Traditional Finance and the Need for Crypto Regulation ~ Part 4

Photo by Michael Förtsch on Unsplash

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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📰 Traditional Finance and the Need for Crypto Regulation ~ Part 3

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DisclaimerThis content is not financial advice and it is not a recommendation to buy or sell any financial instruments, FX trading, cryptocurrency or engage in any trading or other activities. You must not rely on this content for any financial decisions. Acquiring, trading, and otherwise transacting with financial instruments or cryptocurrency involves significant risks.We strongly advise our readers to conduct their own independent research before engaging in any such activities.GMO Trust does not guarantee or imply that any cryptocurrency or activity described in this content is available or legal in any specific reader’s location. It is the reader’s responsibility to know the applicable laws in their country.

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Building Financial-Grade Digital Assets. The World’s First Regulated JPY-Pegged Stablecoin Issuer.