What the SEC can learn from the German regulator

The United States Securities and Exchange Commission’s chairperson Gary Gensler announced this month that the crypto industry should not escape the purview of the regulator. He highlighted that decentralized finance (DeFi) trading and lending protocols need particular attention when it comes to investor protections.

Regulation can extend into a menu of options that covers custody, reporting, counterparty verification and asset classification and issuance. Reports are surfacing that people are waiting with bated breath on how the SEC will regulate the DeFi industry, but Germany's Federal Financial Supervisory Authority, also known as BaFin, has found a way to apply existing securities law to the crypto sector.

Related: FATF draft guidance targets DeFi with compliance

Decentralized doesn’t mean anonymous

It is a utopian view that all DeFi will escape regulation. There will always be a compromise on how decentralized a platform is and the degrees of centralization that exist on different DeFi platforms. For example, even data oracles require some form of external input.

Investors need choices. Those who have a fiduciary responsibility need to operate in a regulated environment and others who trade for themselves don’t necessarily have a compliance team to satisfy. However, for DeFi to reach a $1 trillion market cap, institutional capital must enter the market that has been sitting on the sidelines for too long.

Realistically, the full stack needs to be regulated before institutional capital can move in. Traders need to know what they are trading and that the counterparties they’re trading with are not illicit actors. In this way, regulatory clarity is needed for both asset issuance and removing counterparty risk.

Related: Will regulation adapt to crypto, or crypto to regulation? Experts answer

BaFin has been forward-leaning and literate on the matter. It makes sense given how many blockchain developments are born out of Berlin. The update to the German Banking Act in 2020 brought crypto assets into its remit with the introduction of the crypto custodian license, enabling banks to hold crypto assets. However, these participants will need licensed counterparties to trade with.

Regulators can track blockchain activity easier than traditional finance

Gensler remarked that crypto assets are predominantly used to skirt money laundering laws, but this argument is flawed. Fraud exists in both crypto and traditional markets and illicit activity in the latter remains higher than in crypto markets, according to a report by Chainalysis. The same report discovered that illicit activity using Bitcoin (BTC) has been significantly reduced: It fell from roughly $21.4 billion in 2019, or 2.1% of all cryptocurrency transaction volume, to just $10 billion last year, or 0.34%.

In fact, moving trading on-chain would give regulators a greater understanding of how money is moving across the financial stratosphere, thanks to the transparent nature of blockchain technology. Regulators are able to look under the hood themselves, meaning they rely less on companies reporting to them.

Regulators will need to spend time educating themselves on how this technology can be applied to existing financial structures such as lending. This is apparent in some of Gensler’s comments which fail to recognize that lending using distributed ledger technology (DLT) infrastructure currently relies on over-collateralization as opposed to lending based on future income. The data to support the latter needs time to transition to the blockchain before this can be made possible.

Related: Bitcoin can't be viewed as an untraceable 'crime coin' anymore

Should crypto be regulated like TradFi?

The crypto market shouldn’t be regulated more or less than traditional markets. It should be subject to the same licensing, prospectus issuance and customer protections as you would find in any other market that deals with financial instruments.

This is the view of BaFin which has modernized its securities laws to bring DLT-issued assets in line with traditional financial laws, stipulating that crypto tokens should be classified as securities. While many may fear this ruling, clarity is actually helpful for the market and its participants who now have a clear direction from one of the world’s renowned regulators.

It means asset-backed security tokens, when applicable, must have a prospectus like in traditional markets. This is a positive development for DeFi markets as it helps facilitate integration between traditional and crypto markets.

To quote Marc Andreessen, “Software is eating the world.” The synthetic products that currently exist are murky when it comes to the underlying assets backing them. The solution to this is to tokenize more real-world assets which will contribute to expanding the current DeFi ecosystem even just 10-100 times. For this to be meaningful, it needs to be done using a compliance wrapper and under a legal construct and prospectus recognized by a regulator, like BaFin or the SEC.

Related: Is there a right way to regulate crypto? Yes, and this is how

Investors protection must extend counterparties as well as assets

Tokenized assets need a liquid home to trade on. Investors can be protected from trading with bad actors so long as their identities are connected to the DeFi platforms. This approach moves a key issue for institutional participants — counterparty risk. It is so easily done in the traditional finance world so it should be easy enough to apply the same principles to DeFi exchanges.

German Spezialfonds, or special funds, designed specifically for the institutional market, can now hold 20% of their portfolio in crypto assets as of the beginning of August, meaning some 4,000 firms are not eligible to invest in the asset class. The law change is a big win for crypto and blockchain proponents in Europe and around the world, as the introduction of such a large pool of institutional money to the sector will be profound.

Spezialfonds will, however, have to work with licensed counterparties to buy, hold and trade crypto assets. While this is not necessarily an impediment in and of itself, the current landscape of this part of the sector is growing and will have to adapt to cater to new demands considering the potential of this law change.

The money won’t flow all at once, but it marks the start of a big change and we expect other jurisdictions to follow soon.

Related: Europe awaits implementation of regulatory framework for crypto assets

Putting stakes in the ground

BaFin has taken great strides in taking existing financial market law and applying it to the crypto market. As more real-world assets are tokenized, lawmakers may feel more comfortable with regulating the sector. Security tokens issued without a prospectus, unless an exemption applies, should not be allowed to trade — similar to stocks and bonds issued in traditional markets without one.

The industry must skate to where the puck is headed. Entrepreneurs around the world must engage with regulatory bodies globally to find the environment best suited to establish use cases for licensed DeFi projects. To this end, missing clarity and the guessing game of compliance stifles innovation.

By putting a comprehensive stake in the ground, BaFin is giving entrepreneurial confidence that will allow a healthy market to develop with a regulatory approach.