Insights on Traditional Financial Markets Embracing the Crypto World

This article is from the public account of Distributed Capital.

More and more signs indicate that traditional financial companies are embracing cryptocurrencies and crypto technology. The listing of the cryptocurrency exchange Coinbase, the approval of Bitcoin ETFs by Canadian financial authorities, the decision of U.S. global custodian bank BNY Mellon to handle digital virtual assets like Bitcoin and Ethereum, and the recent $80 million Series C financing of digital asset bank Anchorage backed by Singapore government funds; such events demonstrate that traditional financial companies are embracing cryptocurrencies and technology, making 2021 the year of blockchain.

However, this "embrace" is not instantaneous; the attitude change from "rejection" to "gradual acceptance" among traditional financial companies and regulatory bodies in some more open-minded countries is subtle. (These countries include Singapore, Switzerland, the UK, Canada, etc., which are relatively open to cryptocurrencies.) From a regulatory perspective, "it's better to guide than to block"—when the market has grown to a certain scale, completely prohibiting it is less effective than establishing a clearer regulatory framework (or incorporating the cryptocurrency industry into the existing regulatory system). From a business perspective, when the regulatory environment is clearer, engaging in cryptocurrency-related business activities is considered market behavior. Especially when companies realize that allocating digital assets meets market demand and is a way to expand their business and enhance competitiveness within the industry, it becomes more logical for them to engage in such businesses.

In this regard, many financial companies have come to understand this point, with venture capital, hedge funds, investment banks, and asset management companies being the first to take the plunge. Ultimately, the improvement of cryptocurrency infrastructure has made it easier and more compliant for traditional companies to purchase cryptocurrencies. After all, compliant purchasing channels are the most basic requirement for traditional companies to enter the crypto industry.

After clarifying this broader context, we also need to explore the future possibilities of traditional institutions "entering the circle" and the crypto industry "going beyond the circle." Of course, some of these possibilities have already been put into practice, while others are still being explored.

The Extension of DeFi Protocols to the Traditional World

What we know is that there are users participating behind current DeFi protocols; some are lending, some are borrowing, and others are providing liquidity and market-making—only we do not know who these users are. In fact, many DeFi protocols currently involve various types of financial institutions (including but not limited to licensed financial institutions). As long as the business processes are compliant and meet financial regulatory requirements, licensed institutions can also operate their funds through DeFi protocols. Compared to the 1-2% interest earned by keeping money in banks, the annual interest rates obtained from DeFi lending platforms can maintain between 5%-20%, which is more attractive to traditional institutional funds.

Here’s an example of AAVE. AAVE is currently collaborating with some crypto institutions to promote the extension of DeFi protocols into the traditional world. Recently, Swiss compliant financial crypto company CrescoFin announced that it will develop an insurance collateralized currency market on Aave, creating low-risk DeFi yield opportunities by insuring real-world assets. CrescoFin guarantees the safety of all deposits made by users adopting DeFi protocols through insurance, providing users with returns higher than bank interest rates while reducing the risks associated with DeFi protocols. CrescoFin is a compliant blockchain financial institution in Switzerland, focusing on serving institutional investors in the traditional financial sector for the USD, EUR, and CHF markets. Cresco's "entry" case shows that although DeFi has not yet truly integrated into the traditional financial world, Cresco is acting as a bridge, introducing financial products related to DeFi to the traditional world and striving to make attempts.

Vitalik once said that in the long run, the annual interest rates of DeFi protocols will not exceed the highest levels of traditional finance by more than a hundred basis points; the most valuable part of DeFi may be the most boring part. Indeed, the benefits of DeFi go beyond high interest rates: the lack of entry restrictions and geographical limitations makes inclusive finance possible; DeFi can achieve the disintermediation, trustlessness, and automation of deposits, loans, and repayments through smart contracts, naturally solving the trust issues between individuals… DeFi has revolutionary significance for traditional financial businesses.

The "Legalization" Path of Stablecoins

In the future, stablecoins will undoubtedly be the key bridge connecting the traditional financial world and the crypto world. In the long run, stablecoins are trending towards greater compliance. Recently, Tether, the issuer of USDT, agreed to pay $18.5 million to settle with the New York Attorney General. Although this settlement temporarily removes the sword of Damocles hanging over the crypto circle, the compliance of stablecoins still has a long way to go.

What are the main issues with the operation of stablecoins currently? Theoretically, legal capital flows should occur between individuals with real-name authentication, meaning that holders should be identifiable to prevent money laundering, terrorism financing, and other illegal activities. However, the circulation of stablecoins like USDC and USDT is anonymous, allowing them to flow to any address (regardless of whether it has undergone KYC) without obstacles, and only requires real-name verification when the holder attempts to redeem for fiat currency.

So, what should a legal stablecoin look like? How can compliance be achieved? This certainly depends on the specific regulatory requirements of each country/region, as the requirements vary. But from the perspective of strict financial regulatory practices: the most basic requirement is that compliant stablecoins are limited to internal circulation among KYC-verified customer groups within the financial system; thus, issuers need to ensure the identification of each holder's identity, and stablecoins should not flow into addresses of non-KYC users. Regarding this issue, while on-chain DID is not yet widespread, NFTs can serve as a means of identity verification. During stablecoin transfers, each address owned by a user can be verified by an NFT. If a user attempts to transfer money to a non-KYC user address, the funds should be frozen unless that address proves the identity of the holder through an NFT.

Secondly, the qualifications of stablecoin issuers are also key to "compliance." According to Coinmetrics, since February of this year, the market share of USDT in the stablecoin market has fallen below 75% for the first time. On the other hand, the market share of USDC has grown to a historical high of 15%, largely due to the compliance qualifications of its issuer, Circle. In applications closer to the real world (such as NBA Top Shot, which supports cryptocurrency and credit card payments), many project parties adopt more stablecoins like USDC to achieve compliance.

STOs Have More Imagination Space

STO, or Security Token Offering, refers to the issuance of security tokens under the constraints of securities laws and financial regulations. The act of financing through the issuance of securitized tokens, Security Tokens, is a model that lies between ICO and IPO, and is an effective way for the crypto industry to self-regulate and seek long-term development, with several successful issuance cases already in reality. Of course, the large-scale popularization of STOs still requires the crypto market to adapt to relevant regulatory bodies, which is a gradual process, especially in terms of the infrastructure for issuance.

Observations and Outlook on Various Financial Institutions Embracing Blockchain

As we enter 2021, we find that the trend of traditional financial institutions embracing cryptocurrencies is becoming increasingly pronounced. Blockchain can indeed bring new business models that have never existed in the real financial world, and many financial institutions are eager to explore new business models. Moreover, this trend is spreading from financial institutions that are relatively lightly regulated (such as venture capital, hedge funds, and investment banks) to those that are more heavily regulated (such as banks). It is spreading from risk-seeking financial institutions to those with lower risk appetites. Given the different attributes and risk preferences of financial institutions, the approaches to blockchain vary.

Venture Capital & Hedge Funds: Venture capital, which is subject to less financial regulation, has already reaped early benefits from the crypto market. Smart venture capitalists are betting on blockchain startups with promising future prospects. Similarly, the high volatility and returns of cryptocurrencies are attracting crypto hedge funds to enter the market.

Options and Futures Exchanges: Options and futures exchanges have also begun to offer products related to cryptocurrencies, such as the Chicago Mercantile Exchange, which has cryptocurrency derivatives (like Bitcoin futures). In addition to the CME, there are similar businesses in various countries, such as Deribit and LedgerX. Generally, trading options and futures products require regulation in various countries, so the pace of product development and provision will not be too fast. However, the reality is that there are too many unregulated wild exchanges, and various derivatives related to cryptocurrencies are quite comprehensive.

Investment Banks: Investment banks are already laying out their prime brokerage business for digital assets, such as custodial services or trading cryptocurrencies for clients. Additionally, investment banks will also expand into STO (securitized token) business, helping various real-world assets to be tokenized and put on-chain within a compliant framework.

Insurance: The combination of blockchain and insurance is also the most ideal landing field for token economies, especially for mutual insurance. However, this industry is still in a relatively early stage, and many applications are still in the experimental phase.

Banks: Because commercial banks have the largest capital volume and the lowest risk appetite, banking financial institutions are not suitable for directly entering the blockchain industry, especially not for engaging in DeFi protocols, as even a small amount of funds could overwhelm DeFi. Banks do not pursue speculative activities but rather seek long-term stable investment returns. The stability of banks leads to their demand for blockchain being more focused on improving internal operational efficiency, especially in payments and settlements.