While markets are busy with the O word and its temporary impact on world economies, I’d like to take a step back and see how the cryptocurrency world is interacting with traditional finance.
MERGING CRYPTOCURRENCY AND TRADITIONAL FINANCE
The challenge for cryptocurrencies and traditional finance is that cryptocurrencies are something very new and very different from the technology world. In the first decade of cryptocurrencies, it created a world with its own set of institutions, exchanges, and cultures. The world of cryptocurrency was different, and traditional finance institutions were slow, so there was no mechanism by which cryptocurrency could interoperate with conventional finance.
However, over the last two years, there has been a merging of cryptocurrencies and traditional finance. Traditional finance sees cryptocurrencies as a means for incorporating new technology into finance. In contrast, by becoming part of the conventional financial world, cryptocurrencies can access the financial rewards and benefits of becoming part of the economic mainstream.
The difficulty in merging the crypto-world and the world of traditional finance was in part due to regulation. Traditional finance is a heavily regulated industry, and the rules being created by consensus tend to be highly inflexible. In addition, cryptocurrencies are inherently trans-national, while regulation tends to be highly national. But as the worlds have merged, the regulators have found the means of incorporating cryptocurrencies into the old regulatory system.
THE THREE DIFFERENT TYPES OF REGULATION
In looking at how cryptocurrency is regulated, we need to look at the different types of financial regulation. Each type of regulation has a different set of institutions and goals and approaches cryptocurrency regulations differently. The three types of financial regulation are:
* anti-money laundering
* market conduct regulation
* systemic risk regulation
The first set of regulations to be applied to cryptocurrency involved anti-money laundering regulation. This type of regulation involves tracking and tracing money to make this information available to law enforcement and tax authorities. Although this type of regulation is implemented at the national level, all nations coordinate anti-money laundering rules through the Financial Action Task Force (FATF). As a result, the regulations for anti-money laundering have mainly been standardized. The main effect of these rules is to eliminate anonymous cryptocurrency trading and require that exchanges gather customer information.
The second set of regulations are regulations on market conduct. These include things like consumer protection and anti-trust. Market conduct regulation is concerned less with trading than regulating how financial products are advertised, sold, and processed. These involve national agencies but are not coordinated in the same way that anti-money laundering regulations are. The result is that cryptocurrencies are now treated like any other financial product and are subject to the same rules concerning advertising and product management.
The final set of regulations consist of regulation of systemic risk. The question addressed by these regulations is whether anything can happen with cryptocurrencies that could destroy the entire economy. Central banks typically do this type of regulation.
In the West, there is a mature financial system, and the goal of regulation is to get cryptocurrency to fit into the existing market conduct regulation, and cryptocurrency has not grown to the point where people are worried about the systemic risk to the entire economy. In China, the financial system was less mature, and cryptocurrencies entered Chinese finance at the same time as many other new technologies. So the industry has grown large enough so that China is worried more about cryptocurrency as a threat to the entire financial system rather than market conduct.
TRADE-OFFS IN BECOMING CONVENTIONAL
The fact that cryptocurrency is becoming mainstream is suitable for cryptocurrency investors since it is becoming an integral part of the world financial system. However, one tradeoff in becoming mainstream is that the people doing cryptocurrencies have had to throw away many of its technological benefits. In addition, because regulators insist that cryptocurrency is regulated like traditional financial products, cryptocurrency institutions have been forced to do things in the old inefficient backward ways rather than taking advantage of the new technology.
For example, one of the initial promises of bitcoin would be that you could send money instantly anywhere. However, cryptocurrency now has the same inefficiencies as traditional financial products because you are forced to keep regulatory records.
THE HYBRID FUTURE OF CRYPTOCURRENCY
In this regulatory environment, a lot of new emphasis has been put on decentralized finance and NFTs. NFTs have been used to create digital artifacts that are not subject to regulation, whereas decentralized finance establishes a mechanism that traditional regulators would find hard to regulate.
What is happening with cryptocurrencies is that it is getting the best of both worlds. The parts of the cryptocurrency world that have merged with traditional finance bring the users and capital available in that world, but at the cost of being unable to take advantage of the efficiencies and new workflows made possible by blockchain technology. At the same time, as cryptocurrencies are becoming mainstream, people are moving into new unregulated areas and developing new technology there.
What should an investor do?
A lot depends on one's risk tolerance and appetite for innovation. If you want to view cryptocurrency as just another financial product, then one would focus on the parts of the industry that are merging with traditional financial products and trade in regulated exchanges where things are familiar. If one's interest is in technology and innovations, one should familiarize oneself with the new technologies. Once COVID lifts, we will be in an entirely new world, and the technologies will likely find some unique and creative use that is currently not clear.
Why is the problem with cryptocurrency being so flexible?
Much of the promise of cryptocurrency was that new technology would allow us to do finance in new ways. The trouble is that while technology is flexible, human institutions are not, and much of the story of cryptocurrency has been to mold new technologies into old systems. Unfortunately, however, this creates a situation where the benefits of the latest technologies cannot be taken advantage of.
What is next for cryptocurrency?
The good news about cryptocurrency is that there are parts of the crypto world that have become traditional, while at the same time, there are new, unregulated areas in which innovation can occur. This gives cryptocurrency the benefits of being part of the traditional financial system while leaving space for it to do new and innovative things.
The world has changed enormously because of COVID, and as COVID lifts, we will be in a completely different world. How cryptocurrencies and blockchain technology will function in this new world remains unknown. Still, there is space in the unregulated sectors for unique and creative use of the technology to flourish.
*This communication is intended as strictly informational, and nothing herein constitutes an offer or a recommendation to buy, sell, or retain any specific product, security or investment, or to utilise or refrain from utilising any particular service. The use of the products and services referred to herein may be subject to certain limitations in specific jurisdictions. This communication does not constitute and shall under no circumstances be deemed to constitute investment advice. This communication is not intended to constitute a public offering of securities within the meaning of any applicable legislation.