The Traditional Finance (TradFi) ecosystem is facing increased regulatory challenges as a result of the advent of digital assets and decentralized technologies.

Money guardians appointed by governments, private cartels, and Multilateral Financial Institutions are struggling to keep up with cryptocurrency’s rapid evolution and the interest it has drawn from investors.

Since the start of the recent bull market (end of 2020), publicly traded companies, funds, high-net-worth individuals, and even governments, had increased their digital assets holdings substantially.

To date, they hold around 8% of the total Bitcoin supply (around USD 65 billion).

Bitcoin Treasuries
Source: https://bitcointreasuries.net/

My purpose in this post is to discuss on the surface why it is fundamentally problematic to regulate cryptocurrencies by understanding the nature of decentralized digital currencies, such as BTC and ETH.

A rebellious nature

It all started with the ingenuity of the cyberpunks revolution. More than thirty years of open-sourced developments around distributed networks and cryptography paved the way for Bitcoin, the first decentralized digital money.

Bitcoin inception opened the door for a dramatic upgrade in the way we exchange value.

Its dual reality, being at the same time a secure cross-border peer-to-peer monetary network and a ubiquitous currency outside the control of any centralized authority is, simply, a civilization-grade paradigm shift.

Moreover, its by-product, blockchain technology, poses a major disruption challenge to financial institutions. It is an emerging reality that none of them can escape.

[Blockchain is] an indisputably neutral, distributed way of expressing individual ownership … the most plausible path towards an ultimate long-term open framework where everyone’s in control of their own presence, free of gatekeeping.

Tim Sweeney (2021) cited in Matthewball.vc.

Onboarding the digital ship

On the other hand, the future would be faster and even more interconnected than it is now. This is a solid precept characterized by Moore’s law and, more recently, by Huang’s Law, which goes beyond the hardware improvements capabilities and brings exponential growth to the increasingly AI-dominated era.

This perfect combination accelerated the shakeup of the banking industry. Previously, Fintech made –and continue doing– its part, but now it’s time to shine for Decentralized Finances (DeFi).

Over a decade of Bitcoin and Decentralized Ledger Technologies has attracted more than 300 million people and 18,000+ businesses who have dealt with cryptocurrencies at some point. Moreover, in terms of networks effects estimations, Bitcoin may be at a “tipping point”, similar to the use of mobile phones in 1997.

Then, what does this increasing demand for digital assets means for TradFi? Is it doomed to be replaced by this wave of incremental innovation, or will it subsist and adapt to this fast-changing environment?

Digital monies vs digital decentralized monies

To keep things clear, digital money is not a new concept. Consider PayPal (founded 21 years ago) and the digital dollar in your online banking app you may have held since ages.

By contrast, decentralized digital assets can freely move across jurisdictions in the blink of an eye. What’s more, the same cryptographic principles that protect even the most sensitive classified military record are at the reach of every human or computer-based entity. Hence, decentralized digital assets are fundamentally a different creature.

Former electronic money can be overseen, controlled and subject to law enforcement authorities. TradFi institutions needs licenses and permissions to operate, whereas in DeFi, service providers and users could remain autonomous within the boundaries of its networks.

Compliance challenges

By definition, a public blockchain (and therefore, its underlying currencies and tokens) is meant to be permissionless, immutable, and transparent. Because they are web-native and operate under open protocols, they don’t need central intervention, which sets them apart from TradFi regulatory dependencies.

But, wait, let’s not get fooled. Although regulators cannot interfere with digital assets –at a protocol level– they can intervene both in the entry and exit level. How do you buy cryptocurrencies? More likely through a credit card transaction or a bank transfer (regulated). What about cashing out? The same process applies.

Thus, the regulation of digital assets is subject to issues of interfacing the fiat world with the blockchain autonomous universe.

Here is where regulation challenges start making sense. For instance, how should watchdogs deal with data protection mandates when any record cannot be erased or modified once registered in the blockchain (in most cases).

Or, how to perform effective market surveillance, and KYC/AML/CFT due diligence in an environment where transactions could be masked by non-personally identifiable addresses. Furthermore, escaping traceability by using autonomous, liquid, and censorship-resistant decentralized exchanges (for instance, SecretSwap).

The state of things

Currently, only a few countries have statutory laws and regulations in place​​ for dealing with digital assets, their classification, their custody, and management.

Interestingly, while this conversation occurs, TradFi instruments such as derivates, prime brokerage, and synthetics already had emulated-versions operating under the DeFi multiverse umbrella. Additionally, DeFi is becoming more and more agnostic, scalable, and interoperable through second layers, side-chains, and swaps between blockchain networks. It seems impossible for these digital organisms to stop growing and expanding.

It is extremely worrying that policy-makers have reacted slowly to these important issues that may have huge implications for the world’s financial stability.

If governments are one step behind innovation, then market forces will drive private individuals to push for regulatory clarity and enabling secure environments for interfacing TradFi with digital assets. This scenario would have a limited impact.

Alternatively, it can be the case that due to a lack of consensus, DeFi fortifies to a point where it becomes a legit and independent body. A utopia (or dystopia) dominated by the promising Bitcoin Standard.

How to address cryptocurrency regulations?

Coming down to earth and the year 2021, we may find some clarity on how to tackle this issue in Hayek’s words.

He argued that, by nature, information is scattered between individuals. Therefore, the collective sum of these fractions of information results in better decision-making, being more effective than the narrow views of independent central authorities.

By recognizing the reality of this emerging asset class, international cooperation in this matter can become the basis for creating comprehensive and enforceable frameworks. During these conversations, the private sector as well as those who developed these technologies need to be included.

Arguably, this may foster a secure flow of digital assets under the premises of free-market laws, attuned with the protection that the Enterprise and main actors are expecting.

Wolrd Economic Forum report about blockchain
Accordingly, The World Economic Forum recently published a report about blockchain technologies which presents an interesting overview about policy, regulations and law. It is worth reading.