DeFi poses a challenge for regulators

DeFi protocols are for trading or lending crypto tokens and derivatives. They exist across a throng of validating and coordinating nodes, rather than as a single portal run by an incorporated legal entity. Furthermore, they exist without the formal leadership that regulators would normally interact. 

This lack of an identifiable leadership, plus the fact that the systems are designed without any requirement for users to reveal their identities, poses a challenge for regulators. They feel more comfortable with entities like Coinbase and Kraken, because at least they have comprehensive ‘know your customer’ (KYC) processes.

Regulators see DeFi as “a potential vector for all three of the key risks that financial regulators are tasked with controlling,”

David Z Morris writes. These are basically criminal activities, such as money laundering, tax evasion and terrorist financing, as well as fraud. Their biggest fear though is systemic risk. As Morris says, “DeFi and crypto still probably aren’t large or influential enough to trigger broader financial contagion in the event of a major market collapse or system failure, but you no longer have to engage in wild speculation to foresee that level of influence in the future.”

Regulators traditionally rely on the people managing trading services to control these risks by monitoring their customers and suspicious activity on their platforms, but this simply doesn’t exist with DeFi, which is much harder to regulate than crypto. Katherine Kirkpatrick, co-chair of the financial services practice at King & Spalding said in regard to this, “The ultimate question, beyond how to regulate, is how do you enforce the rules? How do you make someone accountable for breaking the rules? It doesn’t make sense to regulate if you have no enforcement mechanism.”

Don’t stifle DeFi

On the other side of the argument, “premature or misguided” regulations could stifle DeFi innovation and growth. But despite the risk of misguided overreach, there are good reasons to want a regulatory framework for DeFi. It would for a start, “make the fundamental advantages of the technology accessible to many more participants,” as Morris suggests, including making it more appealing to public companies and regulated institutions. At the moment they aren’t participating in DeFi because, “using DeFi in its current state could expose banks like JPMorgan to money laundering or fraud risk,” says Michael Shaulov, CEO and cofounder of Fireblocks, a DeFi custody and infrastructure provider.

The future DeFi landscape

There is little doubt that regulators will pursue DeFi if they find it has become a “powerful entity floating beyond their oversight.” Morris warns, “The modern state’s monopoly on violence as the endpoint of law enforcement will likely find some way to control your access to protocols living in the cloud.” Still, there will always be jurisdictions without strict regulations, where DeFi users who take sufficient privacy precautions will continue to take the risk of using them. It may also be the case that DeFi protocols will become testing grounds for new forms of digital statelessness. However, if we want DeFi to have a role in improving the financial system, there will have to be some compromises made with the regulators.

Analysts urge caution as Bitcoin ETF launches

Today, the 19th October, is the launch of ProShare’s Bitcoin Futures Exchange Traded Fund (ETF) on the NYSE. The company confirmed this on Monday with the SEC, which had given the go ahead a few days before. The fund is linked to bitcoin futures that are traded on the Chicago Mercantile Exchange.

ProShares was among a number of bitcoin ETFs considered by the SEC, with its Chairman Gary Gensler making it clear that funds linked to the futures market rather than the underlying asset were more likely to win regulatory approval.

News of long-awaited approval for a bitcoin-related ETF sent the world’s largest crypto by market value to levels not seen since April. Bitcoin rose above $60,000 for the first time in nearly six months on Friday, following the announcement, and it is hoped that the ETF launch will “open the floodgates to a stream of similar products winning regulatory approval and accelerating the flow of investments into crypto.”

Some analysts are talking up Bitcoin to reach $100,000 on the back of this, but others believe it will cause a sharp, short-term pullback, with some warning that the event could be another “buy the rumour, sell the news” event. It is also widely believed that additional ETFs will rollout over the coming week.

At the moment, bulls are busy defending the market against the bears, who are trying to pull the price back below $60,000. So far, the bulls are holding their ground in the $61,000-$62,000 zone.

Jordan Finneseth, writing for Cointelegraph, says: “According to some price path charts, there’s a chance that Bitcoin tops out below $68,000 in the next few months before heading lower to establish a higher low near $46,000.”

David Lifchitz, managing partner and chief investment officer at ExoAlpha suggests that a “small pullback might be in order,” but added that “the medium-term looks definitely higher.” However, he urges caution for ETF buyers, saying, “these Bitcoin ETFs based on CME futures to track BTC price will underperform Bitcoin spot price due to ongoing futures roll costs.”

Lifchitz also suggests that while ETFs are supposed to open up Bitcoin investing to more retail investors, it will in fact be the experienced traders who will benefit most. He said, So these ETFs will likely be an easy Bitcoin access to unsophisticated retail investors with their broker accounts, who will not get the full return of BTC after all fees are accounted for. These ETFs will also bring arbitrage opportunities for smart traders. Wall Street at its best.”

But there is good news for existing Bitcoin owners. One analyst suggested that BTC price has the potential to drop back to the $53,000 support in the near term before resuming its uptrend, and that uptrend could take it to $98,000.

Crypto threatens financial stability says BoE banker

Jon Cunliffe, the Bank of England’s deputy governor for financial stability has recently given a speech where he tackled the question of whether or not, “the world of ‘crypto finance’ poses risks to financial stability.” Why and how does it do that?

Cunliffe pointed out that cryptoassets have grown by roughly 200% in 2021 ($2.3 tn), and from $16 billion just five years ago. The global financial system is worth $250 trillion, to give some context. He also mentioned that the sub-prime debt market was worth around $1.2 trillion in 2008, just before the financial crisis.

His point in using this comparison was that because the crypto industry is growing rapidly and beginning to connect to the traditional financial system, and there are leveraged players emerging in a mostly unregulated space, systemic risks, while limited now, could grow very quickly.

Referring back to 2008, he reminded his audience that in the case of the sub-prime market, “the knock-on effects of a price collapse in a relatively small market was amplified and reverberated through an un-resilient financial system causing huge and persistent economic damage.” We all remember the effects.

He called for financial stability regulators to take notice, to think very carefully about what could happen and whether they, or other regulatory authorities, needed to act. However, he cautioned against over-reaction. As he said, “We should not classify new approaches as ‘dangerous’ simply because they are different.”

Indeed, he said that innovation and technology, plus new players, could tackle longstanding frictions and inefficiencies and reduce barriers to entry, and that in the past they have been key to driving improvement and to increasing resilience in financial services.

Then, what started as a speech that may have sounded gloomy to the crypto markets, Cunliffe made an important and positive statement. He said, “Crypto technologies offer a prospect of radical improvements in financial services.” But he did add a caveat, “However, while the financial stability risks are still limited, their current applications are now a financial stability concern for a number of reasons.”

He then analysed the crypto market, breaking it down into unbacked cryptoassets used primarily as speculative investments and backed cryptoassets intended for use as a means of payment, pointing out that unbacked assets make up 95% of the market, and includes Bitcoin. His concern is that the main use of unbacked cryptoassets is for speculative investment and that fewer holders now say they see them as a gamble and more see them as an alternative or complement to mainstream investment. His greatest fear appears to be that while he doesn’t believe a collapse in the crypto retail investor sector would bring about instability, the large financial institutions with exposure to crypto are another matter, such as the many crypto hedge funds. He described one scenario: “For example, a severe fall in the value of cryptoassets could trigger margin calls on crypto positions forcing leveraged investors to find cash to meet them, leading to the sale of other assets and generating spillovers to other markets.”

Ultimately, Cunliffe called for faster action on regulating the market to manage risk, saying, “Although crypto finance operates in novel ways, well-designed standards and regulation could and should enable risks to be managed in the crypto world as they are managed in the world of traditional finance.”

While he sounds positive, as ever the demand is to bring crypto more in line with traditional finance, the very thing that caused the creation of crypto in the first place, due to ‘tradition’s’ failings.

Neobanks are challenging the big crypto exchanges

As neobanks like N26 and Revolut, as well as payment providers such as PayPal, Square and CashApp move into cryptocurrencies, does this pose a threat to the cryptocurrency exchanges?

Investing has changed, according to Francis Bignell at Fintech Times. He says, “Due to the pandemic, younger, tech savvy individuals working from home, spending more time online, and flush with stimulus money found solace in investing,” and adds, “As a generation known for not accepting things as they are, simply because it’s how they’ve always been, they relentlessly refused to approach investing in the “traditional way.” 

What we now have is a rising class of retail investors who value investments by the social currency and utility (e.g. meme stocks, NFTs and crypto). The result of these trends raises a number of questions about the future of investing. 

Bignell points out: “In early 2021, Reddit users battled with Wall Street by skyrocketing GameStop’s stock share. This, along with the rise in meme stocks, show that Wall Street is no longer dictating what is worth investing in and what isn’t anymore.” You could say a new approach to valuation is rising, one that’s based on the social worth of a company versus traditional notions of profitability.

Crypto exchanges challenged by new investing environment is an evolving investment platform. It will shortly support trades in bitcoin, bitcoin cash, ether, ethereum classic, dogecoin, litecoin, stellar, zcash, cardano and dash, and is being tailored to a growing, young demographic looking to trade in meme stocks. Public offers zero-commission stock trading and has an added social media component that could leverage the emerging meme stock-fuelled retail investment frenzy, as exemplified by Shiba Inu’s 24,459,593.97% rise in the last year, and Dogecoin’s 8,765.17% increase in value.

Robinhood is also about to challenge the crypto exchanges by introducing crypto wallets for its users to trade with other wallets. Robinhood users had previously been able to buy and sell a few cryptocurrencies, but had been unable to send those coins to external wallets or receive them from elsewhere. When this is implemented, it will offer Robinhood access to the space dominated by Coinbase and others.

US based fintech, MoneyLion, has announced it is adding crypto trading to its all-in-one financial services app, joining the ranks of N26 and Volt. It will introduce buying and selling capabilities for bitcoin and ether, according to its CEO, Dee Choubey. Choubey told CNBC, ““It’s a very important first step if we think that the future of fintech is DeFi. We will have created a segment of the population and have exposed them to DeFi, so when it becomes more ubiquitous, they’re fully prepared to take advantage of it.”

Maurizio Raffone Chief Financial Officer at Credify Pte. Ltd, explained how investing in a neobank would differ from a crypto exchange: “Neobanks’ typical client may not be a savvy crypto investor but is interested in having some exposure to the asset class and may not be bothered about NFTs, altcoins or stablecoins and so just having some degree of exposure to BTC or ETH would suffice. On the other hand, crypto exchanges do not really focus on providing any traditional financial service support but do generally provide a greater investment choice and with more sophisticated investment techniques.” 

What does that mean for banking and financial institutions? It means that they must have some form of crypto or digital currency feature or be left behind as their customers become more digitally aware.