What the US Securities and Exchange Commission can learn from the German regulator

While the public awaits the SEC's decision on how to regulate the DeFi industry, Germany's BaFin has already found a solution.

The chairman of the United States Securities and Exchange Commission, Gary Gensler, stated earlier this month that the crypto industry should not be exempt from the regulator's jurisdiction. He emphasised that when it comes to investor protections, decentralised finance (DeFi) trading and lending protocols require special attention.

Regulation can include a variety of options for custody, reporting, counter-party verification, asset classification, and issuance. People are waiting with bated breath to see how the SEC will regulate the DeFi industry, but Germany's Federal Financial Supervisory Authority, or BaFin, has found a way to apply existing securities law to the crypto sector.

The term "decentralised" does not imply "anonymous."

It is a pipe dream to believe that all DeFi will be unregulated. There will always be a trade-off between how decentralised a platform is and the degrees of centralisation present on various DeFi platforms. Even data oracles, for example, require some form of external input.

Investors require options. Those with fiduciary responsibilities must operate in a regulated environment, whereas those who trade for themselves may not have a compliance team to satisfy. However, in order for DeFi to reach a $1 trillion market cap, institutional capital must enter a market that has been too long on the sidelines.

Realistically, before institutional capital can enter, the entire stack must be regulated. Traders must understand what they are trading and ensure that the counter-parties with whom they are trading are not illegal actors. In this way, regulatory clarity is required for both asset issuance and counter-party risk removal.

BaFin has been forward-thinking and knowledgeable about the subject. Given how many blockchain developments come from Berlin, it makes sense. With the introduction of the crypto custodian licence in 2020, the German Banking Act was updated to include crypto assets in its remit, allowing banks to hold crypto assets. These participants, however, will require licensed counter-parties with whom to trade.

Blockchain activity is easier for regulators to track than traditional finance

According to Gensler, crypto assets are primarily used to avoid money laundering laws, but this argument is flawed. According to a Chainalysis report, fraud exists in both crypto and traditional markets, and illicit activity in the latter remains higher than in crypto markets. According to the same report, illicit Bitcoin (BTC) activity has decreased significantly: it fell from roughly $21.4 billion in 2019, or 2.1 percent of total cryptocurrency transaction volume, to just $10 billion last year, or 0.34 percent.

Indeed, because blockchain technology is transparent, moving trading on-chain would provide regulators with a better understanding of how money is moving across the financial stratosphere. Because regulators can look under the hood themselves, they rely less on companies reporting to them.

Regulators will need to spend time learning how to apply this technology to existing financial structures such as lending. This is evident in some of Gensler's remarks, which fail to recognise that lending via distributed ledger technology (DLT) infrastructure currently relies on over-collateralization rather than lending based on future income. Before this can happen, the data needed to support the latter must be transferred to the blockchain.

Should cryptocurrency be regulated in the same way that trade finance is?

The cryptocurrency market should not be regulated differently than traditional markets. It should be subject to the same licensing, prospectus issuance, and customer protection requirements as any other financial instrument market.

According to BaFin, which has modernised its securities laws to bring DLT-issued assets in line with traditional financial laws, crypto tokens should be classified as securities. While many people are concerned about this ruling, it is actually beneficial to the market and its participants, who now have a clear direction from one of the world's most renowned regulators.

It means that, when applicable, asset-backed security tokens must have a prospectus, just like in traditional markets. This is a good thing for DeFi markets because it makes integration between traditional and crypto markets easier.

“Software is eating the world,” says Marc Andreessen. When it comes to the underlying assets that support the synthetic products that are currently available, the picture is murky. The solution is to tokenise more real-world assets, which will help to expand the current DeFi ecosystem 10-100 times. To be meaningful, this must be done in a compliance wrapper and under a legal structure and prospectus recognised by a regulator, such as BaFin or the SEC.

Investors' protection must include both counter-parties and assets

Tokenised assets require a liquid platform to trade on. As long as their identities are linked to the DeFi platforms, investors can be protected from trading with bad actors. This strategy addresses a critical issue for institutional participants: counter-party risk. It is so simple to do in traditional finance that it should be simple to apply the same principles to DeFi exchanges.

As of the beginning of August, German Spezialfonds, or special funds designed specifically for the institutional market, can now hold 20% of their portfolio in crypto assets, implying that approximately 4,000 firms are ineligible to invest in the asset class. The law change is a major victory for crypto and blockchain supporters in Europe and around the world, as the introduction of such a large pool of institutional money to the sector will have a significant impact.

To buy, hold, and trade crypto assets, Spezialfonds will need to work with licensed counter-parties. While this is not necessarily an impediment in and of itself, the current landscape of this sector is expanding and will need to adapt to meet new demands in light of the potential of this law change.

The money will not flow all at once, but it is the beginning of a major shift, and we expect other jurisdictions to follow suit soon.

Staking out a position in the ground

BaFin has made significant progress in adapting existing financial market law to the crypto market. Legislators may feel more comfortable regulating the sector as more real-world assets are tokenised. Security tokens issued without a prospectus, unless an exemption applies, should not be traded, similar to stocks and bonds issued without one in traditional markets.

The industry must follow where the puck is going. Entrepreneurs all over the world must work with regulatory bodies to determine the best environment for establishing use cases for licensed DeFi projects. As a result, a lack of clarity and the guessing game of compliance stifle innovation.

By putting a substantial stake in the ground, BaFin instils entrepreneurial confidence, allowing a healthy market to develop with a regulatory approach.

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