Regulators are riding to the rescue of traditional banks, making it far harder for cryptocurrencies and decentralised finance, or DeFi, to dethrone them. If anything, crypto is an exciting new opportunity for the banking sector.
The authorities are making a concerted effort to regulate cryptoassets and decentralised finance (DeFi) and are even studying the introduction of central bank digital currencies (CBDCs). These are all moves that will save traditional banks from the biggest disruptive threat they may have ever faced.
What is happening?
The mass adoption of the internet in the late 1990s was supposed to hugely disrupt the banks, as happened to conventional retailing and the media. But that did not happen, despite the best efforts of internet-based challengers. Indeed, the large banks have mostly adapted quite well.
But they now face a new threat and one that could be very disruptive if left unchecked. The creators of cryptocurrencies such as bitcoin and of DeFI set out to ‘liberate’ society from the ‘exploitative’ clutches of traditional financial services and the control of central banks and their fiat currencies, which they see as being constantly debased. DeFi promises to cut out the middlemen and their costs, be they banks, brokers, clearing houses and even centralised exchanges.
However, DeFi is not about to replace centralised finance (CeFi) for two simple reasons. DeFi relies heavily on blockchains and smart contracts to deliver financial services, that is, complete automation. The trouble with this approach is who do you call if something goes wrong? How do you protect ordinary people with no technical knowledge from bad actors? CeFi offers trust and even convenience.
The second moat around banks is going to be regulation. The authorities are very wary of individuals and firms losing large sums of money through unregulated activities operating in an opaque space in what could be termed as being the ultimate definition of shadow banking.
The Swiss, the Singaporeans and a number of small jurisdictions have already established advanced crypto regulatory regimes. Larger jurisdictions, such as the EU, are now catching up fast, and their efforts will ultimately shape the crypto sector.
Why is it happening?
Apart from protecting consumers, the authorities are concerned about issues such as financial stability. If DeFi were to run wild and to seriously disrupt CeFi, it could unleash tremendous financial instability as banks lost customers and depositors in droves. To help protect their fiat currencies and even traditional financial institutions, central banks are developing their own CBDCs. It is clear from listening to regulators that they want to design CBDCs so they include the banks.
Meanwhile, the EU is developing its Markets in Crypto Assets (MiCA) regulation, which covers aspects of crypto, such as stablecoins and crypto service providers, that are not covered by existing frameworks such as the Markets in Financial Instruments Directive II.
Industry sources believe that MiCA could be very influential in shaping ‘regulated’ crypto services and products across the world, even though it will probably take four years to implement. It aims to bring legal clarity to crypto, while offering strong consumer protection. The big benefit is that it will enable crypto products to be sold across the EU under the same regime. On the downside, some in the crypto market believe MiCA will stifle innovation because it is too prescriptive. Many would prefer a principles-based approach that could adapt as new innovations emerge.
Indeed, many crypto firms are seeking to be regulated so they can sell to regulated institutions and mainstream retail investors. They also realise that remaining in the shadows could see them cut off from traditional payment systems, which would probably be game over for them.
What do the bankers say?
Bankers are not too worried about DeFi. Many see it as an exciting opportunity to further automate their operations and to deliver new financial products such as via stablecoins and even non-fungible tokens (NFTs) — the latter are currently heavily associated with digital art. Stablecoins offer the chance to financialise new asset classes and NFTs could play a role in areas such as structured finance.
Bankers welcome clear and proportionate regulatory frameworks so they can develop and sell these new products. Also, bank-friendly CBDCs would further help the development of regulated crypto products. However, banks will face competition from a growing army of blockchain start-ups that are also keen to market crypto products.
Will it provide the incentives?
Properly regulating crypto products without stifling innovation should offer mainstream users the best of both worlds: vast choice at low costs in a safe environment. However, the real difficulty will lie around any potential gaps in these frameworks and the arbitrage potential between various frameworks and jurisdictions.
Regulators will also need to be alert that this innovation doesn’t get abused to hide reckless leverage and risk taking, as happened for instance with supply chain finance in the ongoing Greensill scandal.
