Regulations and Crypto. Oil and water?

By 14/05/2021June 2nd, 2021No Comments
Photo by Rodion Kutsaev on Unsplash

When we look at Decentralised Finance (DeFi) we see a fast-moving, innovative, convention-breaking spirit and at the heart of it a mindset to fully embrace a decentralized model. The philosophy behind the decentralized model is a global network that through some magic transcends borders and importantly the rules and regulations that apply to finance. Where it becomes powerful is in aggregating global liquidity rather than having pockets based on sovereign countries (and their local regulations), the smart contracts enforce the workflows matching the supply and demand of the traded pairs.

While the innovation is fully applauded there is a significant barrier to adoption by regulated institutions, namely the pseudo-anonymous nature of blockchains means you don’t know who you are dealing with, nor the origin of funds. This creates a big problem for compliance with Anti-Money Laundering (AML) and Know Your Client (KYC) regulations.

When companies and institutions want to raise capital either through share issuance, debt, or hedging through derivatives, they need fiat currency and not tokens. This will change when tokens are widely accepted. Tokens are perceived as highly volatile and trading in tokens can cause complications with their banking providers. Banks will check the origin of funds and connections with tokens will raise compliance and risk flags.

The barrier to entry in building a functioning secondary market for asset-backed tokens has resulted in a small industry servicing a small pool of qualified investors who have to demonstrate an understanding of financial investments and are subject to a minimum wealth threshold.

In traditional markets, there are layers of regulation around trading and settlement to ensure a fair and orderly market and mitigate risks in clearing, and while tokens have additional mechanisms and safeguards there is no exemption from regulators or special legislation, nor recognition that the mechanisms have equivalence.

What is working in the tokenized world is that there are many Proof of Stake chains that accept delegations and in return for locking up tokens the holders are given a share of the revenue by the validators, there is an even larger market where returns are made for locking tokens in liquidity pools used by DeFi and finally there are lending and borrowing platforms that use high collateral in place of credit rating which enables leverage. These yield opportunities have created a foundation for a nascent investment ecosystem, and bypass many of the traditional structures which would require regulatory controls and in some cases capital.

The two parallel worlds currently co-exist as the regulators do not see a threat from cryptocurrencies or DeFi to the markets as a whole or the comparatively low levels of retail investor interest for the moment, however, this can quickly change.

What would happen if DeFi grew to a market size of trillions of dollars if retail investors sparked a rush into the sector? The regulator would need to step in and they have a big box of tools to enforce their actions. They can, for example, take action against anyone promoting financial instruments, and while some projects are structured as Decentralised Autonomous Organisations (DAO), if they have a legal entity behind them (and a board) then the regulators have the means to do something, if not it would be interesting to see how the DAO would be collectively liable?

Photo by Daniele Levis Pelusi on Unsplash

Emulsify regs and crypto?

There is a solution to knowing the origin of funds and who your client is with the Tgrade blockchain. The initial step is in the self-sovereign groups, each group decides how much or little they do to check the identity and information about someone and importantly match the off-chain persona to a blockchain address. This allows a good deal of flexibility depending on the needs of the self-sovereign group.

The adoption of tokens will come in stages, firstly there are the asset-backed tokens that are sold for fiat, the fiat currency is used in the case of a fund to buy whatever the underlying assets are, or a tokenized fixed-income asset will borrow the money in fiat, issue tokens, and the coupons and redemption are paid in fiat currency. The purpose of tokenizing is to move to a much simpler mechanism of the exchange of value while retaining the checks and balances seen in the traditional systems.

The second phase of tokenization is where fiat is phased out and capital or debt is raised in cryptocurrencies (and these are likely to be stable coins or central bank-issued coins).

The issuance of the tokens whether for debt, equity or derivatives will need a few steps such as the correct structuring and issuance of a prospective. The book-building exercise is done through an auction system, as this is a well-understood mechanism in traditional finance and can be fully automated.

Where it gets more complex is in the secondary markets. Is the token a security or a digital asset? Does it need a listing on an exchange? Does the exchange need to be classified as a Multilateral Trading Facility, a full-blown exchange? This has big implications for the licensing, capital requirements, and need for qualified people.

The most problematic are the rules on clearing. While it would be possible to create a clearinghouse on a blockchain and reproduce all the entities and code the workflows it would not make sense at all as it would add unnecessary infrastructure, and costs where they are not needed. A blockchain transaction handles both the exchange and clearing in one, so if either party does not have sufficient inventory the exchange cannot go ahead and thus clearing and settlement cannot happen.

How is this resolved?

Let’s start with the intent of the regulations around clearing. The rules have evolved through best practice, responses to failures or shocks to the system, or industry lobbying and protect the process of clearing. The common time between the trade and settlement is shortening and we see T+2 or in some cases T+1. This gap between the execution of an order (a trade) and settlement introduces risk and to mitigate these risks there has been the introduction of central counterparties (CCP), a requirement to hold inventory in a central securities depository (CSD), margin requirements, and the obligations of custodians to book the cash legs associated with the securities cleared. All of this makes a lot of sense for clearing T+2 which is vulnerable to liquidity, delivery, and settlement risk.

Blockchain workflows combine trading and settlement, thus mitigating the risks of clearing. The intent of the regulations and the stipulation for the structures is to protect the financial system from a collapse in clearing through events such as liquidity drying up or failure to deliver which potentially cause a negative spiral. The mechanisms in blockchain are such that if you cannot settle (clear) then you cannot trade and in doing so demonstrates that it meets the intent of the regulations around clearing. By ensuring that the controls are in place as intended by the regulators there should be some acknowledgment by the regulators that there is equivalence even if it is not in the exact prescribed way?

The robustness of blockchains is how transactions can be conducted in a trustless environment without any intermediaries and shorten the paths we currently see in traditional finance without removing key controls or introducing systemic risk.

What next?

Let’s say that the blockchain workflows are acknowledged as equivalent to clearing and the classification of the assets traded determines what rules the exchange fall under. We have now unlocked the secondary market in a non-restricted way.

We already have the mechanisms for self-sovereign groups to form, such as French fixed income traders, which means we know who we are trading with and have off-chain mechanisms in addition to the on-chain mechanisms.

Having the basics in place, the big opportunity is to focus on the real opportunities, namely around smart contracts and what new businesses can be built.


Author TgradeFinance

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