Last week was dominated by reports relating to Facebook’s crypto project; regulators have been quick to pinpoint the project’s design flaws and the risks surrounding the digital currency. Apart from the widely publicized testimony to US lawmakers on Libra by the head of Facebook’s blockchain subsidiary Calibra, a working group set up by the G7 group of major western economies and Japan noted that cryptocurrencies such as Facebook’s Libra will need to be tightly regulated or they could destabilize the global economy. In a preliminary report by the group led by Benoît Cœuré of the European Central Bank, the digital currency risks being used for money laundering and the financing of terrorism. So, does this mean that the contentious project will lead to tighter regulatory surveillance over Bitcoin and the broader cryptocurrency industry?
On the one hand, regulators and policy watchdogs have been much more proactive in targeting groups and firms that they believe have been circumventing securities related regulation, and this is of course very much applicable to crypto exchanges.
The latest case is BitMex, which is said to be under investigation by the CFTC. The probe is focused on whether BitMEX broke rules by allowing Americans to trade on the platform, which isn’t registered with the agency. As reported by Bloomberg, BitMEX Chief Executive Officer Arthur Hayes said in an interview in January that BitMEX removes anyone who flouts company rules barring US residents and nationals. However, it is possible clients masked their location by using virtual private networks to give their computers an Internet protocol address from a BitMEX permitted country, tricking the filters put in place. The SEC may not have immediate jurisdictional power over the exchange but it is worth highlighting that in the 24-hours following the news release, there was around $70mln worth of outflows reported on the platform.
In the grand scheme of things, the outflow statistic may be insignificant as it represents a small proportion of the total volume that is traded on the venue but it does show that even with somewhat limited oversight power, a threat of regulatory action is enough to cause capital flight. Still, more likely than not, and similarly to the Tether/Bitfinex lawsuit, the threat of an extended sell-off as a result of this development alone is low.
At the same time, there is plenty of evidence to suggest that the very same regulatory bodies are getting more comfortable with the idea of digital assets. For example, the UK approved its first asset manager that specializes in cryptocurrencies, namely Prime Factor Capital, while over in the US, LedgerX got approval to trade Bitcoin futures and swaps that are settled in the digital currency. However, for fund managers and banks to enter the crypto arena, there needs to be more clarity—specifically around the topic of a qualified custodian, which by law funds have to turn to for the safe keeping of securities. On that note, according to press reports, Fidelity’s cryptocurrency investment arm filed an application with the New York Department of Financial Service (NYFDS) and if approved the institutional brokerage will be allowed to offer crypto-custodial services in the state.
A number of crypto commentators and high-profile members of the fast-growing crypto community have been very vocal to speak of the benefits that Bitcoin and other cryptocurrencies will bring to the global economy, especially in the face of global growth stagnation. Alongside this, there have been studies showing that adding crypto assets can be beneficial to optimizing and balancing out portfolios. This may be particularly appealing given the falling bond yields, where according to data from Barclays, the total amount of bonds that provide a negative yield is at $13tn by the latest count, up from $6tn in October. What is also notable is the apparent correlation between the growing volume of negative-yielding bonds and the rising value of gold.
In normal times buying gold means missing out on earning interest on other assets such as bonds and stocks, the so-called “opportunity cost” of buying the precious metal. But given the precarious times in the bond market, that appetite for gold is on the rise and is once again seen as one of the few solid hedges against the possibility of a US slowdown, further rise in geopolitical tensions or currency devaluation risks. Gold recently hit a 6-year high above $1,400 and as reported by the FT, that move higher has been sustained by inflows into gold-backed exchange-traded funds, which rose to a 5-year high of 74m ounces of gold worth $105bn. That is 17.7m less than the all-time peak of 92m ounces of gold held by ETFs in 2011, at the height of the Eurozone debt crisis.
Even billionaire hedge fund founder Ray Dalio said in a LinkedIn post that in a negative yield environment it “would be both risk-reducing and return-enhancing to consider adding gold to one’s portfolio.” On that note, earlier in the year, press reports indicated that blockchain trust company Paxos’ digital token backed by precious metals will be launched sometime this year.
Getting back to regulatory issues, only last week Federal Reserve Bank of St. Louis President James Bullard discussed “Public and Private Currency Competition” and also touched on the topic of cryptocurrencies. Specifically, he said that research on the “private money” suggests that public and private currencies can compete and coexist. Cryptocurrencies are creating drift toward a non-uniform currency in the US, a state of affairs that has existed historically but was disliked and eventually replaced. He also noted that global currency competition is nothing new, nor is electronic delivery of value. Furthermore, there are also micro-currencies of many types, while also pointing out that cigarettes became a currency among prisoners of war (POW) during World War II, and he quoted a folk theorem from monetary theory that says “anything can be a currency.” Reading between the lines, it seems like the Federal Reserve isn’t too concerned, at least not presently, about the rise of digital currencies.
However, there is one area of digital asset market that may catch the attention of the Fed and other regulatory bodies and that is Decentralised Finance (DeFi), particularly projects that provide decentralized lending. In other words, decentralized lending platforms that provide loans to business or the public with no intermediaries. One of the leading firms engaging in this is the Celsius Network, which launched in July 2018, and provides cash and stablecoin loans. The company receives interest when users deposit coins into respective Celsius Network wallets and, according to company slides, it has already provided over $2bln in coin loans. Other firms such as Atomic Capital specialize in crypto-backed loans, where users can receive up to 85% of the value of their assets in USD.
There are many more platforms out there, some good, some bad and, just like challenger banks that are yet to pose a material threat to mainstream banking system, this has meant that these innovative firms have been allowed to operate even in spite of apparent regulatory and non-regulatory overlaps. However, similarly to BitMex and Bitfinex, any slip-ups when it comes to strict KYC/AML checks will not go unpunished and, given the exponential growth of these companies and stretched resources, there is a risk that it is a matter of when and not if, such a case will be brought to light by regulators.
As a reminder, earlier in the year, the United States Securities and Exchanges Commission (SEC) Chairman Jay Clayton confirmed that Ethereum (ETH) and cryptocurrencies like it aren’t securities under US law. Now, while it is possible that this view might change should the DeFi market continue to grow, it is more likely that the firms that conduct lending practices will come under greater scrutiny which in itself is not a bad thing. In fact, the opposite is true, regulation and oversight will only serve to encourage traditional firms to enter the market, especially given the favorable yield environment. Directly, given Ethereum’s dominance in the market, this would likely further network growth and therefore bring about a higher valuation. The above isn’t expected to serve as an argument for Ethereum to displace Bitcoin as the most valuable digital asset but the scope for Ethereum derived applications to penetrate legacy systems is probably higher than that of Bitcoin.
Finally, as alluded to earlier, gold continues to attract plenty of interest despite a lack of dividend or coupon payments, and it does not carry the same price volatility risk as Bitcoin…
Thank you for reading,
The BeQuant’s Analytics team