How One Word Could Desolate DeFi

Date: 4/1/2022
Author: Mr. X


A single word contained in a footnote could desolate an entire market sector.

I’m using that word very carefully and deliberately. It wouldn’t outlaw DeFi. It would just cause most people who are providing the needed liquidity to flee. What would be left behind is a ruin.

The Securities and Exchange Commission (SEC) recently released a proposed rule change. It sounds technical enough. It is designed to “Further Definition of ‘As a Part of a Regular Business’ in the definition of Dealer and Government Securities Dealer.”

I can feel your eyelids falling already so I’ll be blunt. What the rule essentially would do is force anyone who provides liquidity in a decentralized financial market via cryptocurrency to register as a regulated securities dealer.

The key excerpt is on page 6, with a critical footnote explaining what’s really at stake. The key sentence: “The proliferation of fully electronic trading venues has been accompanied by the rise of certain market participants who are not registered as dealers and who today account for a majority of trading in the Treasury interdealer market.”

The accompanying footnote has this passage:

(“Trading on these platforms [in the Treasury cash market] has become increasingly automated, with transactions conducted using algorithmic and other trading strategies involving little or no human intervention . . . bear[ing] some resemblance to other highly liquid markets, including equities and foreign exchange markets, where PTFs and dealers transact in automated fashion, sometimes in large volumes and at high speed.”); FEDS Notes, “Principal Trading Firm Activity in Treasury Cash Markets,” James Collin Harkrader and Michael Puglia (Aug. 4, 2020); G30 Report at 1. The Commission separately has proposed, among other things, amendments to Exchange Act Rule 3b-16 to include within the definition of “exchange” systems that offer the use of non-firm trading interest and communication protocols to bring together buyers and sellers of securities. See Amendments regarding the Definition of “Exchange” and Alternative Trading Systems (ATSs) that Trade U.S. Treasury and Agency Securities, National Market System (NMS) Stocks, and Other Securities, Securities Exchange Act Release No. 94062 (Jan. 26, 2022), 87 FR 15496 (Mar. 18, 2022) (“2022 ATS Proposing Release”).

In English? The point of DeFi is that you don’t need to go a bank. Of course, the reason we have banks is because you need institutions that have large amounts of money that they can afford to lend out for some length of time (and survive an occasional loss). That’s the necessary liquidity.

DeFi removes the theoretical need for banks by using large pools of liquidity provided by countless users who don’t know each other. Smart contracts carry out the necessary functions for different financial instruments. Crucially, there is no single source of liquidity. There are countless thousands. You might be among them.

That liquidity not only allows you to trade with other people but to swap one kind of asset to another kind of asset even with no one on the other side of the trade. That’s fundamentally different than, say, buying or selling stocks. This is enabled by Automated Market Maker (AMM) protocols and the many, many people providing liquidity to the system.

What the rule would do is force every single one of these people to register with the government as a “dealer,” with all the accompanying regulation. The references to “algorithmic and other trading strategies involving little or no human intervention” are pretty on the nose when it comes to DeFi. One might even call that part of the very definition of DeFi.

I know how to play banking stocks or judge which bank is doing better than another, but I don’t know how to literally run a bank and comply with the surely vast amount of paperwork that goes along with it. Neither do 99.9% of people providing liquidity to cryptocurrency exchanges. The body that would be in charge would be the Financial Industry Regulatory Authority.

Do you sweat when you do your taxes because you are afraid of making a mistake? Try complying with banking regulations.

Adding to the confusion, DeFi can’t really be tied down to one country, continent, or culture. One of the inherent benefits of cryptocurrency and smart contract technology is that you don’t have to know, trust, or have any connection with the people on the other side of a transaction. You don’t even need to share a common language. You’re really not dealing with a single person or institution at all, but a gestalt.  Any bureaucratic attempt to track “dealers” operating all over the world would lead to chaos and a ton of paperwork. Alternatively, even if it could be done, it would mean that the only source of liquidity in these applications would be coming from outside the United States.

This rule coincides with a general increase in regulation for cryptocurrency. Most leading exchanges are complying with regulations that require the Treasury Department to get customer names, account numbers, and transaction dates. Of course, you don’t have to use these exchanges to trade cryptocurrency, but many do.

The European Union has just passed similar legislation, though the exact form it will take is still subject to negotiation. For example, Cameron Winklevoss tweeted (and his brother retweeted): “Unfortunately, the EU Parliament voted today to pass the Transfer of Funds Regulation (TFR) amendment. BUT ALL IS NOT LOST.” There are still many negotiations to come with the government.

Cryptocurrency investors will recall the SEC’s ongoing dispute with Ripple and its token XRP. At stake there is a fundamental issue: If you generate tokens for a crypto project, does that mean the same thing as issuing securities? If you are enthusiastic about cryptocurrency, you want the answer to be no. But you can see why some people think the answer is yes.

However, let’s take a breath. The general trend of more regulation isn’t just springing up for no reason.

Just in the last few days, we had one of the largest hacks in cryptocurrency history, with $600 million worth of tokens used to play the blockchain game Axie Infinity stolen. Last month, about $1.7 million in NFTs were stolen. There are safe ways to store cryptocurrency but the fact remains that most people will remain vulnerable to hacks, especially phishing attacks.

It’s one of the great quirks of history that so many people got into cryptocurrency because they were horrified by the role banks had played in the 2007-2008 financial crisis. Banks turned risky loans into repackaged financial instruments that were seen as “safer.” When the game of musical chairs finally stopped and people realized these assets were toxic, the entire world economy almost collapsed.

Why were these assets toxic? Banks were increasingly lending to people who had no means of paying it back. There were fewer checks on creditworthiness. It was also simply assumed that the housing market would go on forever. Some say we are repeating the risk now.

Right now, right this second, I can use a DeFi app to get a loan instantly. You could say that a certain smart contract or procedure ensures that there is some kind of collateral, but that’s still vastly different than the process needed to get a loan from a bank. It might even be simpler than borrowing money from a friend.

That may excite you or horrify you. Maybe both. Yet everyone should agree that this is at least a valid concern. Even if I hold a higher opinion of the intensions of federal government employees than you might, you’d at least concede that they don’t want to preside over a complete meltdown of the global economy. If it is triggered by crypto instead of big banks, it hurts them as well as us either way.

We also shouldn’t completely dismiss that risk. It is an open question whether some stablecoins that are used to facilitate cryptocurrency trading really have the assets necessary to back their tokens. If some don’t, the emerging cryptocurrency economy could essentially fall apart.

I don’t want to be negative. For every horror story, there are innumerable tales of how DeFi has benefitted people.

For example, if you are opposed to Russia’s war in Ukraine, you might protest that cryptocurrency provides a potential way to dodge sanctions. I could respond that  Ukraine’s government and Ukrainians as individuals are benefitting from donations that could only be done on this scale through cryptocurrency. I want crypto to stay because I believe it creates more opportunities for people to do good and make money. I feel especially strongly about DeFi and its promise.

For that reason, I hope this rule doesn’t pass in its current form. More nuanced solutions are possible. It’s important that we recognize that the government isn’t just being wildly irrational or doing these things for no reason. We must be honest about the potential threats and downsides presented by decentralized finance and cryptocurrency generally. In the United States, the FDIC insures accounts of up to $250,000. Its pretty unthinkable that your wealth in a bank would just be wiped out overnight, at least in the United States. In the crypto sphere, as many have learned, it is very, very possible.

Crypto and blockchain technology may provide the very solutions to the problems created by them. Yet the sector will require people willing to act politically. There are some signs cryptocurrency traders are becoming something of a voting bloc. They (we) may soon learn to wield their influence in a coherent way.

I hope that happens – but for that consolidation to start, it means recognition that the government and people who don’t hold cryptocurrency have legitimate concerns. At the same time, I hope the government sees cryptocurrency and decentralized finance as a boon, and not just a threat. It would be a shame if America’s leadership in the crypto sphere were to be choked off at a time when inflation is a wolf at the door that can no longer be ignored.

Mr. X is an investment analyst working in the Washington DC area who specializes in the intersection of business and public policy. After fifteen years working in politics, he writes on a classified basis for RogueInvesting.com to bring you news on what those with power are debating, planning, and doing.

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