Have You READ THIS!? The DeFi Crypto Regulation THEY Want!!

Have You READ THIS!? The DeFi Crypto Regulation THEY Want!!

Regulating at the protocol level is one of the most terrifying possibilities for blockchain technology, and it’s a possibility that many regulators are trying to turn into a reality. Case and point. The BIS recently released a paper that proposes protocol-level regulation for decentralized finance. Obviously, this could have huge implications for cryptocurrency, so today I’m going to give you a bit of background about the BIS and its DeFi paper, tell you exactly what it says in simple terms, and what it could mean for our beloved crypto.

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What is the BIS?

So now that you know how I bend, let’s see what the BIS wants to do about crypto projects that make it possible to borrow and lend. If you’re unfamiliar with the BIS, lucky you. Here’s what you need to know. The Bank for International Settlements, or BIS, is the self-described bank for central banks. Naturally, the BIS is based in Switzerland, in Basel to be precise. The BIS is actually owned by the 63 central banks that make up its membership, and its board of directors consists of 18 central bankers, with Bank of France head François Villeroy de Gallo as chair. The BIS is managed by former Bank of Mexico governor Augustin Karstens, who Mexican billionaire Ricardo Salinas referred to as one of the three high priests of fiat at the bitcoin conference in Miami. In case you’re wondering, Ricardo regards United States Treasury secretary Janet Yellen and European Central Bank president Christine Lagarde as the two other high priests or priestesses of Fiat. I digress.

The BIS’s purpose is to facilitate coordination between central banks, and for the last few years its focus has been helping central banks research and develop central bank digital currencies. If you read our article about the BIS CBDC report from last September, you’ll know that the central banks have some pretty dystopian design plans for their digital currencies, and these design plans can be summed up in a sentence uttered by Agustin himself in a 2020 interview, quote central banks will have absolute control over how money is spent.

As you might have guessed the main reason why central banks have been developing CBDC’s is because of cryptocurrency, which they view as enemy number one. While some central banks are explicitly using CBDC’s as a means of fighting against Bitcoin adoption it’s not BTC that most central banks are concerned about, but decentralized finance or DeFi.

As some of you will know DeFi protocols make it possible to do things like borrow lend and save without commercial banks. More importantly DeFi protocols make it possible for the free market to set interest rates on the lending and borrowing of fiat currencies, which come in the form of stablecoins like USDC.

As most of you will know interest rates in the economy are typically set by the central bank and this basically means that many DeFi protocols are direct competitors to banks of all kinds. It should come as no surprise then that there have been calls for a coordinated crackdown on DeFi from both domestic and international regulators for a long time, but these calls have recently grown louder.

As far as I can tell the DeFi paper recently released by the BIS is a part of this renewed trend, and it could serve as a sort of template for the DeFi regulations that we could see rolled out in many countries.

The BIS’s DeFi paper is titled ‘embedded supervision’ how to build regulation into decentralized finance and unlike many of the BIS’s papers it was not penned by a person from a central bank. The BIS DeFi paper was instead penned by Rafael Auer, the current head of the BIS’s innovation hub, and former economic advisor at Switzerland Central Bank, who holds a PhD in economics from MIT.

Raphael’s previous papers appear to focus on the so-called governance i.e control of money by central banks and international organizations, which is not surprising given the disturbing title of his DeFi paper.

What’s interesting is that Raphael first published his DeFi paper back in September 2019, but it was updated in May of this year. This is why I think it’s part of the wider trend of renewed DeFi scrutiny, and with that out of the way let’s see what this crazy paper is suggesting note that I’ll leave a link to the full paper in the description and give you my thoughts as we go along.

Abstract

The BIS paper begins with an abstract and the first sentence is well listen for yourself ‘the emergence of so-called decentralized finance DeFi and a shadow financial system of cryptocurrency exchanges and stablecoin issuers raises the challenge of how to apply technology neutral regulation’.

There’s already so much to unpack here but for the sake of time I’ll quickly say that it’s funny how all these international institutions describe every crypto technology that sees lots of adoption as so called rather than what it really is, which is direct competition to equivalence in the existing financial system.

The abstract goes on to explain that DeFi regulation can be achieved via embedded supervision at the protocol level and even seems to suggest replacing proof of work proof of stake and other crypto consensus mechanisms with ‘blockchain enabled credibility’ i.e permissioned consensus. Of course, no abstract is complete without a subtle promise that this DeFi regulation will be applied in such a way that small fintech companies don’t threaten existing financial institutions, or as the authors of these reports often call it a quote level playing field double speak indeed.

Introduction

The first part of the BIS paper is the introduction and the author immediately reveals that the reason why regulators are paying so much attention to DeFi is because of the recent crypto market crash. The author also reveals that the term shadow crypto financial system was coined by himself in a previous paper, so be sure to give him credit where credit is due.

Remember of course that cryptocurrency blockchains are transparent you can see all transactions taking place on them unlike in the traditional financial system and certainly more transparent than the ‘anonymous referee’ mentioned in the footnote, who Raphael says helped him write the paper.

Anyways Raphael then rightfully points out that most crypto trading takes place on centralized exchanges and that most stablecoins are likewise centralized and that this presents a point of centralization in crypto.

The author states that his justification for demanding the protocol level regulation of DeFi is that the same financial risks require the same financial regulations and that ‘supervision should evolve in parallel with technology’.

As mentioned earlier the protocol level regulation being proposed is called ‘embedded supervision’, which the author defines as ‘a regulatory framework that provides for compliance to be automatically monitored by reading the market’s ledger’. This is odd because I’m pretty sure crypto transaction monitoring is already what blockchain analytics companies like Chainalysis do for regulators around the world.

Now to the author’s credit he specifies that embedded supervision could be designed in such a way that it preserves privacy but given the warped definition of privacy that international organizations seem to have I suspect it will only apply to certain individuals and institutions not the average person.

The author then clarifies that his interpretation of embedded supervision doesn’t stop with just analyzing transactions in DeFi protocols. It also includes modifying the consensus mechanisms of cryptocurrencies themselves.

Why is that you ask. It’s because regulators need to ensure the transactions being processed on blockchains that DeFi protocols exist on are legitimate not the first time we’ve seen this kind of subtle regulatory overreach. As mentioned in the abstract the only way that cryptocurrencies can be compliant with embedded supervision is for their consensus mechanisms to be permissioned meaning that regulators will decide who can run validator nodes or miners on a given cryptocurrency blockchain. Not only that but regulators will also decide, which tokens can exist on cryptocurrency blockchains and decide who will be allowed to interact with DeFi protocols, doesn’t sound like crypto to me, but wait there’s more.

All this regulation is just the first of the four ‘principles of embedded supervision’ that the report is advocating for.

The second principle of embedded supervision involves transaction finality meaning how you establish when transactions are final and how to ensure they stay final. Funnily enough the report notes ‘to this end I develop a distributed and permissioned market in, which blocks of financial contracts are verified by third parties’. These verifiers stand to lose a given amount of verification capital should a blockchain reversal ever occur that voids existing transactions. Call me crazy but it sounds like he’s crediting himself with the idea of combining a permissioned blockchain with a proof-of-stake consensus mechanism to ensure transaction finality, even though this is nothing new.

The third principle of embedded supervision sounds similarly asinine as the report seems to imply that validators on cryptocurrency blockchains actively manipulate transactions when regulators aren’t reading. This is why the third principle involves being aware of these alleged effects. To be clear if validators on cryptocurrency blockchains were actively manipulating transactions nobody would use that cryptocurrency and opt to use a better one instead it’s called the free market and it’s what’s made crypto so successful rant over.

The fourth principle of embedded supervision quote concerns the broader societal goals when designing embedded supervision, which just screams ESG.

Embedded Supervision

Anyhow, the second part of the BIS paper provides a primer for what embedded supervision would look like and at this point all I can picture is a boot stamping on a human face forever, that’s George Orwell by the way.

The author starts by explaining how the cost of compliance in the traditional financial system is too damn high. This is because every single transaction and interaction must be meticulously documented stored and submitted to regulatory authorities on a regular basis. As a result around five percent of the operational costs of corporations go towards compliance and the author highlights how the cost of regulatory oversight is likewise high for central banks. To that I say you can literally print money out of thin air.

The author then goes on to say that we must quote look beyond Bitcoin and other permissionless cryptocurrencies, and see just how much potential there is in a blockchain that’s totally controlled by the central bank and the government, I wish I was making this up.

To add insult to injury he then states that ‘such permission technology primarily enables the decentralized trading of stablecoins and other asset-backed tokens as well as decentralized financial engineering based on these tokens via self-executing smart contracts’. Besides the fact that this is already possible with actual cryptocurrencies none of this would be decentralized, because it would be centrally controlled by the central bank and the government.

After talking about how smart contracts could be used to automate most of what happens behind the scenes in the existing financial system, the author confirms that institutions would not be comfortable sharing all their data and would therefore prefer the permissioned blockchains be encrypted. To solve this the author states ‘the compliance process would then consist essentially of determining, which internal and external institutions could access, which part of the underlying data and at what level of aggregation’. Put differently privacy will not be possible, but then we already knew that.

The author then casually drops a bombshell and that’s that ‘embedded supervision can only be useful in the context of transactions involving regulated financial intermediates’, suggesting that only the institutions will have access to this inverted version of DeFi not regular folks like you and me.

Last but certainly not least, quote a final key element must be a watertight and potentially globally coordinated KYC identity framework that keeps illicit activity out of this novel ecosystem. You know that sounds like a grand old time, but I think I’ll stick with Vitalik Buterin’s proposal to create decentralized digital identities using non-transferable NFTs.

Transaction Finality via Regulation

Anywho, the third part of the BIS paper explores how embedded supervision can be used to ensure transaction finality, which our repeat is something that can already be done using existing economic guarantees in cryptocurrency. As far as the author is concerned however the only thing that can provide true finality is laws and regulations. Hence why they must be implemented at the blockchain level.

He then goes on to essentially explain how proof of stake works and once again seems to pat himself on the back for being so clever as to combine it with a permissioned blockchain. What’s nice is that he elaborates on the point he made earlier about validators manipulating transactions when regulators aren’t looking, and seems to admit that this would also be done when regulators are looking because validators want to give the illusion of compliance.

Luckily for the folks unlucky enough to be subject to such a system he says a simple solution to the problem he created is to apply regulations retroactively meaning recent transactions won’t be viewed with regulatory scrutiny, but ones that took place further back in the past will be spooky.

The author then goes on to do a whole bunch of complex maths to prove that his supposedly novel system of ensuring transaction finality works. Low and behold, it does. Someone, please, give this man a Nobel prize.

Jokes aside there was some pretty serious stuff scattered amongst the maths such as suggestions that even the code of the smart contract’s underlying DeFi protocols must be assessed by regulators before being pushed to the blockchain. Now don’t get too excited yet though because the paper isn’t over.

‘Benefits’ of Embedded Supervision

The fourth part of the paper talks about how embedded supervision can make it possible to ‘harness the fintech opportunity’. Oddly enough this section of the paper is seemingly meant to convince any regulators reading it to implement embedded supervision. The author highlights all the benefits like total control total compliance financial stability financial inclusion and lower transaction and compliance costs. I’m not exaggerating either. The author clearly states that ‘one operational aspect is for regulators and supervisors to take an active role in the design of the market’.

In addition to lowering costs, the author states that regulators should focus on the digitization of official information to maximize the benefits of embedded supervision. Now this is actually scarier than you think, because digitizing things like the ownership of real estate as the author suggests means the government will have the ability to revoke those rights at any time. This isn’t possible to do with physical documents in your possession proving that you own a plot of land or a house for instance.

The author ends this section with ‘ultimately the world is often too complex to be put into code’, and at this point I’m thankful he thinks that because I can only imagine what hellish regulations he would root for if he thought the world could be put into code.

Conclusion

The fifth and thankfully final part of the BIS paper is the conclusion, where the author reiterates that quote the basic premise is that regulating blockchain-based finance should not require a departure from long-established principles on the regulation of specific economic activities.

He then goes on to criticize regulators for focusing too much on the classification of cryptocurrencies, which is a not so subtle reference to the SEC. He instead urges regulators to go deeper by enforcing the same standards on cryptocurrency as they do the rest of the financial system all the way down to the blockchain level.

He even goes as far as to claim that cryptocurrency will never see adoption in traditional finance, if it doesn’t conform to existing regulations and to some extent he has a point. If you’re wondering whether regulators are listening to what the author is saying he reveals that ‘around the globe many supervisors are open to this possibility and some have developed the requisite sandboxes’, and notes Lithuania’s Central Bank and the Boston Arm of the Federal Reserve as the first movers.

For his grand finale, the author concludes that ‘once DeFi ecosystems are properly regulated and supervised central banks could support them by developing wholesale central bank digital currencies with programmability similar to today’s crypto currencies’.

Contrary to what he claims, the reality is that central bank digital currencies and cryptocurrencies couldn’t be more different.

What Does It Mean For Crypto?

For the big question what does this paper about DeFi mean for cryptocurrency. I’ll start by saying that the fact it was recently updated suggests this is something the BIS is actively pushing for. Whether it manages to convince regulators to adopt this so-called embedded supervision is another question entirely however. This is simply because there’d be next to no incentive for innovation in such a heavily regulated system, and I don’t think very many individuals or institutions would adopt it voluntarily either. Any proposal to regulate DeFi or cryptocurrency in such a manner would also result in extreme pushback from the crypto community, especially the crypto companies that have been spending tens of millions of dollars to make sure politicians pass pro crypto regulations. This is called lobbying and yes, it’s entirely legal.

Now another reason why we probably won’t see embedded supervision anytime is because it’s just well it’s just completely insane. The fact that the author was frequently citing his own papers suggests to me that he’s built an airtight echo chamber for himself and his ideas during his years at the BIS, and there’s no question any critical eyes will see this and wonder whether they should take his ideas seriously.

In his defense when you’re surrounded by control obsessed central bankers and big personalities like Agustin Carstens all day you’re likely to forget what those ideas look like to the average person. There’s also no denying that crypto can be an echo chamber of its own but at least there’s open and honest discussion about things like regulation. With the BIS, it’s a one-sided discussion and it’s one where the average person has next to no chance of having a say. That’s one of the reasons I think it’s important to cover the papers and reports that are written by these international organizations.

Bringing awareness to what’s being said by people, who have power eventually leads to a collective response that can’t be ignored. In this case I’m not really that concerned because nobody wants to see what was discussed in the BIS DeFi paper and the moment it’s proposed it will be rejected and rightfully so.

Now, that’s not to say there won’t be some kind of crackdown on DeFi. I reckon that much is imminent, but as Polkadot founder Gavin Wood said this is a good thing because the only projects that will survive the purge are those that are truly decentralized.

[This article is a transcription of a video made by Coin Bureau]

Original video: https://youtu.be/CIRsEOBYxbA ]