Crypto regulatory wargames
The holidays are here, so we are going a bit lighter in the serving size to the end of the year. But the meal should still be delicious.
The guiding concept for today is power structures and hierarchies. The threads of hierarchy are woven with neural fibers into our mammalian brain. It is a shortcut for resource allocation, and the utility function of the super-organism created by the collection of animals into a social construct. If we have a mental model of who is strong and wields power, we do not need to adjudicate it often with violence. The theater of power will do.
In this light, let’s look at (1) American regulation and legislation intended to slow or hamper the adoption of digital assets and currencies, (2) the behavior of early crypto companies in establishing regulated entities, and (3) the strategies available to DeFi protocols for preserving their success. What may seem like a set of disconnected symptoms is actually, to us, the functioning of an immune system at the level of the American state.
Behold the Regulation
First, the Financial Crimes Enforcement Agency (FinCEN) issued a notice of proposed rule making today called, “Requirements for Certain Transactions Involving Convertible Virtual Currency or Digital Assets”. The short of it is that crypto wallets holding digital assets would need to KYC into the banking system in order to convert decentralized assets into centralized ones. If you have a “permissionless” account, such as a MetaMask address on Ethereum which you funded with some money from Coinbase, new obligations are created around record keeping for transactions over a certain size ($10,000 in a connected series) for the companies enabling those transactions.
Moreover, the comment period to respond to the proposed rule has been shortened to 15 days, which is an unusually short time. The SEC, OCC and CFTC have been generally more cautious not to step on financial technology innovation. However, FinCEN and Steven Mnuchin are rushing to get the rule through before the inauguration of Joe Biden, and a potentially different posture on the substance. Why? What world view brings forth this desire to control, and what control is it trying to effect?
We are just going to leave the following excerpt from Mnuchin’s career below to anchor the cultural source of the regulation. To what type of organism is a permissionless, open source, programmable financial ecosystem most uncomfortable? To what type of technologist is decentralized technology a risk?
As an aside from on the big tech world, we could say that open source operating systems (Android / Linux) disintermediate closed source operating systems (Microsoft). Disintermediate does not always mean fully replace, but it does mean structurally impact over time to the detriment of the incumbent. And in particular, the detriment comes from changing the game, rather than fighting for positions within the same game.
There is one economy in which a company like 1990s Microsoft holds the dominant market position, and is hierarchically able to generate financial outcomes across its customer relationships in particular ways. There is then another open source economy, which functions by different rules and norms, and in which Microsoft’s hegemonic position holds far less weight. If your organizing values are explicitly that economic profit is not the priority and that sharing intellectual property to subvert economic profit is a virtue, then a company whose core key-performance-indicator is economic profit is going to have a tough time exercising power.
The above is of course caricature and allegory. Microsoft has evolved far from this point. But let’s replace the word Microsoft with Wall Street, or banks, or generally the reserve status of the US dollar. FinCEN explicitly combats financial crime, but it also defines financial crime through its operation. A crime is a breach of norms for a particular social or economic set of assumptions and rights. Some norm or law must be breached.
Permissionless finance is a paradigm breach. It pays no regard for the very nature of the incumbent financial market. Without banking, it creates its own banks. Without a sovereign, it bestows law on mathematics and consensus. Without broker/dealers, it creates decentralized robots. And so on. It tilts the world in such a way as to render the economic power of the incumbent financial market less important. Not powerless — the allure of institutional capital is a constant glimmer of greedy, opportunistic hope. But the hierarchy of traditional finance does not extend to DeFi, and thus has to be re-battled for the incumbent. This is cost, and annoying.
As an example, don’t think about Goldman Sachs or JP Morgan who can extend their budget and human capital to defend position. Compare instead something like Fifth Third or Deutsche Bank (both of which we like) to Uniswap and Aave. How much power do the former have over the latter?
It is from this same place of fear that we see the American left proposing regulation to control stablecoins. Representative Rashida Tlaib, a lawmaker part of the AOC squad, has cosponsored a bill requiring stablecoins like Facebook’s Libra to be issued by banks. The proposal would treat any private crypto-asset that pegs to the dollar as requiring a bank backer. That would put a regulatory burden on crypto-native products like DAI from MakerDAO, and potentially be impractical to implement. That impossibility could force technology innovators to exit the market — likely exit the US market for another jurisdiction.
Why does this bill exist? Our hypothesis would be that it is in part a reaction to Facebook’s desire to create Libra/Diem and expand out into finance in the US, as they have done in other Whatsapp-dominated geographies. Facebook is emotionally attached to the Trump presidency on the Left. Its dominance in forming and controlling public opinion, meanwhile doing little practical work on the type of governance that would make the pitchforks go away, creates a bogeyman for politicians.
The second constituency that is aided by such a bill is the long-tail of small community banks and credit unions that are stuck in the past with branches, human employees, and old core banking software. Jack Henry and Fiserv each have over 2,000 such bank clients. And boy, are they good at lobbying against and suing federal regulators. Small banks do not want to see fintech charters, or fintech companies grow. They do not want the phone to replace Main Street. Such views do not make the US a leading innovator worldwide, to put it kindly.
Going back to our hierarchy framework — you might be a small fish, but at least you get to eat the scraps under the shark. A paradigm that says financial services are free and distributed by Google isn’t a great environment in which a small bank can compete. “Let’s kill the paradigm” is the right strategic reaction to preserve your place in the hierarchy.
Behold the Response
It was nice of the OCC to clear up that all banks are crypto custodians. It was also nice of a whole bunch of banks, including BBVA, to become crypto custodians. Another example is Standard Chartered and Northern Trust partnering on a platfrom called Zodia. We expect that this is years of work, starting in 2017, coming to fruition. These players are leveraging their existing position to notch market share in the new world, where they are starting from scratch. They had to measure the jump very carefully to not sabotage the existing incumbency, both reputationally and from an investment perspective.
In the same spirit, last week we noted that BitPay filed to become a federally regulated US Bank (link here), and that trust company Paxos, which powers PayPal’s Bitcoin features and raised over $140 million last week, also applied for a national bank charter (link here). That means that if you are making enough money — likely $20 to 100 million in revenue — you will get in line. As a crypto company, Paxos and BitPay are close to the top of the hierarchy. Not a Coinbase level of top dog, but more bite than bark. By gathering enough resources in the new paradigm, these companies are able to muscle into the incumbent system and start spending to build status. Partnerships with companies like PayPal are both commercial and a signal — PayPal’s brand and social dominance are reflected onto its crypto friends.
Decentralized finance is not immune from this desire either. The larger you get, the more you want to carry your status over from one platform to another. It’s like a TikTok superstar moving over to Instagram. Gotta hedge those platform bets!
For this reason, we can understand why MakerDAO was eyeing the broker/dealer license, and why Aave has an Electronic Money Institution license in the UK. Speaking of the UK, if you are a firm that trades crypto assets on behalf of customers, but aren’t registered with an FCA, the direction of travel is FCA registration. That opens up the entire KYC/AML salad bar.
The last symptom we want to discuss is the developments over at Compound. Compound recently announced that it was launching its own blockchain for operating the Compound application, which would settle on multiple other layers (like Ethereum), and which comes with a native stablecoin called CASH. Thus, the technology and capital are still interoperable with DeFi, but there is a technological layer of separation between the venue of underwriting and coin settlement, and transaction settlement.
Lots of theories have been spun up about why a DeFi favorite like Compound would put up a wall to the hand that feeds it, Ethereum. The hypotheses range from including CBDC integration, to pressure from investors for integrating into the protocol layer, to a discussion of gas fees and performance.
We think it is simpler. Compound has, to the extent available for any particular player, won top rank in Ethereum DeFi. In now needs to expand further into non-crypto markets, and it needs to protect its position in the DeFi hierarchy. This is tricky when the mental paradigms are so different. By building a collection of walls and bridges, they can create a road to the assets of a regulated incumbent, and then control how the money flows between rooms. Playing in DeFi and playing with banks. Think about compartmentalization on a ship that allows some rooms to be flooded by water (i.e., KYC/AML requirements), while keep the ship in fine condition.
Not everyone has this strategy, but if you are a DeFi protocol that has tasted victory in the permissionless web, it is very hard to not want to re-establish that victory in an adjacent market. And so we see protocols raise money from Western investors, and compete with data aggregation sites for the user, and “acquire” functionality from other open source protocols.
A challenge is that, end of the day, all of these things are run by individuals subject to their local jurisdictions. However, it is a collective labor, and over the long enough time horizon, the very nature of hierarchical competition will change to advantage the pioneers. There are now enough utopians that attempts at a digital nation may yield legal fruit, though it is hard to see its foggy shape just yet.
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