I want to highlight for those within the legacy financial services industry the importance of awareness of events taking place within the virtual asset (VA) ecosystem. To quote the great NBA legend Bill Bradley, “Becoming number one is easier than remaining number one.” This post is especially for those still skeptical of VA’s and virtual asset service providers (VASPs) and who may follow renowned economist and VA naysayer Nouriel Roubini (Dr. Doom Opinion). Legacy financial service providers must take the time to understand how the VA ecosystem operates and how to adapt to those functions and adopting operating principles that may seem somewhat unconventional when compared to how financial institutions have functioned for decades. This should not be viewed from a position of competitive fear but more as an opportunity to embrace conventions that will benefit the entire world.
Bitcoin provided the initial disruption impacting money service businesses, credit, and debit card providers; removed financial intermediaries; empowered developing economies; and established a borderless universal currency. Thanks to the underlying blockchain technology, a more profound wave of legacy financial institution disruption has taken shape in the form of decentralized finance (DeFi).
The first entity to fully exploit significant characteristics that define DeFi is MakerDAO, an entity whose name is derived from Maker (a governance token that supports the functioning of the enterprise) and DAO (a distributed autonomous organization). A DAO is not operated by any one entity or individual and is fully automated through smart contracts (in this case running on the Ethereum Blockchain). Dai is the organization’s stable coin (a VA not exposed to the extreme price volatility exhibited by other VAs such as Bitcoin and Ethereum) pegged to the US Dollar. MakerDAO provides virtual asset-based loans to users, and a stability fee is assessed to the loan takers that fluctuates based upon Dai’s price in relation to the Dollar. When Dai's price falls below the Dollar, the loan takers are incentivized to pay back their loans and allow the ecosystem to “burn” those Dai units returned to lower the supply, thus increasing the value. Suppose the price of Dai rises above the dollar peg. In that case, the stability fee will decrease, incentivizing users to take out Dai for loans, creating additional Dai, thus reducing the value. This activity is an example of central bank protocols operating via computer code, taking away the human element that has the potential for bias, corruption, and overall economic instability. The Maker token works in conjunction with Dai, which is also created/destroyed based upon supply and demand. Holders of the Maker token comprise the decentralized community who administer the overall decentralized organization. The holder of one Maker token equals one vote resolving administrative issues. The entire MakerDAO ecosystem has been in operation since January of 2018 and is a perfect example of how whole, VA-based economic protocols can be developed, become established, and be globally adopted in a brief period of time. For more information, I encourage you to watch one of the many explanatory videos on YouTube, as the overall detailed operation is fascinating (MakerDAO Explained).
I’ve always been impressed by how little physical infrastructure is required to participate in the VA ecosystem; a smartphone and reliable internet connection are the only requirements. The MakerDAO ecosystem's creation has established DeFi as a significant competitor to firms that offer legacy financial services: no brick-and-mortar footprint, no employees, anti-inflationary with borderless worldwide access. DeFi has an extraordinary competitive advantage over traditional financial services.
Players within DeFI also benefit from less stringent regulation due to some regulators not taking the time to understand how the ecosystem operates and determine what regulations are applicable. In past posts, I’ve been critical of those regulators (BlocAlt Blog Post Critical of Regulators), but to their credit, many seem to have significantly upped their game, not only with the application of global standards (FATF VA Red Flags) but also with tailored regional regimes adapting to regulatory complexities (Wyoming SPDI – more on this below). In the case of MakerDAO, the DAO has a relationship with UK-based debit card provider Wirex, which operates under a UK e-money license; this relationship compels MakerDAO to conform to UK financial regulations. MakerDAO has over 400 such partnerships with other entities worldwide, which brings up another unique regulatory “advantage” to VASPs. The VASP Binance was initially based in China but later relocated to Japan in response to China's strict VA regulatory regime. From Japan, the organization relocated to Malta due to even fewer stringent regulatory standards, and eventually on to Seychelles and the Cayman Islands, once again for even more relaxed regulatory standards. All of this regulatory arbitrage has taken place since its founding in 2017, the benefit of an exceptionally light operational footprint.
Investment options for investors – such as Initial Coin Offerings (ICOs), DeFi Yield Farming, and Non-fungible Tokens (NFTs), to name just a few - rise and fall within the overall VA ecosystem at an extraordinarily rapid rate. Many of these conventions parallel legacy financial systems, but others do not, and those that do not can be challenging to understand for people not necessarily exposed to the basics of blockchain technology. We’ve entered into a situation where many legacy financial institutions are either in denial or purposely ignoring VA conventions, calling it a "passing fad." This attitude means that, in certain conditions, legacy financial institutions are unaware of the general competitive advantage not only of VASPs, but specifically DeFi entity products and services that could dramatically consume vast swaths of the entire marketplace.
For example, I trade virtual assets through a US-regulated VASP account and store my (inactive) VAs in a blockchain bank that provides me with up to 12 percent API on my VA savings. During these current economic times, legacy financial entities rarely pay above 1 percent. Thanks to the leadership of Wall Street veteran Caitlin Long, the US state of Wyoming has become a leader in establishing VA banking. Wyoming legislators created a new financial institution category, the Special Purpose Depository Institution (SPDI), also known as “speedy banks.” This category was created in response to legacy financial institutions having reservations about dealing with VASPs and customers transacting in VAs. State regulations place a layer of perceived stability on VASPs through special recognition on behalf of regulators.
To pull all of this together, what we’re looking at is a combination of the following: the VASP’s ability to rapidly react to everchanging technology, staying ahead of global regulatory conventions; brick and mortar footprints forced to compete with DAOs (functioning entities that operate based on computer code rather than employees); incentives for customer participation (high-interest rates paid on VA savings accounts and inflation hedge); and loans more favorable to the customer (once again due to the advantage of computer code). When you mix all of these together, this is not just a competitive advantage but a devastating disruption to the legacy financial institution model.
Through this post, I hope to demonstrate the need for legacy financial institutions to adjust their historical view of financial services. Conventions related to the VA economy are somewhat unconventional and require a basic understanding of the VA ecosystem by the legacy firm. The overall relationship between the legacy institution and the VA universe will not be zero-sum. I believe the legacy financial services infrastructure is so vast and embedded that VASPs will be required to implement legacy financial conventions, and legacy firms will have to implement VA conventions. This includes standard operational infrastructure as well as ever-changing standards in regulatory compliance operations. Regulators are already prioritizing VA operations within the scope of examinations (FinCEN Priority). The VA economy has expanded to the point where all legacy financial institutions are now exposed to VAs in some way (i.e. unknowingly onboarding a VASP, a customer using a branded credit/debit card to purchase VAs, intermingling traditional bank accounts and VASPs on behalf of the customer, to name just a few).
COVID-19 (and the inflationary tendencies on behalf of the traditional central bank model in response to the crisis) (Money Printer Go Brrr) have provided increased benefits to VASPs in addition to the already existing benefits such as T plus 0 settlement, dramatically reduced money transfer and trading fees, a deflationary tool during inflationary times, and the elimination of intermediaries such as DTCC and FOREX. My goal with this post is to ring an alarm bell for those still unconvinced that the VA ecosystem is not only here to stay but is positioned to dominate the entire financial services landscape in the very near future.