When worlds collide: DeFi meets TradFi

Decentralised finance has become big enough for central banks to take notice. Will subsequent rules and regulations help DeFi grow or will the bubble burst?

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So too in the emerging world of alternate finance. The world of AI, Web 3.0, DeFi, NFTs and crypto assets. Part of the mission of these developments of course is to change the rules. Why should banks be at the heart of payments? Why should nations be the only entities that can create currencies?

“Central banks are looking at not just intervening in the [cryptocurrency] market but participating in it.”

Some rules, however, are immutable.

One of those rules is the rule of bistability of regulation: when innovation is small and interesting, regulators do nothing. But at a certain point, when that innovation becomes significant, regulators suddenly act, changing the world. And often this happens just when the second and third waves of investors and proselytisers are looking to cash in.

That is exactly the era we are entering today. Cryptocurrencies are registering such volumes that securities regulators are very interested and central banks are looking at not just intervening in the market but participating in it.

Necessary intervention

NFTs – non-fungible tokens, particularly popular in an emerging art market – face much greater scrutiny as do crypto-assets more generally.

There is a reason for this that goes beyond regulators and central bankers being killjoys: there is always a tension between innovation and stability and when system stability – which underpins the basic function of the real economy – is threatened, intervention is necessary.

In Australia we have just seen the Australian Securities and Investments Commission (ASIC) issue a guidance note on the obligations of so-called “finfluencers” – influencers who provide financial opinions on social media – which has had seismic repercussions on those in the sector who now face jail terms for providing inappropriate advice or providing certain advice without a licence.

ASIC chairman Joe Longo made this clear in a speech on ASIC’s priorities emphasising a focus on “addressing the deceptive promotion of riskier asset classes such as crypto” and “disrupting investment ‘gamification’ on digital platforms”.

On a more macro level however it is increasingly clear you can longer enter a Web 3.0 world of bizzaro finance and not expect the presence of a regulatory avatar.

Timely and coordinated policy

The latest, and probably toughest, line came from the international securities regulator IOSCO – the International Organization of Securities Commissions whose members represent 95 per cent of the world’s securities regulators.

In a report, the agency noted risks from decentralised finance (DeFi) “are quickly evolving as the crypto-based markets grow to the point where they are ‘cloning’ mainstream financial markets”.

IOSCO will set up a new task force to help members “take timely and coordinated policy action to appropriately address the risks arising from this fast-growing area”.

This is the regulatory equivalent of “nice place you’ve got here, shame if something happened to it”.

IOSCO – and other regulators – don’t doubt “the potential benefits and ‘novel’ financial products and services” DeFi brings. The issue is, in IOSCO’s view, many of these “mirror” conventional financial markets but, critically, with far weaker regulation, poorer governance and greater risks.

One significant risk is the pseudo democracy of these alternate worlds. Supposedly free of the tyranny of governments and regulators, the rules – and there are rules – of the decentralised universe are typically set by a vote. But the vote inevitably will skew towards those with the most power in the networks.

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That echoes concerns from the global banking regulator, the Bank for International Settlement (BIS), which argued supposedly peer-to-peer, decentralised marketplaces often have de facto central authorities - project creators, venture firms and other institutional investors with outsize control of the cryptocurrency governance tokens used to vote on all management issues.

 “DeFi purports to be decentralised,” Andreas Schrimpf, head of financial markets for the BIS, said in the latest BIS Quarterly. “Although DeFi’s main vision is to be decentralised, providing financial services without intermediaries, full decentralisation in DeFi is illusory”.

To quote George Orwell, “all animals are equal but some animals are more equal than others”.

Bubble or seed

Oliver Wyman’s Douglas Elliott captured the essence of the debate when tossing up whether crypto assets were a classic bubble or the seeds of a new era: “Coherent regulation could channel this activity for the good of society yet there is no consensus among central bank governors, finance ministers, or regulators on how to proceed.”

“They remain divided on a central question: are crypto-assets merely beneficiaries of speculative excess, like the famous Tulip Mania of the 1630s, or are they 1998-style dot-coms, containing the seeds of a major technological and economic transformation even if surrounded by speculative excess, naivete, and sometimes fraud?”

It’s important to note though that markets can also be self-correcting and self-regulating, up to a point.

We are already seeing this, for example with stablecoins – cryptocurrencies using underlying blockchains but linked to conventional currencies to provide more stability. Investors and end users are also looking for the participation of trusted intermediaries – often banks or central authorities – to give them confidence assets will hold their value and transactions will be completed.

Trust is the crucial component and the BCG Henderson Institute has analysed this in some detail.

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“As more and more transactions and social interactions move online, the demand for trust is burgeoning,” the research institute notes in a report “Beyond Blockchain: The promise of a digital trust network”.

“Blockchains, touted as the tech solution, address only part of the problem: the need for a trusted intermediary database,” the report says. “But it is end-to-end trustworthiness that matters to transactors. And that requires systemic engineering of trust across the entire value or supply chain, what we call a digital trust network (DTN). Trust is quite complex, and we count seven practical mechanisms by which the various forms of trust are nurtured—or its deficiency managed.”

Back to the future

Ultimately, history tells us, it is quite rare for an established ecosystem, like TradFi – “traditional finance” – to be consumed by a revolution. It can happen, as with digital photography all but killing off film stock and companies like Kodak, but unlikely.

More likely is TradFi and DeFi merge. TradFi brings the trust, the scale, the regulatory imprimatur and DeFi the innovation. This is what many investors are backing such as Global Macro Investor’s Raoul Pal.

He believes DeFi is likely to see much more interest over time and “we have only seen the first mini-wave”. In Pal’s view the “real magic applications” will arrive when “TradFi goes on blockchain”.

TradFi meets DeFi is today’s sci-fi and tomorrow’s reality.

Andrew Cornell is Managing Editor at bluenotes

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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