As featured in TabbFORUM
By Brock Arnason, Founder and Chief Executive Officer of Droit
Applying distributed ledger capabilities to TradFi use cases has piqued the interest of many market observers in 2023. At the beginning of the year, the co-mingling of TradFi and digital assets was more apparent than ever at the World Economic Forum’s gathering at Davos, as demonstrated by the increase in the number of workshops and sessions for the blockchain and cryptocurrency sectors. The primary takeaway there was that many TradFi participants clearly feel there are opportunities in digital assets. To help these entities progress with confidence at this juncture, we thought it would be prudent to examine some regulatory lessons from the traditional finance space.
Unique benefits of digital assets
While digital assets pose a unique challenge, they also have the potential to bring unique benefits. Digitization of assets provides the ability to create a digital ledger, affording opportunities to improve elements of TradFi, such as settlement facilitation and collateral exchange.
The market characteristics of decentralized finance (DeFi) – an emerging financial ecosystem based on secure distributed ledgers – mean that market participants can be matched algorithmically with trades executed via smart contract. Instead of a centralized market participant acting as a trusted counterpart to these trades, it is replaced by what is essentially a software protocol. When it comes to order execution, the nature of the DeFi marketplace is transparent and egalitarian. Digital ledgers provide a mechanism for instantaneous settlement, something traditional exchanges have yet to widely provide.
What can be learned from TradFi?
One of the biggest lessons for the regulation of digital assets springs from the 2008 global financial crisis, and the resulting onslaught of new regulations around the world. Post-crisis, the G20 focused on drawing up a comprehensive regulatory framework for a new global financial system. The principles behind this framework included increased transparency for OTC derivatives, more stringent transaction reporting requirements, and improved investor protection rules; all intended to make sure that the marketplace is fair, risks are disclosed, and that investors can invest safely.
Fortunately, aspects relating to these principles can be mapped directly from TradFi to decentralized finance. It is expected that DeFi protocols, for instance, will eventually have to comply with anti-money laundering (AML) and Know Your Customer (KYC) rules relating to themes of suitability, appropriateness, reporting and transparency. In addition, best execution requirements may be established in order to ensure the competitiveness of market structure.
Custody of digital assets has many aspects similar to custody in TradFi as well as risks unique to these evolving products. Regulatory progress needs to keep pace with the evolution and speed of market participants. In addition, TradFi mechanisms for transaction reporting and credit risk management do not have exact analogues in the digital asset space.
Aspects of decentralized finance
Nevertheless, there are some distinct elements in the digital asset space that need to be considered with regards to future regulation. Questions have been raised around stablecoins, such as who will be allowed to issue them and whether ring-fencing should be required around the reserves of a stablecoin issuer. Likewise with custody: who should be allowed to act as a custodian, and how will assets be protected?
Furthermore, the lack of central intermediating legal entities causes regulators to ask questions around clarity of responsibility for regulatory compliance. What is the jurisdictional nexus for a digital asset that is executed via smart contract on a distributed ledger? Ensuring that market participants have undergone appropriate AML/KYC checks is a challenge when there is neither a central entity to hold accountable for such checks, nor a universally recognized standard for identity verification. This could potentially be solved through liquidity gatekeeping or the introduction of third party KYC/ID services for market participants. There may be a role to play for a ‘compliance Oracle’ that could take information about the nature of the transaction and record a verifiable proof of compliance directly to the ledger.
The key to achieving decentralized execution revolves around compliance being verified by software and third party proofs, rather than a single trusted central party.
Much work is left to be done. Institutions are continuing to engage in their exploration of the digital assets space, and simultaneously global digital assets regulation and guidance are being progressed in countries such as the US, Europe, UK, and Singapore, amongst others.
While large financial institutions might still remain cautious about entering the digital asset space in 2023, we expect there to be deeper penetration once there is more regulatory clarity on custody and balance sheet requirements. The European crypto-asset regulation (MiCA) provides a starting point for a regulatory framework that facilitates meaningful market structure, yet pragmatic interpretation of MiCA’s thresholds, transparency, and reporting will most likely be guided by existing advice in, and experience with, previous regulations such as MiFID/EMIR.
It is critical at this draft stage for industry participants to help inform regulations around digital assets, and adherence will need to be prioritized when regulations do eventually come into place.
In order for TradFi to more fully integrate digital assets, it is likely that money laundering sanctions and identity exchange will feature as interface points to facilitate compliance. We have seen increased regulatory activity and enforcement actions related to digital assets that organizations and companies are going to have to adhere to for consumer and investor protection. In the long run, the establishment of the regulatory landscape and the incorporation of these rules will determine the extent to which institutional or professional investors seeking opportunity will invest in digital assets. Governance will be key.