Dialogue and Collision Between Traditional Finance and the Crypto World - Interview with Columbia University Finance Professor Prof Agostino

Author: Prof. Agostino Capponi

Compiled by: Joseph, Sutianne, Arcane Labs

"Crypto investment has enormous potential to expand traditional financial services, but the key is to empower the financial investment paradigm to deal with the unique risk profile and investment opportunities of the digital world."

------Professor Agostino Capponi

"Cryptocurrency investment has great potential to expand traditional financial services, and the key to unlocking this potential is to empower the financial investment paradigm to address the unique risks and investment opportunities of the digital world."

------Professor Agostino

Professor Profile:

Professor Agostino currently serves as an Associate Professor of Finance at Columbia University and is the founding director of the Center for Digital Finance and Technologies, as well as a member of the Data Science Institute.

Professor Agostino's research has been published in several prestigious academic forums and journals, including the Journal of Political Economy, Journal of Monetary Economics, Review of Asset Pricing Studies, Journal of Financial and Quantitative Analysis, Management Science, Operations Research, and Mathematical Finance.

Additionally, Professor Agostino is a researcher at the Crypto and Blockchain Economic Research Forum, a fellow at the Luohoan Academy of Alibaba Group, and a researcher at the Fintech@Cornell Center.

This article is a core excerpt from an interview conducted by the Arcane Labs team with Professor Agostino from Columbia University, focusing on hot topics such as regulation, academic research, DID, SBT, DeFi, industry trends, and more. Highlights from the Interview:

• It is suggested to consider revising the standards of the Howey Test to include asset classes of digital assets, thereby establishing a new regulatory framework that aligns with the development of the digital asset industry.

• The future regulatory system for digital currencies may be distributed, with some regulations automatically enforced by smart contracts, while others are implemented by KOLs through incentive mechanisms.

• The future regulatory system and its institutions need to be decentralized, operated by an international regulatory committee.

• The decentralized status of DAOs is difficult to achieve autonomously in the absence of a complete incentive mechanism.

• There is almost no conflict of interest between academia and government or private institutions, and it can even generate significant synergies.

• In the next decade, the core business of banks is unlikely to be challenged or disrupted by DeFi.

• DeFi introduces a series of entirely new unknown risks and potential issues, including Oracle risk, protocol risk, governance risk, and arbitrage.

• The development speed of DeFi is in line with its regulatory system and policies.

• In the competition of homogeneous products and services, ultimately, only a few products will survive, while other brands will exit the industry. The test of time will ultimately filter out value-driven projects, while those without value will exit due to a decrease in users.

• Solutions that allow users to protect transaction privacy and gain value from verifying transactions may become an important track in the next bull market.

1: The Crypto Industry, Digital Assets, and Regulation

Frank Fan: How will the Howey Test affect digital currencies?

Agostino: The existing securities regulatory framework still needs improvement, and the Howey Test needs to be updated and modified based on digital assets.

The Howey Test legally defines the core characteristics of traditional securities—"agency theory," which means shareholders extract value from the manager's work results in the form of investment returns. Currently, project parties in the crypto industry avoid income distribution by repurchasing issued governance tokens, indirectly circumventing the Howey Test. The digital assets designed by project developers, such as stablecoins and governance tokens, do not fully comply with the applicable objects of the existing asset regulatory framework due to their intention to avoid regulation.

Such situations demonstrate that the existing regulatory framework is difficult to apply to the newly emerging digital assets in the crypto industry. Therefore, it is recommended that the regulatory system consider revising the standards of the Howey Test to include asset classes of digital assets, thereby establishing a new regulatory framework that aligns with the development of the digital asset industry.

Frank Fan: What might a future framework to replace the existing digital asset regulation look like?

**Agostino: First, it is necessary to define each type of token and its characteristics, establishing a classification and subject for tokens. The subjects and classifications serve as the foundation for the regulatory framework, upon which specific rules of regulatory provisions can be automated through smart contracts. *The future regulatory system for digital currencies may be distributed, with some regulations automatically enforced by smart contracts, while others are implemented by KOLs through incentive mechanisms.*

Frank Fan: Will there be dedicated institutions responsible for regulating digital assets through smart contracts?

**Agostino: Due to the volatility and innovation of the industry, digital assets will certainly require dedicated regulatory institutions in the future. However, the regulatory provisions for digital assets will not be formulated by traditional institutions such as economists, financial professionals, or lawyers. *On the contrary, the personnel of future regulatory institutions must understand the core operational mechanisms of digital assets, be able to develop smart contracts, and comprehend the governance rules embedded in smart contracts to formulate and enforce a comprehensive regulatory framework.*

Considering the friction between different jurisdictions and the 24-hour operation of the digital asset financial market, the regulatory institution must be operated and managed by an international regulatory committee. This international regulatory committee can respond promptly to emergencies in the crypto industry while avoiding friction between national policies. If the institution is based on a country or region, it must establish automated regulatory infrastructure to avoid the need for a single centralized solution. After all, the underlying technology and philosophy of digital assets are decentralized.

When discussing decentralization, it is also important to distinguish between the parts of DeFi that need regulation and those that do not. If DeFi becomes gradually centralized due to regulatory influence, potential scenarios may include strong requirements for collateral within the DeFi ecosystem. The advantage of this requirement is the enhancement of resistance to network attacks and widespread acceptance by users, while the downside is the strengthening of centralization. Another potential scenario of centralized DeFi is that users may need to undergo layers of KYC certification to conduct transactions, making DeFi inefficient.

In summary, a non-centralized regulatory system and institution are necessary, while excessive regulation will lead to the centralization of infrastructure, which contradicts the philosophy of blockchain and digital assets.

Frank Fan: What current government or institutional regulations exist for digital assets?

Agostino: Currently, the United States has entrusted the regulatory responsibilities of the digital asset market to two agencies: the SEC and the CFTC.

The current debate revolves around how regulatory agencies should treat digital assets, whether as securities or derivatives. These agencies have not conducted investigations or research on the emerging new types of digital assets. There is still no consensus on how digital assets should be traded.

Additionally, the sanctions against Tornado Cash have sparked a debate on whether smart contracts should be subject to oversight. Regulatory agencies should pay equal attention to the technological characteristics of digital assets while focusing on their financial attributes to fully understand the core of digital assets. The regulatory standards and systems applicable to securities and derivatives do not apply to digital assets, and it is impractical for regulatory agencies to manage digital assets using traditional financial market regulatory methods.

Some Web3 users believe that the crypto industry does not need centralized government regulation, and the Web3 ecosystem can achieve autonomy through incentive mechanisms. However, from various perspectives, achieving autonomous regulation of digital assets is quite difficult. If the digital asset industry wants to implement an autonomous regulatory system, the motivations of investors must align with the social optimal solution and the intentions of regulatory agencies. Existing autonomous governance systems are mostly very intuitive and easy to understand, but at the same time, there are many hidden dangers and risks within the structure.

Taking DAO autonomy as an example, most governance tokens in DAOs are often held by early investors and whale accounts. In fact, individual accounts may hold more than 50% of the total tokens, meaning these individuals can control the decision-making and core governance of the DAO. Combined with the misalignment of incentive mechanisms, this creates significant potential for manipulation, layering, and attacks.

Therefore, the current decentralized status of DAOs is difficult to achieve autonomously in the absence of a complete incentive mechanism. If DAOs struggle to achieve fair and just autonomy, how can autonomy be realized in DeFi or even the entire Web3 ecosystem? This will be an area that the industry needs to continuously improve.

2: Academia, the Education Sector, and Blockchain Technology

Frank Fan: What is your view on the relationship between academic research and the digital asset industry?

Agostino: I believe there is almost no conflict of interest between academia and government or private institutions, and it can even generate significant synergies. Academia can help the industry and government agencies understand the potential of digital assets and also provide guidance to government agencies to support them in making the right decisions. I see many scholars joining the leadership teams of Coinbase or participating in the development of consensus mechanisms, which indicates that academia is helping the crypto industry progress more rapidly.

The research and information provided by academia are based on the current state of the market and its fundamental operating rules. Just as during the 2008 financial crisis, scholars joined the federal government to help explore how to improve the regulation of financial markets. Of course, it is also necessary to consider the differences between academia and the crypto industry.

Since academia studies the innovations observed in the industry, the research subjects and outputs of academia are delayed compared to the emerging digital assets and services in the industry. For example, I am currently researching automated market maker protocols and designing more efficient automated market makers to expand the liquidity providers and investors in the ecosystem. From another perspective, academic research does not focus on the precise details of mechanisms but rather on the underlying logic and mechanisms. In terms of automated market makers, I focus on what type of convex curve can yield how much return, thus deriving the optimal convex curve. Given time, other DEXs may apply our research results, benefiting a broader user base.

Currently, there are two types of scholars in the digital asset field. One type strongly supports blockchain technology, while the other is skeptical. I believe some scholars' skepticism stems from a lack of trust in cryptocurrencies, as cryptocurrencies are the first type of product that scholars encounter in the digital asset field. These skeptical scholars are accustomed to fiat currencies and do not understand the value of digital assets. The inefficiency of cryptocurrency mining and the high energy consumption lead scholars to believe that cryptocurrencies are not well-designed or successful. The design of blockchain consensus algorithms is another reason why scholars are skeptical and dismissive of digital assets. Scholars supporting this field believe that blockchain has the potential to become a technological infrastructure rather than a narrow use case for fintech and cryptocurrencies.

Frank Fan: Do you think DID and soulbound tokens can have an effective impact on the existing education system?

Agostino: DID and SBT have many potential application scenarios in the education system, such as incorporating teaching level certificates into the education system. For example, certifying the completion of online courses or rewarding students through digital assets. However, centralized education systems and certification systems provide many empowering aspects that decentralized systems cannot achieve, such as the networks established between teachers and students in centralized education systems and the research topics generated through communication and discussion. From this perspective, blockchain is unlikely to completely replace centralized education systems and certification agencies in the short term, but the application of new technologies like DID and SBT may lead to innovative practices in some niche areas.

3: Outlook on the Future of the Crypto Industry and Industry Trends

Frank Fan: Is DeFi an innovation in models or a repetition of CeFi's mistakes?

Agostino: DeFi has both advantages and disadvantages. On the positive side, DeFi can overcome some limitations set by CeFi, providing better financial services to a larger user base. For example, reducing intermediary costs, real-time settlement, increasing liquidity for users limited by counterparty risk, and reducing negative externalities through incentive mechanisms.

On the other hand, one of the drawbacks of DeFi is the limitations of its projects. Most projects merely replicate the mechanisms of CeFi and are inefficient. Algorithmic stablecoins are a failed example in the digital asset industry.

Moreover, we should proceed with caution, as DeFi introduces a series of entirely new unknown risks and potential issues, including Oracle risk, protocol risk, governance risk, and arbitrage risk.

Overall, the current DeFi design in the crypto industry is inefficient, and the development and improvement of digital assets still have a long way to go.

Frank Fan: Do you believe there will only be a limited number of successful products or a winner-takes-all scenario in the digital asset industry?

**Agostino: I believe that the digital asset industry will develop into a winner-takes-all market structure in the future. Taking DeFi as an example, many existing DEX projects offer similar services. *In the competition of homogeneous products and services, ultimately, only a few products will survive, while other brands will exit the industry.* From an industry perspective, I believe the core services of digital assets will remain, such as lending and swapping. The rest, like algorithmic stablecoins, will exit the digital asset industry.

Frank Fan: Many asset management companies' portfolios now encompass both digital and traditional assets, blurring the lines between traditional finance and digital assets. Do you think the two will merge in the future or remain separate?

**Agostino: From a long-term development perspective, the industry will certainly see a gradual integration of CeFi and DeFi. Currently, companies and individual clients have begun to use both centralized and decentralized exchanges simultaneously; other examples of integration include stablecoins, which, while pegged to the dollar in CeFi, also exist within a decentralized system; the industry is also about to see the inclusion of central digital currencies (CBDCs); another example is oracles, most of which are manipulated and extract information from centralized exchanges. My guess is that *CeFi and DeFi will merge to some extent in certain specific financial areas, creating a new business model.*

Frank Fan: Regarding the widespread use of digital assets, how do you view the relationship between its progress and the loss of access to addresses and custodial risks?

**Agostino: This depends on the progress of DeFi in developing products and services for non-technical background users. *I do not believe that DeFi will ultimately replace banks unless DeFi services are friendly and easy to use for non-technical users.* Furthermore, DeFi must also be safer and more convenient to be widely adopted by the public.

Central banks have evolved over thousands of years, improving with each iteration. Therefore, I believe that if the industry continues to develop at its current pace, the core business of banks is unlikely to be challenged or disrupted by DeFi in the next decade.

Frank Fan: Do you think the speed of DeFi's development will change?

Agostino: The speed of DeFi's development is in line with its regulatory system and policies. If we can accelerate the pace of designing and improving the regulatory system to establish trust in digital assets among a broad user base and non-technical users, and increase the public's understanding of digital currencies, it will effectively speed up the adoption of DeFi by the masses.

Frank Fan: You mentioned that the industry should eliminate digital assets that are not value-driven. What is your definition of value-driven?

Agostino: The core driving force of value refers to the demand of users for services or products. Taking the automotive industry as an example, Honda addresses users' demand for private transportation within the economic capacity of the public. Analyzing from a transaction perspective, Honda, as a car brand, indirectly provides benefits and value to paying customers.

Web3 projects have such potential, like DEXs and zero-knowledge proofs, but most projects in the industry currently do not genuinely provide valuable or beneficial products or services to users. I believe that the test of time will ultimately filter out value-driven projects in the industry, while those without value will exit due to a decrease in users. This is a self-adjusting process within the market.

Frank Fan: From a macro perspective, who are the ultimate winners and losers in the transition from Web2 to Web3?

Agostino: The winners will be those projects that can design innovative assets, provide valuable services, the users of these projects, and (unfortunately) the bad actors who successfully implement scams. There is currently a project in Kenya that provides financial products and lending services to farmers who cannot borrow from banks due to credit issues, which is a high-quality win-win case.

Losers include most gamblers and scammers. Through the innovation and development of the Web3 space, speculative and hype-driven users will lose their arbitrage opportunities and gradually exit. As the transparency and efficiency of Web3 improve, other losers may include large intermediary institutions based on Web2.

Frank Fan: What applications or infrastructures do you think will become the trigger points for the next bull market? What types of products or services can stimulate large-scale trading and usage? What facilities are currently lacking at the foundational level?

**Agostino: The core issue here is the obstacle faced by DeFi exchanges—"excessive transparency." Transparency is one of the fundamental principles of blockchain, but excessive transparency also deprives users of arbitrage opportunities in trading digital assets, thereby hindering trading volume to some extent. I believe that *solutions that allow users to protect transaction privacy through methods like zero-knowledge proofs while ensuring that miners benefit from verifying transactions will stimulate broader use of DeFi, thereby triggering the next bull market.*

Current innovations, such as Flash Bots and privacy channels, partially address the issues caused by excessive transparency. Dark Transactions can effectively solve user privacy issues, with the process allowing users to submit orders directly to validators, bypassing the blockchain's mempool. Flash Bots also began to be widely used by Ethereum users in mid-2021 to address transaction privacy issues. However, these methods, while successfully protecting user privacy, have deprived miners of arbitrage opportunities, affecting the sustainability of the entire ecosystem. In summary, existing solutions have not yet fully succeeded in protecting user transaction privacy while safeguarding miners' interests. If there are applications or mechanisms that can protect the interests and privacy of all participants in the DeFi ecosystem, DeFi will see broader usage, thereby triggering the next bull market.

Frank Fan: Do you think government or national funds could potentially participate in or inject into the digital asset ecosystem to accelerate the development of digital asset technology?

Agostino: At this stage, due to the lack of industry regulation, government and national participation is limited. In the future, if the digital asset industry can establish a comprehensive incentive mechanism and the government participates in automated governance, then the general public may begin to hold digital assets, generating large-scale trading volumes.

The premise of this phenomenon is the understanding and trust of government agencies in the digital asset industry. Before government agencies consider injecting funds into the crypto industry or incorporating it into the existing economic system (such as taxation), they need to have sufficient trust in the crypto industry.

The current state of the crypto industry, including risk aversion, autonomy in the DeFi space, and incentive mechanisms, is insufficient to instill enough trust in the government regarding the crypto industry. Therefore, the industry has many areas that need continuous evolution and to embrace regulation to reach a point where the government can participate with confidence, which will be an important driving force for industry compliance.

Postscript

Professor Agostino provides insightful perspectives, recognizing the technological and financial value of innovations in digital assets like Crypto and DeFi, while also offering effective suggestions for addressing industry issues and bubbles, ranging from regulation to industry development. Professor Agostino is confident in the industry's development and has provided valuable advice for the investment themes and directions of our Arcane Fund.

This interview marks the first in-depth exchange between Arcane Labs and the Center for Digital Finance and Technologies at Columbia University in the United States. In the future, both parties will engage in comprehensive cooperation in industry research, technology research, project research, and more. Arcane Labs will provide in-depth industry data, industry dynamics in the Asia-Pacific region, and the latest industry trends to the Center for Digital Finance and Technologies at Columbia University. Meanwhile, the center will combine the latest regulations, technologies, and models in the global digital finance industry to provide objective, in-depth, and rational academic analyses and research reports, jointly promoting the deep integration of industry and academia, as well as communication between Western academia and Eastern markets.