Most crypto firms, however, are yet to do so — which will hurt the industry more the longer it lasts.
Presumably, under pressure from their investors, major crypto firms like Coinbase, BlockFi, and Crypto.com have announced big layoffs, blaming it on a looming recession. But these moves are less about a recession than about earlier bets placed on hypergrowth that has suddenly vanished. The risk now is that many tokens could be delisted, which would dam the revenue stream for many companies just as looming regulations mean that many will need a lot of cash on hand for attorney fees. As part of a massive conglomerate of more than 100 companies, GMO Trust is largely free from these concerns.
Due to the stringency of AML and KYC standards, regulators will likely never accept the permissionless aspect of crypto trading — or not at least until they are confident that the industry’s infrastructure is solid and secure. Crypto players will in the meantime have to sacrifice the competitive advantage of anonymity and begin to identify users in order to enter the mainstream economy. Questions remain, however, about the use of avatars and handles and whether many of the more advanced crypto users could still evade identification even within a permissioned protocol like Aave Arc.
Regulators, too, should also aim to strike a balance between protecting retail customers and stifling innovation. The question is whether they will be able to appreciate that meaningful innovation in crypto mainly occurs within the rubric of “what we can’t get away with within traditional finance”. “The new and unique uses and functions that digital assets can facilitate may create additional economic and financial risks requiring an evolution to a regulatory approach that adequately addresses those risks,” Biden said in his executive order. We are still finding our way to the appropriate legislative and regulatory measures, the optimal forms of oversight and compliance enforcement.
Smart DEXs need to be able to thread the needle between KYC compliance and their ability to continue deal-making on a user-to-user basis. This will likely become all the more important as we gain a fuller understanding of DeFi contagion. The recent desperation moves of Solend and Three Arrows Capital likely portend still more platforms feeling the heat. Any protocol that offers a high-yield lending product like Celsius — Babel Finance and Matrixport come to mind — could soon face a similar reckoning, as the poor risk management practices of many major industry players come to light.
“The only thing that seems sure is that more and more compliance challenges are coming for the industry,” writes Paul Brody, global blockchain leader at Ernst & Young, describing the coming crypto regulations as likely to be more accommodating than annihilating. “Fair rules and a level playing field will unlock a huge amount of institutional capital that wants to get into this exciting new ecosystem.”
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