Regulating Crypto Exchanges: What Does it Mean For Crypto and DeFi?by@finanzsache
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Regulating Crypto Exchanges: What Does it Mean For Crypto and DeFi?

by FINANZSACHEMarch 6th, 2022
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Most believe that regulation goes against the spirit of cryptocurrencies. And they are right about that. However, as you can see from some examples, a legal framework can indirectly help Bitcoin, Ethereum and other cryptocurrencies to get more popular and gain more acceptance.
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Cryptocurrencies - the new, unknown asset. At least in the eyes of regulators in the USA and Europe. Many refer to the market around Bitcoin, Ethereum & Co as Wild West territory, where platforms and brokers like Binance, Kraken and many others serve as pivots.

Investors, on the other side, are often happy about the new opportunities that cryptocurrencies can offer. This is also true for the corresponding crypto exchanges themselves, which until now often not had to follow the same standards as exchanges for other assets. This was mainly because simply no one knew how cryptocurrencies and the new DeFi products such as lending, staking or liquidity mining should be legally classified.

Now, however, the wild times seem to be over. Authorities and the Biden Administration are pushing more and more for regulation.

But is this actually good or bad for the development of cryptocurrencies and DeFi?

In the crypto-scene, many are worried about the development. One notices that the free time is slowly coming to an end.

However, you'll find out below why the whole thing could actually turn out to be helpful in the end.

And yes, this view is controversial, of course. However, there are a few good arguments in favor of it.

Should Coinbase, Binance & Co be more closely supervised?

In the crypto scene, and more specifically in the Bitcoin scene, many investors see regulation as a threat to the entire space.

This is understandable from several angles.

On the one hand, crypto and in particular Bitcoin stands for freedom for many investors. Therefore, hardly anyone would like to see the so-called on and off-ramps such as Binance and other platforms be more closely monitored.

However, it is important to realize that regulation does not automatically mean regression. In fact, regulation can also mean progress - indirectly!

What many fear is that Bitcoin and other cryptocurrencies will be forced into a tight, legal corset in which innovative products will be limited from growing.

What should not be overlooked, however, is that regulation can also have very positive side effects on the entire market.

Why the heck would curtailing freedom have positive effects?

Let's explain.

Many institutional investors, and Wall Street in general, have indeed opened up to cryptocurrencies much more than they did last year. However, there is still a veil of the unknown over it.

Steps are only being taken very cautiously. People don't really dare yet.

If a clear classification, investor protection, and legal framework are now prescribed by legislators and authorities such as the SEC, then this does limit freedom in the ecosystem to a certain extent.

On the other hand, it also ensures that funds and institutional investors get closer to the crypto topic and in some cases are even allowed to do so first.

After all, if we're being completely honest, the "big money" from institutional investors is exactly what everyone is waiting for.

More money in the market means more attention and thus more adaptation.

So indirectly, regulation can be a big growth driver. Coinbase, by the way, has led the way - it is the first port of call for many institutional investors.

Not because the fees there are so favorable. That is not the case in comparison with many other exchanges. But because the exchange is the most closely monitored.

The important thing is always to find the right balance.

Too much legislation can stifle the market. If there are too few laws, the REALLY big growth boost for BSDEX, Changelly, Bittrex and others may be a long time coming.

The curious case surrounding Coinbase

A particularly bizarre event occurred when Coinbase wanted to launch a lending product on their platform.

So, as one of the most well-known exchanges in the world, Coinbase went to the SEC (Securities and Exchange Commission) and informed the authority about their plans and asked for their assessment. The goal was to offer a lending product with 4% APY on the USD Coin (USDC).

Now, it must be said that Coinbase also had no choice but to knock on the SEC's door. The difference between Coinbase and other exchanges such as Kraken, Binance, Bitfinex and others is that Coinbase is considered a gateway for institutional investors. Precisely, because they are regulated by the SEC there.

So if Coinbase were to start going it alone in a similar way to some of its competitors, it would mean a certain loss of trust.

Anyway, back to the topic at hand. So Coinbase knocks on the SEC's door and provides all the documentation it needs. But none of it helps. The agency refuses on the grounds that Coinbase's proposed action involves securities.

No further details were provided.

Of course, this is curious in that other Exchanges offer similar products without a problem. Even a Bitfinex or Anycoin Direct could presumably launch such a product without any issues.

"Problem-free" in the sense of no teething problems. How it is to be judged legally, of course, remains an open question.

So, strictly speaking, Coinbase was punished for asking and playing by the rules.

By the way, the point here is not to highlight Coinbase in a big way. There is enough criticism of the exchange as well. However, the case is particularly well suited to demonstrate how much legal uncertainty there still is regarding these types of platforms.

The special case of DEX (Decentralized Exchanges)

With Binance, Bison, and Kraken, the case may be clear. But what about decentralized exchanges (DEX)?

DEXs are part of the DeFi environment and are referred to in some places as the future of trading platforms.

The biggest difference to centralized exchanges are basically three things:

  • Smart contracts often handle order execution,
  • DeFi allows investors to cut in on fees and other rewards,
  • The platforms stand on decentralized legs.

So from an investor perspective, totally positive. From the point of view of the traditional financial market, not without restrictions. For regulators even a thorn in the eye.

DEXs are often inherently designed in such a way that they could fundamentally evade regulation. But what about KYC (Know Your Customer), deposit insurance or customer support then?

There are three possible scenarios here:

  • Trading on a DEX is declared illegal if there is no centrally responsible entity.
  • Despite the ban, investors have confidence in the platforms and use them anyway.
  • All DEX that want to survive become semi-centralized and are subject to the same laws and regulations as any other exchange.

So this area remains particularly exciting!

DeFi vs. the traditional financial system. A battle that will probably be won by DeFi - partially!

We see a development in which traditional centralized finance models are becoming less and less important and decentralized solutions such as DEX are becoming more and more important.

However, the latter means at the same time that the revenue from, for example, fees from the acquisition and trading of cryptocurrencies or from interest from credit transactions is also distributed to more and more hands - because everyone can participate.

One can foresee that this development will be massively fought and strong lobbying will take place against it. Nobody likes to let the butter be taken off his or her bread.

However, as with any innovation - and DeFi is undoubtedly one - it can be assumed that it will prevail in the end.

The advantages are too great to be nipped in the bud by law and extreme regulation.

The countries that strike a good balance here will become pioneers in these areas. Those that refuse to do so will fall behind. In other words, this is a classic game-theoretical situation in which you have to make your moves carefully. Incidentally, it is this competitive situation that could lead to the individual countries not turning the screws on cryptocurrencies too tightly.