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DeFi and banks: Is this the end of traditional banking?

13-09-2022 | Carlo de Meijer | treasuryXL | LinkedIn |

The unregulated DeFi market has experienced remarkable growth in 2021. DeFi use cases bring a number of benefits and may remove a number of the shortcomings of the traditional financial ecosystem.

By Carlo de Meijer

Next to that the attitude of a growing group of new generation consumers is changing triggered by higher yields and the emergence of alternative digital and crypto assets. This paper attempts to answer a number of questions such as: what does DeFi mean for the traditional financial system?; should traditional financial institutions worry and why?; should they adapt to the new Defi environment?; what steps could be taken?; and finally, what will the new financial ecosystem look like?

INTRODUCTION 

Decentralised finance or DeFi caught a lot of attention in 2021 from both regulators  and traditional banks. The advent of this, until now unregulated, DeFi system has raised a new wave of investors and possibilities that the financial markets never envisioned. This has led to a massive inflow of liquidity since the summer of 2021. This paper will go into more detail as to what this could mean for the traditional financial world. The main questions are: will DeFi be sustainable in the long run and should traditional banks worry? Or is DeFi a new chance for the traditional banks to solve their present shortcomings by bridging the gap between CeFi and DeFi?

SHORTCOMINGS OF THE TRADITIONAL FINANCIAL MARKET

To understand the new DeFi world and its spectacular growth, the roots of the problem with the current financial system need to be examined. For a long time, traditional finance has been largely reliant on intermediaries, like banks, insurance companies and stock exchanges, thereby governed by strict regulation. For their operational needs and day-to-day transactions regular consumers need to deal with a raft of financial middlemen to get access to everything from loans and mortgages to trading stocks and bonds. They are then governed by strict regulation and controls. A business would have to complete anti-money laundering and ‘know your customer’ checks for every source of capital. These rules have been increasing to the point that compliance is often one of the biggest cost centres for many banks. Given the various diferences in national regulations, conducting a cross-border money transfer through a financial institution may be a long process with possible delays, making it more expensive. As a result, the current  market is not as efficient as desired, especially when it comes to inclusiveness and accessibility. This financial system is also not  transparent about what is happening, with customers having no control over their assets.  This keeps the risk and control of money,  financial products and financial services at the centre of these systems.

NEW GENERATION CONSUMERS:  MILLENNIALS AND GEN Z 

Triggered by these shortcomings and upcoming technological financial innovations, as well as the lack of attractive yields  in traditional financial products, a growing group of consumers, especially the Millennials and Gen Z, is fundamentally changing their attitudes. They are increasingly looking for alternative loans and assets to invest in. Many consumers are thereby searching for systems that are more flexible and less restrictive than the traditional ones. These new technologies have led to changes in financial products. Many of the existing traditional assets move to digital or have digital equivalents. A growing group  of consumers is increasingly looking for and experimenting with these more attractive financial assets, thereby driving the under current of interest in DeFi. 

In order to provide investors with more secure and easier access to crypto-assets, other platforms seek to bridge the gap between blockchain-based finance and traditional capital markets. Some companies are currently exploring this new marketniche by providing crypto-services to those who want to ‘take a safer road’, preferring to turn to ‘regulated’ institutions that trade and store crypto-assets on their behalf. In a way, these platforms create a bank-like environment meant to give crypto-beginners a sense of security — albeit a distorted one, as the companies’ accounts have been hacked more than once. 

WHAT IS DEFI? 

Decentralised Finance, (1) or DeFi for short,  encompasses a new type of emerging financial ecosystem enabling decentralised financial applications, such as trading, borrowing and lending activities, powered by public blockchain or distributed ledger technology (DLT) networks and using cryptocurrencies.  DeFi refers to replicating traditional financial services used today in a decentralised way. The goal of DeFi is to create an open and transparent financial ecosystem that can be accessible (via the internet) to everyone anywhere across the globe. DeFi allows users  (buyers, sellers and borrowers) to interact directly with each other, so peer-to-peer, via decentralised platforms without a sign-up process. This is by building trust in the technology and the governance behind it. DeFi seeks to improve the efficiency of  financial transactions by replacing traditional middlemen with automated or smart contracts built on blockchains. These are coded, self-executing agreements where users directly interact with the application.  From borrowing platforms to stable coins (disposable tokens), the DeFi ecosystem consists of a vast network of integrated protocols and financial instruments. 

Users could access DeFi products through decentralised applications (DApps), or other  programs called peer-to-peer protocols, which are web-based applications powered by smart contracts and secured by blockchain technology. These require no access rights for easy lending, borrowing or trading of financial tools. As a result, anyone can transfer or lend money to another party without a bank, making these transactions easier, more affordable and more accessible.  The vast majority of these DeFi platforms and most applications are hosted on the Ethereum network, but many alternative public networks are emerging. 

DEFI USE CASES/APPLICATIONS

DeFi is making its way into a wide variety of simple and complex financial transactions (2). They encompass nearly everything  that can be done at a bank with regular old (non-crypto) currency. These range from DeFi-based lending and borrowing including overcollateralised loans, decentralised  trading, staking to yield-aggregating or yield farming (earning) and liquidity mining. Margin trading and insurance and even NFTs or non-fungible tokens are also possible through DeFi protocols. DeFi developers are actively exploring and building more and new services to the ecosystem. 

Overcollateralisation 

This segment of the DeFi lending and borrowing space is rapidly growing. The lender and the borrower come together on a DeFi lending platform and execute smart contracts. By using DeFi lending protocols, crypto holdings can be used to obtain a loan. Most DeFi lending protocols do not allow for traditional credit checks on potential borrowers. 

Traditional finance loans in DeFi however are commonly secured by overcollateralisation.  

In the absence of a credit-approval process, posting collateral is typically essential to mitigate credit and fraud risks. The borrower gives his crypto as collateral and obtains a loan from the platform, while the lender gives his fiat money to the platform to earn some  interest. Borrowers leverage their trading by holding an existing asset in a vault and use  the borrowed asset to trade or compose more complex lending, borrowing and staking activities with the same collateral base. 

Staking 

A typical example of DeFi use cases is staking, (3) a way of earning rewards for holding certain cryptocurrencies. This involves ‘staking’ (lending or investing) digital assets into a proof-of-stake platform, a consensus mechanism, and earning a percentage-rate reward over time. This usually happens via a ‘staking pool’, which can be thought of as being similar to an interest-bearing savings account, ensuring that all transactions are verified and secured without a bank or processor in the middle. Staking enables money to be borrowed against this stake and a small amount  of interest to be paid, which is probably going  to be beaten by the appreciation in the staking earnings. It eliminates almost all of the traditional finance concerns that people have. 

Yield farming 

Another DeFi use case and one of the most  promising is yield farming. (4) Yield farming  involves providing liquidity or lending out cryptocurrency to a DeFi protocol that puts it in a smart contract-based (trading or lending) liquidity pool in exchange for interest  or trading fees plus liquidity provider tokens that can then be staked in a yield farm to earn additional yield. These returns are expressed as an annual percentage yield (APY). Often the amount of interest earned or paid is less important than the amount of  governance tokens one can earn by lending  or borrowing (or both). Users earn tokens by locking cryptocurrencies in smart contracts running on the exchange’s trading plat forms. This protocol essentially means that a crypto-holder can farm for more crypto-tokens by using the existing tokens. There are a lot of diferent and sometimes very complex strategies to do this type of farming.  However, the most popular one is where a  platform consistently moves the user’s tokens between a number of lending platforms in  search for a higher return on a blockchain  like Ethereum. 

Liquidity mining 

Another area that is likely to grow in importance is liquidity mining. Providing liquidity is hugely important for the healthy running of decentralised exchanges  (DExs), although it is currently held back by the threat of impermanent loss (where providers risk losing some of their initial  investment due to price changes). Reducing impermanent loss is imperative to the development of liquidity mining. New formulae for automatic market makers that reduce impermanent loss are being developed, and the results look promising. 

Prediction markets 

Prediction markets are platforms where individuals can make predictions on the realisation of future events. These markets allow people to bet on the price of a currency, stock prices or the results of a future event like sporting events or elections and more. DeFi opens these markets for participation. In DeFi, prediction markets are intermediary-free, more accessible and typically have lower fees compared to centralised prediction markets. 

THE DEFI ECOSYSTEM 

With the emergence of DeFi, a completely new ecosystem of platforms, working applications and protocols is developing through which borrowers, lenders and investors can undertake bank-like transactions with out banks. Decentralised platforms entered  the financial scene including decentralised banks (lending and borrowing), decentralised exchanges, decentralised insurances,  etc. This has also attracted a growing number of fintech companies, challenger banks and neobanks or cryptobanks that are disrupting the traditional financial system across the world with more agile, cheaper and more inclusive services. DeFi banks: Lending and borrowing Lending platforms are one of the most popular DeFi applications. Because borrowers  do not need personal checks, they can access loans faster and geographical barriers do not apply, making loans more obtain able. All they must do is deposit collateral. Lenders can lock cryptocurrency into these  platforms to earn interest, while users can borrow stablecoins by putting up collateral — 150 per cent of the amount borrowed  is common to account for price volatility.  There are various platforms that deliver  decentralised lending and borrowing services mostly using the Ethereum network.  These include protocols like Aave, Bancor, Compound and MakerDAO, with tens of billions in market size. 

Decentralised exchanges 

DeFi also gave birth to decentralised exchanges or DExs that are popping up at a growing rate. These exchanges benefit  from being independent and not being controlled by any regulatory authority. Right now, most cryptocurrency investors still use centralised exchanges like Coinbase or Gemini. At DExs however there is no company operating it. With the emergence of  decentralised exchanges, holders of crypto do not need to leave the crypto space to swap  their tokens. Decentralised exchanges allow users to exchange or swap tokens with other assets, without a centralised intermediary or custodian. The extra cost on each transaction is another negative aspect of centralised  exchanges (CExs), which DExs address, where there are fewer parties taking a cut of a transaction. 

DExs also do not require users to deposit funds to start trading. They facilitate peer to-peer financial transactions with the help  of smart contracts and function according to defined pricing mechanisms and let users retain control over their money. The most prominent example of a DEx is Uniswap, which allows people to trade crypto-tokens and swap tokens (5) that run on the Ethereum network. Other examples include Curve,  PancakeSwap and dYdX. 

DeFi insurances 

Thanks to the popularity of decentralised banks and exchanges there are now even crypto-insurances that may insure their DeFi investment for a percentage of the yield  they generate. They offer insurances that cover bugs in smart contracts. Decentralised insurances are still in origin stages. One example is Nexus Mutual, which is designing a decentralised alternative to insurance by allowing virtual communities to come together to pool their funds and share risks. As these platforms are built on self executing smart contracts, more options would be created sometime in the future, bringing further opportunities for the public. It is anticipated that larger and more sophisticated insurance models may emerge in the DeFi space in the years to come. 

Decentralised asset management, another evolving class of service offered  by DeFi is decentralised asset management.  This trading or creating of complex financial products and management of assets nowadays falls into the sector of traditional investment banks. Decentralised asset management intends to make investing faster, less expensive and more democratised. Transparency  delivered by DeFi promises to make information accessible and secure, composable to enjoy hyper-customisation of portfolios  and trustless to allow access to historically  illiquid assets and manage their investment regardless of location. Ampleforth is an asset management protocol of DeFi designed to be synthetic and smart commodity-money. It aims to provide a non-collateralised digital asset that helps traders and investors diversify their crypto portfolios. Ampleforth adjusts its tokens’ supply daily to match the market demand using a smart contract. 

THE PRESENT STATE OF THE DEFI  MARKET 

The DeFi market has shown spectacular growth over the past two years. DeFi growth accelerated since mid-last year when services became more mainstream for the crypto-community. Decentralised finance has thereby developed into a complex ecosystem of platforms, working applications and protocols through which borrowers, lenders and investors can under take bank-like transactions without banks.  Today, billions of US$ have been put into the DeFi-ecosystem, locked on the various DeFi platforms (6). 

According to DeFi Pulse, the total value locked in DeFi contracts that was injected  in diferent DeFi protocols/services as of the end of last year was almost US$100bn  compared to US$500m in early 2020 — a  staggering 1,000 per cent growth in the past  two years. The recent hype around DeFi apps is driven by the growth of lending and borrowing protocols, especially those built on the Ethereum network. Lending currently represents nearly half of the DeFi  market. There are hundreds of examples of DeFi applications on the Ethereum ecosystem today. The majority of these are based on DeFi lenders Aave, Compound and Maker showing the concentration of lending and borrowing markets within DeFi.  This demand is especially evident amongst Millennials and Gen Z who will expect such services to be offered. 

ASSESSING THE PROS AND CONS  OF DEFI 

DeFi is quickly emerging as a transparent  and permissionless way for users to interact directly with each other. The DeFi system offers a number of benefits for crypto-traders and investors that are currently not provided by the conventional financial intermediaries, including speed, efficiency  and lower cost. DeFi may thereby eliminate many of the traditional finance concerns that people have. 

Despite the various benefits and opportunities, the DeFi industry is still in a nascent stage, and has not been stress-tested by long or widespread use. It faces many challenges  much related to its non-regulated stance and  the resulting lack of consumer protection that need to be tackled for a real break through. These challenges still make many  traditional banks and consumers reluctant  to enter the DeFi space. 

More accessible versus attraction  of malicious players 

DeFi could greatly reduce the barriers to entry. By eliminating the need for centralised financial institutions and intermediaries,  being replaced by self-executing programs, DeFi makes financial services more accessible and more inclusive, regardless of credit history, networth, geographical location or class. The anonymity of DeFi users and the absence of checks however could attract  malicious actors that may use DeFi services to launder money and fund criminal operations and fraud. 

Faster and more (cost) efficient versus  congestion (7) 

DeFi may enable to handle the management of finance in a faster, more efficient way, eliminating the high costs associated with regulation and poor infrastructures. The lack of intermediaries and the use of smart contracts could greatly reduce operational costs and delays.  Furthermore, decentralised finance services are available 24/7.  As a result, DeFi may surpass the present banking system in terms of speed. But there are some negatives such as the concentration risk. Decision-making power on DeFi  blockchains runs the risk of being concentrated in a small group of large investors.  Concentration can facilitate collusion and limit blockchain viability. Large validators could also congest the blockchain with artificial trades between their own wallets or risk insider trading. 

Financial sovereignty control versus  lack of consumer protection 

Financial sovereignty is another advantage of decentralised finance. As intermediaries do not need to be relied on, people have full control over their assets and view their storage location and use. The existing lack of consumer knowledge could make it a breeding ground for fraud and manipulation by malicious developers, while the anonymity of DeFi users could attract actors that may  use DeFi services to launder money and  fund criminal operations and fraud. With DeFi being unregulated there is however no consumer protection if something goes wrong. 

Higher yields versus market risks DeFi may give users incentives for their  financial activities. DeFi offers more opportunities than traditional markets to earn higher yields, while the absence of intermediaries may considerably reduce the interest on loans procured on DeFi platforms. Consumers that currently participate in DeFi do so at a great(er) risk and may sufer losses. First, there is the investors’ risk, the sheer volatility of the crypto-asset markets. Cryptocurren cies are often subject to extreme volatility in the valuations of various digital assets. If  there is a downturn, the crypto-assets used as collateral may sharply decline in value  and some investors may see their positions  liquidated. 


Read here the article in which Carlo provides his opinion on what the expected conclusion is of crypto volatility for corporate Treasury

 

Stable coins versus illiquidity 

Stable coins are increasingly being used to  facilitate transactions on DeFi platforms. The growing use of stable coins may contribute to more stability. There are possible vulnerabilities with stablecoins. Stablecoins like Tether  (USDT) risk liquidity mismatches because  they are backed by commercial paper, which are short-term securities with mostly illiquid  secondary markets. The present cryptomarket is also very illiquid. Every small quantity of ‘buy’ or ‘sell’ of these assets may  hugely impact their value. Given the typically (over) collateralised nature of the  activities, volatility in the valuations of various digital assets posted as collateral could translate into volatility in the valuations of  the digital assets acquired. 

Address cybersecurity versus  security risk 

DeFi also has the potential to address cyber security challenges. The decentralised  blockchain makes financial transactions  secure and provides more transparency for users, maintaining a high level of privacy.  This is through the protocols that provide the assets, allowing anyone to inspect the code or the product, reducing the margin for human error. While a blockchain  may be nearly impossible to alter, the lack of regulation could make other aspects of the DeFi system, like the open source of smart contracts, vulnerable for hacks, cryptocurrency investment scams, fraud  and mishaps, which can lead to funds’ theft. Smart contract risks, such as bugs in the code, could lead to losses for users, as demonstrated by certain protocols in recent months. 

SHOULD BANKS WORRY? 

The debates around decentralised finance are heating up. If DeFi could become main stream, it might pose big challenges to traditional banks. DeFi may prove a disruptive force for traditional financial companies  and would have a great impact on how banks operate in the future. It will certainly revolutionise the way finance would be handled.  DeFi also has the potential to change the  structure of financial systems, completely shake up and potentially even replace the current financial system. 

DeFi: Still a tiny market 

But within the present environment that would be a step too far. Numerically DeFi  does not pose an imminent threat to traditional lenders. While the DeFi market has grown signif­i­cantly in historical terms, encompassing remittance, trading, lending, borrowing and various other types of  transactions, their market size is still very small compared to traditional banking.  The decentralised finance sector currently represents only a tiny 0.1 per cent of the trillion-dollar traditional finance industry.  Its potential for disrupting the larger financial system in the short term remains low. 

DeFi: Upcoming solutions 

In the meantime, a lot of work is already being done to overcome these hurdles.  Thereby changes are being made towards a more acceptable view of DeFi by both consumers and traditional banks. 

Within the DeFi space 

Within the DeFi space there is a growing number of initiatives that are especially aimed at removing hurdles such as collateral requirements and volatile digital assets.  Companies including Aave are working on permitting uncollateralised loans akin to traditional finance. And in 2022 there will be increasing interoperability between DExs, which is vital for improving liquidity. The German financial services firm Paycer is developing a bridge protocol to combine DeFi and cross-chain crypto services to integrate them with traditional (centralised) finance (CeFi) services. This should support full interoperability across multiple blockchains. 

Education 

Also on the education issue, there is a massive effort to upgrade the level. There is a growing number of educational institutions that are trying to improve the education of potential DeFi users and lower the high knowledge barriers. This will certainly help traditional bankers and regulators to become familiar  with blockchain technology. And there are initiatives such as DeFi for the People that can help industries identify how to integrate DeFi into their existing business models. 

Compliance 

There is a growing consensus from both the traditional financial world and DeFi parties that DeFi products and services  must be compliant, secure and appropriately audited and monitored to ensure users’ security and privacy. More DeFi platforms featuring KYC tools and compliant reporting systems to protect the DeFi market from regulatory uncertainties  and to lure traditional financial institutions are being seen. Concordium (8) and Verum Capital AG are collaborating to launch the first lab focused on developing regulated  decentralised finance products. 

Formal regulation 

Formal regulation is expected to come to the DeFi market in 2022 and beyond.  Multiple policymakers and regulators world wide are already keeping a close eye on the growth of DeFi and its potential negative impacts and are making up their minds. A positive signal is the growing trend among regulators worldwide to develop a collaborative approach. 

The EU’s upcoming Regulation of Markets in Cryptoassets (MiCA) (9) is expected  to have strong implications for the DeFi sector. There is increased scrutiny from the US Securities and Exchange Commis sion and the US government, which will  require protocols and platforms to significantly improve. But it is very likely that they will also come with regulatory solutions to ensure consumer protection while the innovative potential of DeFi may bring overall benefits to finance. 

WHY SHOULD BANKS REACT?

DeFi is here to stay and is expected to fundamentally change traditional banking.  Bringing more real-world assets and financial  products on-chain will certainly expand in  the DeFi ecosystem, attracting more investors and traders alike. New types of DeFi assets, more regulatory clarity and lower  costs for transacting will further increase  mainstream adoption of DeFi. It is yet to attract more traditional financial institutions.  But once greater access to DeFi gets easier, traditional banks might have a real reason to  worry. Should recent DeFi trials prove successful, and more product offerings take off,  these protocols could start competing with traditional banks, presenting a main threat for them. Ignoring this trend might lead to a wake-up call in the future but by then it may be too late (10, 11). DeFi and the benefits it brings  to the industry should be seen an opportunity rather than a threat for traditional banks.  This goes especially for those banks that are willing to adapt. Financial institutions should therefore understand DeFi and start making big changes to their existing business model and fix those issues that DeFI corrects. 

THE BANKING INDUSTRY IS  AWAKENING 

The banking industry, especially the larger institutions, increasingly sees DeFi as a potentially signif­i­cant growth engine and disruptive force, challenging traditional banking. As DeFi further grows in size, and thus economic importance, they are increasingly seeking involvement in this sector, thereby exploring how they might engage with DeFi and the crypto-markets. 

Most already have large crypto research divisions investigating to understand the ins and outs of DeFi and the various use cases. They are considering the advantages and risks of DLT solutions, thereby monitoring developments in the DeFi market and are beginning to see DeFi’s potential to overhaul the inflexibility of present processes. Because of heightened consumer and institutional investor demand for DeFi triggered by much better results compared to stretched valuations and low yields in conventional markets, established banks and hedge funds are increasing their exposure (12) to the DeFi ecosystem. 

WHAT STEPS SHOULD BANKS TAKE?

But to be effective, what steps should the traditional financial sector take in order to  survive? As on the scale of global finance, DeFi is still tiny, they should react in a phased way (13). Traditional finance should accept some DeFi products for existing customers, embrace DeFi and help shape the regulatory environment, create bridges and  develop middle-way options and finally cooperate with the DeFi industry through partnerships with leading fintech firms. 

Meet customers’ DeFi demands

A first step for traditional banks is to allow consumers wider access to DeFi via their  banking services. Many customers are looking for more flexible, beneficial and less controlled ways to meet their financial wishes. If banks want to embrace DeFi, they need to embrace this shift by acknowledging that both DeFi and crypto are here to stay. DeFi’s superior yield and transparency should  not be seen as a disadvantage, but more as  an asset to banks and other financial institutions. The main condition is that they move quickly enough to custody digital assets and offer users the ability to earn returns on those assets through DeFi. Banks will primarily compete to offer users the best access to DeFi in the near future. For that, financial infrastructures should be prepared to interface with smart contracts and blockchains now.  This will require financial institutions to  allocate and train separate teams dedicated to managing this new asset class and adopt DeFi  products that provide the best yield. 

Serve new generation customers:  Millennials and Gen Z 

Another way to get involved in the DeFi  ecosystem and to get ahead of the DeFi curve is to engage or partner with the group  of new generation customers that are looking for more sophisticated products. These are increasingly being served by challenger and cryptobanks. DeFi could be seen by traditional banks as the next step in providing  their new customers with the type of financial services they want to have. Just like in  the 1990s when the internet was introduced.  This group of risk-taking investors such as Millennials and Gen Z, which is nowadays underserved, increasingly sees value in digital and crypto-assets instead of the traditional low-return assets offered by traditional banks. Looking ahead, a next step will be offering asset management tools that simplify managing crypto for the wider retail  investor market. Given the complexity of investing in digital assets, the development of asset management funds that both democratise and streamline crypto-investment seems  a logical next step for banks. 

Proactively embrace DeFi 

Traditional banks could also align themselves  with the DeFi activities and be more proactive. This may ensure having an active and prominent role in shaping future regulation via technical instruments. There are various  options for banks to take a more proactive  approach to DeFi. These may include developing so-called greenfield DeFi propositions in collaboration with the DeFi community, and collaborating with regulators to work out how to build regulation while still preserving the decentralised nature of DeFi.

For banks, viewing DeFi through an innovationlens is key to enable DeFi to fulfil its potential at large. For that they need to evolve their own internal compliance work flows to connect their banking services and  the wider fiat economy to the opportunities that DeFi is likely to offer. One potential way forward is to shift the culture within  banks’ compliance departments away from  the present risk-averse approach to an innovation-first approach. This could be done by breaking down silos and encouraging compliance teams to work with engineers,  designers and product people to test different compliance frameworks and try to  innovate within those spaces. 

Bridging the gap 

As DeFi becomes mainstream, there will be a growing need to make this ecosystem compatible with traditional finance (14). Traditional banks could try to create a bridge between  the traditional centralised financial services ecosystem (CeFi) and the new DeFi world.  This will be done by developing credible and trustworthy pathways between both financial ecosystems. 

Up until now, any signif­i­cant moves to develop a bridge between traditional finance and cryptocurrency have come from centralised crypto-players like Coinbase and DeFi Alliance. These are establishing themselves as the kind of bridge-building industry thought leader and pioneer that banks should strive to reach. Coinbase is stimulating major banks to follow suit and offer an equivalent product allowing customers interested in cryptocurrency trading to have a wider choice of platforms. Another interesting player in this sector that focuses on bridging CeFi to DeFi is the Alkemi Network. This platform features an institution-grade liquidity network, offering CeFi institutions a professional avenue to invest in DeFi. Alkemi’s flagship product,  ‘Alkemi Earn’, is a lending and borrowing platform that allows institutions to access DeFi through its permission pool. This particular pool features a KYC framework and compliant reporting systems to enable institutions to navigate the — up until now still  obscure — DeFi market. 

FUTURE FINANCIAL ECOSYSTEM:  CONVERGENCE CEFI-DEFI 

Decentralising financial products at scale is increasingly becoming a reality. It is still in the early stages and although DeFi is promising, it still has some way to go before it is widely accepted by customers and financial institutions. But in the end DeFi could open a completely new ecosystem. What will that look like? 

To survive in the long term, traditional  financial institutions should move and adjust  to the new financial realities and start preparing (15) by adopting some DeFi principles and follow a phased approach. They should find ways to integrate DeFi into their systems and achieve coexistence. 

In the short and medium term, CeFi  and DeFi will behave as competitive or oppositional forces, which both have their own advantages. Banks could try to start bridging the gap by adopting compliant ecosystems, transforming the stream of old money into new digital and crypto-assets.  But DeFi’s distance from the traditional finance system is also likely to narrow as participants in traditional markets look to expand into crypto, thereby strengthening the links between both (16). 

Ultimately the two may converge in a  ‘competitive battle’, whereby the blockchain based principles that DeFi relies on are likely to become fused with the underlying architecture of global finance. Banks should think of the emergence of the internet in  the 1980s and 1990s and the rise in the  number of fintechs. After some time needed  to adjust to the new situation most of these fintechs were absorbed by the big financial institutions. That might now also be the scenario.

 


 

Carlo de Meijer

Economist and researcher

 

 

 

 

References 

(1) Wojno, M., 2022, ‘What is DeFi?  Everything you need to know about the  future of decentralized finance’ available  at https://www.zdnet.com/article/what is​­-defi​­-everything​­-you​­-need​­-to​­-know about​­-the​­-future​­-of​­-decentralised​­-finance/  (accessed 23rd March, 2022). 

(2) Cryptotract, 2022, ‘What is DeFi? Should you jump into this evolving crypt segment?’ available at https://cryptotract.io/ what-is-defi-should-you-jump-into-this evolving-crypto-segment/ (accessed 23rd  March, 2022). 

(3) ‘Legacy banks should learn staking and  DeFi or risk and kick’, 30 May 2021, avail­able at https://www.investing.com/news/ cryptocurrency​­-news/legacy​­-banks​­-should learn​­-about​­-staking​­-and​­-defi​­-or​­-risk extinction​­-2518821 (accessed 23rd March, 2022). 

(4) Banerjee, A., ‘Staking vs yield farming vs  liquidity mining — What’s the diference?’  available at https://www.blockchain­ council.org/defi/staking​­-vs​­-yield​­-farming vs​­-liquidity​­-mining/ (accessed 23rd March, 2022). 

(5) Lee, P., 2021, ‘New DeFi swaps could  transform, conventional finance’ available at https://www.euromoney.com/ article/29b5w8wge0prncr8u4nwg/capital markets/new​­-defi​­-swaps​­-could​­-transform conventional​­-finance (accessed 23rd March, 2022). 

(6) ‘DeFi trends in 2022: Growing interest,  regulation & new roles for DAOs, DExes,  NFTs, and gaming’, 26th December, 2012  available at https://blocknewsmedia.com/ index.php/2021/12/26/growing​­-interest regulation​­-new​­-roles​­-for​­-daos​­-dexes​­-nfts and​­-gaming/ (accessed 23rd March, 2022). 

(7) ‘DeFi News: Better, faster, safer: How DeFi  will kill the retail bank’, 25th June, 2021  available at https://www.fxstreet.com/ amp/cryptocurrencies/news/better-faster cheaper​­-how​­-defi​­-will​­-kill​­-the-retail bank-202106251143 (accessed 23rd March, 2022). 

(8) Concordium, 2021, ‘Concordium will launch  a DeFi lab focused on creating regulated  decentralised financial products’ available at  https://www.prnewswire.co.uk/news​­-releases/concordium​­-will-launch​­ a​­ defi​­-lab​­-focused​­-on​­-creating-regulated​­ decentralized​­-financial-products-804302101. html (accessed 23rd March, 2022). 

(9) De Meijer, C.R.W., 2021, ‘DeFi and regulation: the European Approach, Finextra’ available at https://www.finextra.com/ blogposting/20516/defi​­-and​­-regulation the​­-european​­-approach (accessed 23rd  March, 2022). 

(10) IBM Contribution, 2021, ‘Is DeFi the end of the traditional bank as we know it?’ available at https://www.ibtimes.com/ defi​­-end​­-traditional​­-bank​­-we​­-know​­-it 3260305 (accessed 23rd March, 2022). 

(11) Hodgson, F., 2021, ‘How traditional finance  can survive DeFi’ available at https://fcpp. org/2021/07/14/how​­-traditional​­-finance can​­-survive​­-defi/ (accessed 23rd March,  2022). 

(12) ‘DeFi opens new possibilities for banks to  embrace change’, 30th November, 2021  available at https://www.pymnts.com/ digital​­-first​­-banking/2021/defi​­-opens new-possibilities​­-banks​­-willing​­-embrace change/ (accessed 23rd March, 2022). (13) Ibid. 

(14) Knegtel, J., 2021, ‘Crypto banks: The intersection of traditional finance and DeFi?’  available at (accessed 30th March, 2022). 

(15) Popa, A., 2022, ‘The opportunities of DeFi  for the financial sector explained’ available at https://thepaypers.com/expert opinion/the​­-opportunities​­-of​­-defi​­-for the-financial-sector​­-explained—1253966  (accessed 23rd March, 2022). 

(16) BIS Quarterly Review, 2021, ‘DeFi’s  decentralisation is an illusion’ available  at https://www.bis.org/publ/qtrpdf/r_ qt2112b.pdf (accessed 23rd March, 2022).

 

Blockchain and the Music Industry: Singing the Blues again

22-08-2022 | Carlo de Meijer | treasuryXL | LinkedIn |

There is a technology that could bring fundamental changes to the music industry: blockchain. Blockchain may solve many of the existing problems and challenges in the music industry. Read now the latest blog by Carlo de Meijer, in which he argues the shortcomings within the music industry, and how blockchain can be a solution for these.

By Carlo de Meijer

I am a music fan. Of all sorts, from classic, to pop, to etc. In the sixteenths, I visited the National Jazz and Blues Festival in Plumpton South England. And there I saw Deep Purple for the first time. It was great.

Recently I read that, notwithstanding the music industry is an incredibly big business, many artists still have a pover life. This while the main streaming platforms such as Spotify and other intermediaries are grasping more than 80% of the revenues.

There is however a technology that could bring fundamental changes: blockchain. Blockchain may solve many of the existing problems and challenges in the music industry.

The Music Industry: present state

But before going into more detail in what blockchain could bring, let us first look at the problems in the music industry this technology could help to resolve.

Over the past few decades, the music industry has undergone constant change and

has seen many disruptions over the years. For decades record labels like Universal Music Group, Warner Music Group, and Sony BMG have dominated and controlled the whole music industry, managing the music rights and reaping much of the profits.

Since early 2000 music streaming platforms have emerged as new market leaders thereby triggered by the arrival of the internet. These streaming platforms such as Spotify and YouTube have helped to change the story to some extend and transformed the way music is experienced by making it more widely accessible to users.

Shortcomings within the music industry

Though these platforms brought in more disruptions, while changing the stakeholder landscape, the old structures that formed the music value chain have hardly changed.

That also means that a number of big shortcomings still exist, including rising operational costs and high administrative fees, minimal artist pay-outs due to lots of middlemen, overall lack of transparency especially when it comes to metadata and copyrights, and as a result inefficient and lengthy royalty payment processes as well lack of global collaboration due to an absence of trust.

Many middlemen
The current music industry is overloaded with a large number of middlemen like record labels, radio companies and streaming services. That also means that a very significant proportion of royalties are not received by artists, either because of high and costly administrative fees while it is hard to determine how much one typical artist is supposed to receive.

Centralised services
Another shortcoming is that most centralized music streaming services act like search engines. These are often inaccurate, unsafe, and vulnerable to malicious agents. And, as with any centralized search engine, there is an algorithmic bias that might favour and give more exposure to some artists or tracks and neglect others.

No global database for copyrights and neighboring rights
And there is the low transparency, especially when it comes to metadata and copyrights. Although the volume of data has increased manifold, there is still no global database for copyright and neighboring rights. To manage this chaotic amount of different rights, a complex structure has been developed, whereby the music industry was turned into a complicated array of publishing and recording agreements and other licenses. Finding who is the owner of a determined right in order to obtain a license could be difficult or even impossible. Artists often don’t know how their royalty payments are calculated

Minimal artists pay-outs
And as a result of all these shortcomings, while the music business is still very much booming and makes billions of dollars, most of the artists themselves are receiving minimal pay-outs. In 2020, musicians only gained 12% of $50 billion generated in the music streaming industry, according to a Citigroup report. On top of that it can take years for the money to reach the artist’s bank account. 

Blockchain as a solution

Since blockchain technology is based on the ideas of fully database decentralisation and enhanced security, it holds huge potential for the music industry to overcome a lot of these challenges faced by music fans and artists.

Blockchain and the use of smart contracts could revolutionize and fundamentally change the music industry by removing third party middlemen from music sales and centralized music streaming platforms  and put the power and control back into the creators’ hands from an economic and creative perspective.

By bypassing this long list of intermediaries blockchain could ease the process of copyright, allow artists to verify the copyright of their songs, thereby streamlining royal payments. They could thereby solve the problem of adequate compensation for artists and right holders, ensure more efficient and equitable royalty distribution and revenue sharing, and secure music rights and intellectual property management.

Improve copyrights/intellectual property management
Blockchain holds huge potential for the music industry, particularly for music copyrights and intellectual property management. This technology can help securely manage music rights by introducing transparency in music ownership rights and royalties, via the launch of music rights marketplaces and royalty management platforms.

For artists blockchain could bring direct management of copyright and intellectual property by having a comprehensive peer-to-peer database in which detailed music copyright and intellectual property information is stored. This by using smart contracts containing up-to-date information anybody can view and verify, thereby ensuring that the right people get compensated for the content’s use.

Deeper data insight: transparency and traceability
This massive database would present benefits and opportunities for both collection societies, distributors, and labels, in terms of better marketing and curation, along with verification of the data itself thanks to its immutability, inalterability and transparency.

As music is recorded on the ledger with a unique ID and time stamp, this would address the longstanding issues of consumers downloading, copying and altering digital content. By saving their work directly to a blockchain, it creates an immutable ledger which makes it impossible for someone to steal or copy lyrics or melodies—artists can essentially own their own “masters.” That would also make it more difficult to attack a blockchain database or tamper with the data, because the members of the blockchain network will immediately spot a change to one part of the database.

Full audience ownership
Blockchain platforms also allows full audience ownership. The blockchain makes up for a secure way to prove ownership over a specific piece of music, as well as confirm every person who is involved in its copyright. Blockchain and smart contracts can automate this process by allowing artists to create an immutable record listing all their contributors, producers, and others who participated in the creative process of music files. Every time music files are transferred on the blockchain; this data stays intact. Additionally, it can grant all streaming and fan activity data directly to the hands of the artists. As a result blockchain provides deeper data insights into music lovers’ favourite artists, music videos etc

Instant micro-payments
Blockchain and the use of smart contracts could also solve the issue of adequate compensation for artists and rights holders with instant micro-payments. Blockchain smart contracts could thereby be used to optimise automatic payments, with no middlemen delaying or taking a portion of this payment. They could set the terms under which the music can be downloaded and used, as well as the percentage of royalties to be destined to each copyright holder. Through smart contracts musicians could be paid for fractions of a cent after each sale or stream, allowing the process of royalty payments to take place in seconds instead of multiple months. This paves the way for a new approach to providing on-demand music services, whereby users choose their favourite record and reward and royalties and profits go directly to the artists themselves.

Fostering closer artist-fan relationships
Blockchain technology also enables artists to access some other important sources of revenue for independent musicians: engaged groups or fans. Blockchain music distribution platforms would be able to connect artists directly with listeners, building a direct seller-consumer relationship. Everyone would have equal chances to be found based on relevancy to the search query instead of being pushed by an algorithm.
Composers and artists will no longer be obliged to go through intermediaries such as purchasing platforms and financial brokers, enabling them to take a much large share of the earnings when their music is played while reducing the cost for listeners to access music.  

Blockchain based music platforms

The interest in blockchain technology by the music industry is rapidly growing.

There are now a fast growing number of initiatives by artists and start-ups developing and launching music platforms based on blockchain technology, aimed at changing the face of the music industry and put power in the hands of artists and fans.

Apart from platforms focused on music streaming, streamlining royalty payments and allow direct artist-fan interaction, blockchain is increasingly being used to construct music licensing platforms, platforms to manage ownership rights and payments, while there are a growing number of platforms that operate as music rights marketplace, and as a peer-to-peer blockchain music database creating a music library for film and television.

In this blog I will only describe these platforms to give an idea how they work, what their goal is and just mention a number of interesting platforms that are nowadays operational. A number of these platforms can be found in other blogs such as “15 companies utilizing blockchain in music to reshape a changing industry” from Sam Daley, June 29, 2022.

Music streaming platforms

Blockchain-based streaming platforms allow for the transparent and secure peer-to-peer transfer of music and music related purchases. They connect artists and fans directly without the interference of intermediaries, thereby greatly solving the payments issue getting up to 90% of the streaming revenues. These platforms that are aimed to facilitate the creation, consumption and distribution of music in a shared economy, may bring a high level of trust, automation and transparency to the process. Through new streaming platforms using blockchain technology and non-fungible tokens, or digital assets, it is the artist themselve, and not the record labels, who stand to benefit. They ensure that artists receive compensation for their music straight from their fans, while most of the revenues goes to the artist. There are a number of these platforms that incentives music discovery even further by allowing users to receive a share of royalties. Main streaming platforms include the names like  Audius, BitSong, Music Foundation, NewCoin Founder and Opus.

Music licensing platforms
And there are decentralized music licensing platform for music rights holders and creators that allow them to perform their licensing transactions directly, or provides on-chain licensing for blockchain native content such as intellectual property for audio, visual and images. These platforms thereby utilizes smart contracts and crypto to facilitate more efficient licensing transactions and payments. These music licensing Platforms include names like Dequency and  Digimarc.

Music copyrights marketplace/platforms

There are also several platforms, like eMusic, Mediachain, Musiclife, Open Music Initiative, as well as others, that address the copyrights problem and use blockchain technology to monitor music right holders and act as a royalty management platform that rewards both artists and fans. These platforms are exploring the use of blockchain to help identify the rightful music rights holders and originators so they can receive fair royalty payments.

There are music rights marketplaces that allow music fans to directly fund their favourite artists, songwriters and producers. In exchange, fans can receive royalties generated from their favourite recordings. The platform accomplishes this by collecting royalties from performing rights organizations, record labels and publishers on behalf of fans and then tracks them using proprietary blockchain technology. Other platforms feature instant royalty pay-outs, a rights management and tracking database, fan-to-artist crowdfunding and back-catalogue monetization for copyright holders.

Music database
And there are the various platforms like Viberate, Mediachain, Blokur, Verifi Media and Mycelia that act as peer-to-peer, blockchain music database for sharing information across different applications and organizations. Some of these music databases act  as a source for global publishing data for management and monetization of music, thereby combining different sources of rights data in one database. And there are  peer-to-peer, blockchain databases for sharing information across different applications and organizations. Others run an entire database on blockchain to ensure that artists are paid fairly and acknowledged quickly, containing full information about a song, including ID’s, acknowledgements, business partners and payment mechanisms, so all contributors are treated fairly.

Direct artist-fan connection platforms
Artists are looking to blockchain technology to connect more directly with fans and to bolster their earnings. These direct artist-fan connection platforms can also offer economic rewards to music listeners, increasing the entire experience more interactive and rewarding. Artists could thereby promote their own music and offer special rewards for buyers like extra downloads or rights. Consumers can directly pay for streaming music using blockchain platforms. They would then have the same access to their music, with a more direct connection to the artist who would be paid instantly via the same currency. Examples are Choon that is helping to provide new avenues for more revenue and incentivizing fans through rewards for listeners curating personalized playlists, while Drrops allow artists to communicate directly with their fans and offer them exclusive content and perks while Viberate rewards fans with native VIB tokens.

Non fungible tokens (NTFs)

A growing number of artists in the music world now also have entered the world of NFTs in a massive way. NFTs or non-fungible tokens are seen as the perfect way to create proofs of authenticity for digital contentThey promise improved access to global markets for so-called indie artists and other creators to showcase and sell their art including music streams.

NFTs are stored on a blockchain network, are unique and indivisible and can be used to indicate ownership of one-of-a-kind goods. They are protected by the blockchain, which means no one can change the ownership record or create a new NFT. This helps artists to prove that they have created their artworks. In turn, this helps them to get fair compensation for their work.

An NFT can either be one of a kind, like a music song, or one copy of many, but the blockchain keeps track of who has ownership of the file. These attributes make NFTs ideal for tokenizing music. Music NFTs can technically contain anything digital, like logos, album covers, live performances, concert photo prints, videos of life streams  etc.

NFTs allow you to buy and sell ownership of unique digital items and keep track of who owns them using the blockchain, aside from a musician making an initial NFT sale and profiting from it, as they can keep a percentage of all future NFT sales.

 

Current and future challenges 

But not all risks are gone when using blockchain. Notwithstanding the arrival of official crypto regulations such as MICA in the EU, there are still no guidelines, legislation, or established case law for using blockchain in the music industry.

There are still a number of challenges, regulatory and structural, that need to be addressed. One of the most pressing issues for the music industry, notwithstanding blockchain, is the lack of a global, comprehensive database of rights. And there is the issue of disintermediation, as is common with many, if not all, tech-driven disruptions. Another issue is: how will the traditional players in the music world react.

 

One standard across all music databases
With multiple stakeholders, including artists, music publishers and labels, music streams, collecting societies, and event organisers, achieving consensus on data standards is inherently challenging. If blockchain is to be adopted at industry level, it is all the more crucial to have correct and complete rights data at the onset, since once recorded on the blockchain it will be inherently unalterable. Today’s music industry consists of a large number of databases with little to no interoperability, meaning that if you mention a songwriter in one database, it is not going to synchronize in another. Stakeholders in the music industry don’t share their data nor use a standard music file format.

Data protection

And there is the issue of data protection. Just as other industries, the music industry is also required to comply with the EU General Data Protection Regulation (GDPR). When using blockchain to record personal data, these rules become especially complex since the technology is designed to prohibit retroactive changes to the ledger. This is directly in violation at the GDPR guideline allowing individuals the right to ask for their data to be deleted. Other areas like intellectual property laws will also need to be revisited in the light of new ways of working. This would solve many issues such as conflicting or incomplete records and allow content creators to have all elements of their musical work completed on a universal system.

Hacks
Notwithstanding it was said that blockchain for the music industry would prevent hacks and other misuses, Audius, the blockchain music streaming platform, lost  millions in a recent hack. Hackers that breached the platform were able to steal approximately $18 million AUDIO (Audius crypto token) that is estimated to be worth around $6 million. This is definitely a wakeup call for these platforms to continuously update their security measures.

Transition period
With blockchain adoption, the role of traditional labels, streaming platforms and copyright collection societies could be diminished with the increase in smart contracts and micropayments. But it is still uncertain what will happen during the transition period. How will traditional players react: in a cooperative way or would they “back against the wall”. Steering the industry past the chaotic phase will be critical for it to achieve its full potential.

Forward looking

Though blockchain in music is still in its early years, the technology undoubtedly has the potential of disrupting the music industry for good. Given the firm rise in blockchain-based music platforms it will fundamentally change the manner in which the music business is being conducted. It will lead to the development of a more balanced and fair music ecosystem, one focused on artist and consumers.

The music market will certainly undergo structural change as blockchain adoption spreads. It will shift the power from present intermediaries thereby saving the music industry billions in lost revenues, delayed payments and legal costs and help artists regain ownership and revenue. It will also create ways to reward artists directly, this by revolutionising the rights and royalties process, ensuring artists, writers, publishers and everyone in the music. Ultimately, the financial benefits to artists will likely boost overall creativity.

But in order for this to happen, the industry needs to come together to determine a standard practice and trust in each other and the technology. Thanks for reading!


 

Carlo de Meijer

Economist and researcher

 

 

 

 

Source

Payment Platforms & Collections in China

11-08-2022 | treasuryXL | ComplexCountries | LinkedIn |

Cryptocurrency, digital wallets, virtual everything – there is a huge amount of change. China has been at the forefront of a lot of digital trends, partly due to the fact it had an antiquated banking system which has been thoroughly modernised, and partly because the explosion of internet shopping in the country required a digital payments solution. This is a challenge when there are no credit cards.

Source

This report is based on a Treasury peer Call which explored how this is affecting members’ companies, and how they are adapting to this brave new, digital, world.
  • Most participants are accepting payment using WeChat Pay and Alipay. None is using these tools to make corporate payments.
  • The collections process using these tools is efficient and effective: you work with a third party (usually accessed via a banking provider), who will transfer the funds to your account the following day. One participant did an RFP, with two Chinese and two foreign banks, and found the service was identical – though pricing was different, and not transparent.
  • There was no mention of billbacks, the excessively high fees and acquirors which blight the use of credit cards in other countries
  • The one complaint all participants had was the difficulty linking this process to internal systems, for the reconciliation of receipts or for compliance purposes in terms of identifying the source of cash. The third party companies do provide detailed lists of payors, but it can be difficult to upload these into the ERP system.
  • There was a lot of discussion about travel expenses. The low acceptance of credit cards in China complicates the automated links which often exist between credit cards and T&E management and control systems. Allowing employees to use Alipay and WeChat Pay generally raised problems in terms of obtaining adequate receipts. One participant’s company was doing extensive auditing of travel expense claims, but this is expensive.
  • One company is using virtual credit cards to solve some of these issues, while one is routing payments made on AliPay and WeChat Pay via credit card providers to get the automated expense reporting.
  • Another issue was that, in some cases, sales teams had opened Alipay and WeChat Pay wallets for customers to pay into – but there was no way to stop them from taking this cash to pay themselves. The solution is to require all collections to go via the third party providers, who are under instructions to only remit the cash to the Company’s bank account.
  • Most B2B collections still go through bank transfers or BADs (Bankers’ Acceptance Drafts). One participant is introducing controls to ensure BADs are only accepted if drawn on banks with an acceptable credit profile. Some participants are making payments by endorsing customers’ BADs to their own suppliers. There are some collections by cheque.
  • On the payments side, most participants are making payments via the banks’ host to host systems, or using the payment tools in their TMS products. Participants are using a variety of local and foreign banks: ICBC and Bank of China got the most mentions amongst the Chinese banks, with a spread across Citi, HSBC, Standard Chartered and Deutsche Bank for the foreign ones. Kyriba was the TMS mentioned.
  • One participant is using Pcards for small value purchases – but this is not easy.
  • One participant was struggling with customers who have operations in both mainland China and Hong Kong, and who regularly make payments out of the wrong entity.
  • One participant has experience of linking their IT systems directly to the banking system, to get reporting from all their banks. While possible, this requires a lot of IT work.

There as also a discussion about cash pooling: this works in China.

Bottom line: China is at the forefront of innovation in dematerialised payments. As one participant put it, it has become very hard to use old fashioned cash.

But, as this is China, things are not straightforward!


This report was produced by Monie Lindsey based on a Treasury Peer Call chaired by Damian Glendinning

To access this report:

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EU crypto regulation: towards global cooperation?

19-07-2022 | Carlo de Meijer | treasuryXL | LinkedIn |

 

Finally, after two years of intensive deliberations, EU legislators have reached a provisional agreement on its landmark Markets in Crypto Assets (MICA) directive, that is aimed to govern the crypto space in Europe for the years to come.  



The recent crypto market crash shows how highly risky and speculative crypto currencies are. It confirmed the urgent need for enhanced regulatory and law enforcement frameworks in the EU. So far, digital assets, such as cryptocurrencies, have been largely out of the scope of EU legislation, while divergent laws exist in the member states.

But what may we further expect? Is this the start of further regulatory co-operation worldwide or will it trigger growing regulatory competition between the various countries, especially the US and UK, that are presently dominating the crypto market.

The deals

The deal reached on 30 June consists of two elements: the Markets in Crypto Assets or MICA regulation and a Bill on the Transparency of crypto asset transfers. Both laws are put in place to set clear common rules for a harmonized market in the EU.

The aim of the regulation is to put an ’end to the crypto wild life’ by creating a comprehensive regulatory framework for the crypto-asset market in a balanced way that supports innovation and harnesses the potential of crypto-assets while preserving financial stability and protecting investors.

Such a regulation should provide legal clarity for the crypto business including crypto asset issuers, guaranteed equal rights for asset service providers, as well as ensuring high standards for consumers and investors.

While MICA will put new requirements on exchanges and issuers of stable coins, and provide legal certainty for crypto-asset issuers, guarantee equal rights for service providers and ensure high standards for consumers and investors, the Transparency Bill will force crypto asset service providers(CASPs) to gather information about the transfers they operate to prevent money laundering in crypto.

New provisions

The proposed EU regulation is especially targeting so-called crypto asset services providers(CASPs) and aims to provide a consistent approach across all 27 member states and covers issues like authorisation and supervision, transparency, disclosure and authorisation and supervision of transactions by crypto asset service providers (CASPs) as well as consumer and investor protection, stablecoins and environmental considerations.

License

MiCA will change the registration and authorization process for crypto asset services providers in Europe. Under the provisional agreement they will need an authorization in order to operate in the EU. National authorities will thereby be required to issue authorisations within a timeframe of three months. Regarding the largest CASPs, national authorities will transmit relevant information regularly to the European Securities and Markets Authority (ESMA).

These CASPs will have to be licensed by national authorities and must be based in the EU and have their office within the European Union by a legal person, with a predetermined capital base and adhere to consumer protection safeguards, and be listed on a register held by the European Securities and Markets Authority.

This license will give issuers of crypto assets and providers of related services a “passport” to issue and sell digital tokens in the EU \nd serve clients across the EU from a single base.

Public register

To avoid any overlaps with updated legislation on anti-money laundering (AML), which will now also cover crypto-assets, MiCA does not duplicate the anti-money laundering provisions as set out in the newly updated transfer of funds rules agreed on 29 June.

The new framework will put ESMA in charge of a public register where all non-compliant crypto providers who offer services without authorization will be listed. This to reduce anonymity to tackle money laundering and evasion of sanctions.

EU cryptocurrency exchanges will be obliged to identify users and track suspicious transactions. Entities issuing crypto assets will have to disclose basic information such as a description of the issuer, the project and the use of the funds. This “identity card” will be backed up by details of the rights, obligations and risks associated with these digital assets. National authorities will be notified of all of this information.

Crypto-asset service providers, whose parent company is located in countries listed on the EU list of third countries considered at high risk for anti-money laundering activities, as well as on the EU list of non-cooperative jurisdictions for tax purposes, will be required to implement enhanced checks in line with the EU AML framework. Tougher requirements may also be applied to shareholders and to the management of the CASPs, notably with regard to their localisation.

White Paper: transparency

CASPs will also be obliged to be more transparent about their financial position as well as the tokens they offer. The regulation makes it a legal obligation for crypto projects to issue a White Paper on all tokens, with all the characteristics and risks  and submit it to the regulatory authorities, although the submission will be merely declaratory and the regulatory authorities do not enjoy the power to authorise or reject crypto projects, other than stablecoins.

The list of information that crypto projects are required to share with the public is relatively slim and does not include many aspects that are already customarily included in white papers. Most importantly, the regulation does not require white papers to explain the project’s ‘tokenomics’.

Consumer and investor protection

This regulatory framework also aims to provide an appropriate level of consumer and investor protection against some of the risks associated with  the investment in crypto assets. Consumer protection standards adopted in the regulation will legally protect consumer funds against cyber-attacks, theft or misuse which are within the responsibility of the cryptocurrency exchanges.

Crypto companies will be held more accountable for investor protection and for investor losses. They must act ‘fair, honest, professional in the best interest of their clients and provide such clients or potential clients with fair and not misleading information’.

Once implemented, the law will require crypto asset service providers (CASPs) to adhere to certain requirements aimed at protecting investors as well as warn clients about the potential risk associated with investing in a volatile crypto market, and publish their pricing policy on their website.

Although these regulations will not provide protection against all of the risks associated with cryptocurrencies, individuals’ own knowledge and analyses will therefore continue to be a key method of consumer protection.

Un-hosted wallets

Unhosted wallets, also known as cold storage or self-custody that enable the user to maintain a cryptocurrency balance outside of an exchange, are mostly excluded from regulation. Transfers between exchanges and so-called “un-hosted wallets” owned by individuals will need only to be reported when transfers are made to a person’s own wallet, and when the value tops the 1,000-euro threshold. This move is designed to reduce anonymity, and thus money laundering, through crypto transactions.

Stablecoins

Stablecoins, which the regulation calls ‘asset-referenced’ tokens’, are also subject to strict regulatory standards of transparency, operation, and governance.

When the regulation comes into force, existing stablecoins will have to seek authorisation from the regulatory authorities to be traded within the EU. Issuers of these so-called asset referred stablecoins will need to have a registered office in the EU to ensure the proper supervision and monitoring of offers to the public of asset-referenced tokens. Most importantly, the regulation prohibits the issuance of interest to e-money tokens. The authorisation requirement applies also to stablecoins already in circulation.

Reserves will have to be “legally and operationally segregated and insulated” and must also be “fully protected in case of insolvency.” Stablecoins that become too large/big also face being capped at 200 million euros in transactions a day under the new regulation.

Holders of stablecoins will be offered a claim at any time and free of charge by the issuer, with all stablecoins be supervised by the European Banking Authority (EBA), with a presence of the issuer in the EU being a precondition for any issuance.

 

Environment

MiCA will also address environmental concerns surrounding crypto. Crypto asset providers will be required todeclare information on their environmental and climate footprint and disclose their energy consumption to regulators as well as the environmental impact of digital assets they choose to list, using the EU regulatory standards as a basis.

The ESMA is now developing draft regulatory technical standards on the content, methodologies and presentation of information related to principal adverse environmental and climate-related impact.

Oversight of the crypto industry

The new EU regulation of the crypto market will primarily be enforced by national regulatory authorities designated by the member states. They will employ national procedural rules and impose remedies foreseen in national law, including criminal remedies where applicable, when they enforce the regulation.

While EU member states will be the main enforcers of the rules, the regulation also gives the European Banking Authority and the European Securities and Markets Authority significant supervisory and investigative powers.

ESM will be responsible for oversight of the industry, while a new legal framework will seek to regulate public offers of crypto assets to protect market integrity. ESMA will thereby be given powers to step in to ban or restrict crypto platforms if they are seen to not properly protect investors, or threaten market integrity or financial stability.

In the meantime the European Council reached an agreement to form an anti-money laundering body that will have the authority to supervise certain CASPs. And will  probably get the name of AMLA.

Reactions from the cryptomarkets

 

How ate crypto firms reaction? Overall, crypto industry players are reacting positively to the EU’s MiCA efforts, and largely welcomed this outcome that heralds the end of several months of negotiations.

As such a harmonized, comprehensive framework could give market participants regulatory the desired clarity to make sure their activities are compliant with AML regulations and crypto end-users key projections and market-wide assurances. The rules would underpin the development of a robust and well-functioning market, within which they could safely operate their businesses further driving crypto innovation and adoption in the EU region.

Some called the rules “a significant milestone”, while others said the comprehensive new framework was “exciting”, providing regulatory certainty to the market, and raising industry standards.

Crypto expansion in Europe

These regulatory developments haven’t stopped firms within the digital asset space from planning their expansion in the EU. Several industry insiders see the move as a positive step and believe Europe could lead the way on crypto regulation saying the EU framework represented a “significant milestone’.

A growing number crypto firms operating or planning to expand into Europe have already taken steps ahead of schedule to ensure compliance. Such as cryptocurrency exchange STEX, that  has partnered with KYC and AML platform Ondato in March 2022 to ensure the exchange’s continued customer growth within a compliance environment of imminent new EU regulation of crypto-assets. But also Coinbase, that already holds authorisation  from Germany and Ireland, as well as  other crypto platforms are seeking licenses in several Eurpean countries.

How to progress?

We are not there yet! The provisional agreement will now move to be approved by the Economic and Monetary Affairs Committee, and should be rubber-stamped by the European Parliament before being translated into legislative text and gazetted in the EU’s Official Journal. The European capitals will then have 18 months to implement them in the national legislation. This process could thus take until 2024 for states to implement MICA and the EU crypto regulation effectively be working.

Some loose ends 

There are still a number of regulatory open issues that should be taken into account in a future revision of the EU crypto regulation such as NFTs, the environment, supervision .etc. An additional problem is that legislation is always lagging behind practice, this especially goes for crypto where technological developments are very rapid. In the meantime EU policymakers are already planning MICA2 to tie up any legal loose ends.

NFTs

Members of the European Parliament have proposed that NFT trading platforms should be made subject to the EU anti-money laundering (AML) laws and should be brought in the scope of MiCA, with authorization and supervision of crypto firms at member state level. They have been tasked with determining whether NFTs require a separate regulatory framework to address the emerging risks of such new market.

Environmental impact

Another issue that should be solved is the question how to address the environmental impact of crypto assets. The final version of the new directive mandates co-legislators to take into account the environmental impact of crypto assets in a future review. The European Commission would assess the energy footprint of crypto assets. Within two years, the European Commission will have to provide a report on the environmental impact of crypto-assets and the introduction of mandatory minimum sustainability standards for consensus mechanisms, including the proof-of-work.

Some concerns

But there are still a number of concerns that should be taken into account before the new regulation becomes law and is fully implemented..

Regulatory overlap

The ECB has warned EU member states about the necessity of harmonizing the different crypto regulations across EU member states until MICA becomes law and is fully implemented. The ECB is concerned about the different crypto regulations across member states and the possible regulatory overlap between respective central banks in the EU and crypto companies during that period.

The ECB is set to warn countries in the eurozone of the dangers of national regulators getting ahead of MiCA and proposing new rules that may affect the future harmonization of rules. The ECB is concerned that countries start providing crypto-related licenses to traditional banks when there is not yet a pan-European framework in place.

The central bank wants to discuss the need to harmonize the provision of these licenses across countries before MiCA is fully implemented. Regulators from 19 EU member states will reportedly attend a supervisory board meeting in July to discuss MiCA and its possible implementation.

Regulatory competition or cooperation

The much-anticipated EU crypto regulation is expected to completely change the crypto landscape. But how and at what scale will greatly depend on the attitude of regulators in both the US and the UK.

The provisional agreement by EU regulators is a welcome step in the right direction. It is still questionable if other regulators will follow suit and work together with industry leaders to deliver a clear and effective global framework which will allow the sector to flourish.

What is sure is that the rules plant Europe firmly ahead of the major crypto centres US and the UK in the race to regulate crypto.  These countries have yet to approve similar rules. The Bank of England’s Financial Policy Committee has called for “enhanced regulation” of the crypto asset market to mitigate against potential risks.

The question if they are prepared to cooperate or if they use crypto regulation as a way to compete in this promising market is still open. Here is a great task for international bodies like the G7, the G20, the BIS and others to teak a lead.

 

Thanks for reading!


 

Carlo de Meijer

Economist and researcher

 

 

 

 

Source

Approaches to FX Volatility

13-07-2022 | treasuryXL | ComplexCountries | LinkedIn |

The latest CompleXCountries report is based on two Treasury Peer Calls in which senior treasurers from Asia, the Americas and Europe discussed the latest bout of increased FX volatility, and the impact it is having on their hedging strategies. As to current volatility, some people are adjusting their strategies, but most prefer to stick with the approach which has already been defined.

Source



FX – one of the biggest and most important challenges we all face. It has a direct impact on the business, and everyone has a view.

The calls (European morning and afternoon to accommodate Asia and the Americas) were to discuss the latest bout of increased FX volatility, and the impact it is having on people’s hedging strategies – if any. Unsurprisingly, it turned into a long discussion of the way different companies approach hedging. The report below is long and very varied – we managed to reduce it to 20 pages, but they are dense. As to current volatility, some people are adjusting their strategies, but most prefer to stick with the approach which has already been defined.

What is that approach? The participants came from a variety of different industries, and covered a broad range of different ways of handling the issue.

  • Everyone has a defined hedging approach, though most contain some degree of flexibility. So, if the approach is to hedge the next 6 months, for example, there may be leeway to go down to 4 months or up to 8.
  • Most people add their hedges via a layering approach, where they build up the hedge over time. This provides an average hedge rate, and avoids the risk of choosing a single point in time.
  • Everyone tries to match their hedges to the needs of the business. This involves co-ordinating with the business units to get their input on the ability to change prices, how long it takes to do so, etc.
  • Most companies have a centralised approach to hedging, but there is variety as to whether central treasury acts as and advisor, or as a decision maker. In most cases, this is decided by the company’s internal measurements and incentive system.
  • Several companies try to insulate the operating units from the effects of currency. This is done by various means: several participants operate re-invoicing centres, which invoice the operating entities in their own currencies, and manage the resulting exposures in the centre. One participant achieves the same result by levying a currency specific working capital charge on the operating units. The income from this charge is then used to pay for hedges – which may, or may not, actually be taken out.
  • In these cases, the centre usually operates as a profit centre – but with strong risk management disciplines to contain the danger of positions getting out of control.
  • One other approach is to fix a budget exchange rate for the coming year, and try to lock that in via hedges. There was a discussion as to whether this suits all businesses.
  • Most participants use forwards for hedging, with the choice of deliverable or NDF varying from one country to another. Several use options, though cost and accounting complexity were obstacles.
  • One participant has an approach which is built entirely around options, including a sophisticated trading strategy to reduce the cost of what they view simply as an insurance policy, like any other. This company is also very opportunistic, and will be active or inactive in the market according to their view of current pricing. This company is also private, and family owned, so they have a higher tolerance for earnings volatility than most – and they are not concerned about quarterly earnings announcements. They also have a relatively high margin business.
  • In this company, as in all others, this strategy is only possible because it has the understanding and buy-in of the management and the operating units. Every participant mentioned this as being key for success.
  • Generally, the percentage of hedging is fixed by policy. However, most participants exercise some judgement, based on the cost of hedging. This is particularly relevant for some emerging market countries, such as Brazil, Argentina and many African countries. The judgement as to what constitutes a hedge which is too expensive was often empirical, but the currencies which were left unhedged usually did not represent a significant exposure for the company.
  • Most participants prioritise balance sheet hedging over cash flow hedging, but some take the opposite approach. In all cases, the accounting treatment is a significant factor in determining the approach.

Bottom line: hedging and managing currency is one of the key competences of the treasurer. For many years to come, it will continue to be one of the areas where there is the biggest variation in approaches – and endless debates. If you have an approach which is well defined and which has been fully discussed with the business, there should not be any need to change it during a period of volatility – though it can be an excellent stress test!

Contributors: 

This report was produced by Monie Lindsey, based on two treasury peer calls chaired by Damian Glendinning.


[The full report can be downloaded FREE by corporate treasury practitioners, please Log in to your account to download (if you receive emails from us – use your email address to retrieve your password), if setting up a new account, please ask for the FX report in the comments and ComplexCountries will send you a copy]

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Unstable stable coins: how to regulate?

29-06-2022 | Carlo de Meijer | treasuryXL | LinkedIn |

 

The crypto market was shocked by the sudden collapse of the third largest stablecoin TerraUSD early May. Long-time isolated from the falls in crypto coins like Bitcoin and Ethereum, stablecoins were designed to sidestep crypto volatility and supposed to remain stable across the crypto ecosystem.



The significant crash of TerraUSD that lost more than 90% of their value in a few days and the resulting crypto market turmoil however has put stablecoins in the regulatory spotlights. Regulators worldwide are prompting new calls for regulation highlighting the risk of certain cryptocurrencies and especially algorithmic stablecoins.

In this blog I want to highlight why TerraUSD, also called UST,  dropped below its target value, what the risks are of the various stablecoins, how regulators should react and what investors can learn from the crash of TerraUSD.

TerraUSD collapse

TerraUSD, also called UST, a so-called algorithmic stablecoin, had been another popular option for cryptocurrencies and was even the third largest stablecoin in the world at the threshold of the collapse. That system appeared to work well until then.

But TerraUSD was not able to withstand a panic outburst amongst investors, this notwithstanding they were providing a 20% interest. Sparked by a massive drop in the value of the crypto markets overall, investors lost faith resulting in a mass sell-off in the TerraUSD stablecoin. Luna Foundation Guard (LFG) tried to stop this slide by liquidating part of its 10 billion Bitcoin holdings.

The collateral, partly existing of Bitcoin, was insufficient to maintain its one to one peg to the dollar. As a result it slipped far from its $1 target price and dropped in value beginning May 9, 2022, hitting a low value of $0.015 at the time of publication of this blog.

As of this writing, the combined market capitalization of TerraUSD and partner stablecoin Luna was just over $4.5 billion, indicating a market decline of approximately $14 billion.

How did the  markets react?

Cryptocurrencies
In the wake of the TerraUSD collapse, other signs of the crypto sector’s vulnerabilities have emerged. When the Luna Foundation Guard sold almost its entire holdings of Bitcoin following the crash early May, as a result the price of Bitcoin, that lost already more than half of its value since last November from $64.000, sank to a 16-month low below $28.000 per coin. But also other cryptocurrencies were hit, triggered by  higher inflation and fears of raising interest rates. TerraUSD’s woes contributed to a slide in crypto markets that saw over $357 billion or more than 30% of digital asset market capitalization wiped out week-on-week. 

Stablecoins
While the TerraUSD collapse has spelled trouble for Bitcoin and other cryptocurrencies, the chaos is somewhat contained in the stablecoin sector. That especially goes for the fiat collateralised segment, where most of the stablecoins such as Tether and Binance have the backing of actual cash and other valuable assets. TerraUSD  is however different from most of its stablecoin peers.

Investors fled TerraUSD into more trusted stablecoins such as DAI and USDC, which drove the price of TerraUSD further down. This increased demand for DAI and USDC temporarily increased their price and were shortly after arbitraged back to $1.

DeFi
The failure of TerraUSD’s peg already has sent shocks through the decentralised finance (DeFi) sector, with a key saving and lending protocol, Anchor, seeing massive liquidation of TerraUSD-collateralised loans and the pricing of other crypto tokens also being affected. This has led to further liquidation triggers throughout the ecosystem. ‘Bouts’ of volatility will probably continue as the cryptosector digests the repercussions of the failure of the TerraUSD peg, while US policy rate increases and equity volatility may pressure so-called ‘high-beta assets’.

Regulated financial markets
Recently the Financial Stability Board (FSB) pointed to the increased intertwining of the crypto world with the traditional financial world. Up till recently links between crypto markets and regulated financial markets remained weak. The potential for crypto market volatility to spill over and cause wider financial instability was limited. But that has changed.

A growing number of regulated financial entities have increased their exposure to cryptocurrencies, DeFi and other forms of digital finance in recent months. If crypto market volatility becomes severe the risks for the financial stability of the real economy could as a result escalate.

 

But not all stablecoins are the same

Stable coins are cryptocurrencies designed to be protected from the wild volatility of crypto currencies like Bitcoin and Ethereum. They attempt to maintain a constant exchange rate with fiat currencies, mostly through a 1:1 US dollar peg.

Stablecoins are often used for transactions within the crypto world and between cryptocurrencies and the traditional financial system. They have played a crucial role for cryptocurrency traders, allowing them to hedge against spikes in Bitcoin’s price or to store idle cash without transferring it back into fiat currency.

Regulators should however be aware that not all stable coins are the same. Some stablecoins are more vulnerable than others. The stablecoin sector is a critical and complex part of the crypto ecosystem. Stable coins are an umbrella term. They are not a monolithic asset class and every stablecoin operates differently.

Stablecoin models

Stablecoins can be divided into two broad groups based on how they choose to pursue price stability: collateralised stablecoins and non-collateralised stable coins. Collateralised stablecoins can be split into fiat-collateralised and crypto–collateralised. The newest group of non-collateralised stablecoins are so-called algorithmic stablecoins like TerraUSD.

Fiat collateralised
The value of fiat-collateralised stablecoins is backed by reserves comprising assets, such as fiat currency, mostly the dollar, as collateral assuring stablecoin’s value. Collateral can also consist of bonds, commercial paper, commodities like gold and silver as well as crude oil. But most fiat-collateralised stablecoins have reserves of US dollars.

Dollar-based collateralised stablecoins like Tether and true USDC use a more fluid collection of traditional assets to secure its stable coin. Most of these reserves consist of treasury bills, certificates of deposit, and cash deposits to match the value of outstanding tokens that are maintained by independent custodians and audited regularly to ensure that holders of these stablecoins guarantee they can redeem them for actual fiat money, at some point.

Crypto-collateralised 

Another category of stablecoins are crypto-collateralised stablecoins, with their underlying collateral being another cryptocurrency or basket of cryptocurrencies. Because the reserve cryptocurrency may be subject to high volatility, such stablecoins are often over-collateralised, whereby the value of cryptocurrency held in reserves exceeds the value of the stablecoins issued. The Dai stablecoin for instance which is pegged to the US dollar uses a basket of crypto assets as collateral at a ratio of 150% of the value.

Non-collateralised stable coins
And there is the newest group of stablecoins which are algorithmic or ‘decentralised’ stablecoin. While most stablecoins are reserve backed and are supposed to always be exchanged for one dollar, algorithmic stablecoins ‘forgo this failsafe’ and attempt to maintain their pegs through other means. Their primary distinction from collateralised stablecoins is the strategy of keeping the value of their stablecoin by controlling the supply through an algorithm and smart contracts to control the supply of tokens.

TerraUSD (UST)

TerraUSD, which trades with the symbol UST, is one of those algorithmic or decentralised stablecoins. To get somewhat more insights in this new type of stablecoin, let’s go more deeply into how it works.

The purpose of TerraUSD was to create a “crypto-native” dollar – with all of the supposed benefits of blockchains, like censorship resistance – that would be cheaper to use than a fully or partially collateralized option. It was intended to be worth exactly one dollar, enabling transactions to process with predictable results and giving cryptocurrency investors and traders an option to store their assets in cryptocurrency without the risk and volatility associated with typical digital currencies. Its peg to the dollar was supposed to be maintained by a complex algorithmically driven mechanism rather than by reserves of dollars or other assets, as is typical for stablecoins.

As TerraUSD’s popularity took off, its partner stablecoin Luna increased in value as well. The coin popped from around $5 in July 2021 to a high of $116 in early April 2022. Before its collapse TerraUSD was the third-largest stablecoin by market capitalization with about $18 billion and the largest algorithmic stablecoin.

 

How does TerraUSD work?

TerraUSD as an algorithmic stablecoin, is fundamentally different from most of its peers. Their value is assured not by financial collateral in the traditional markets – though owner Kwo diversified earlier this year their backing by purchasing $10 billion in Bitcoin – but backed by lines of computer code so-called algorithms to stay pegged to the dollar.

This stablecoin used a sophisticated but complex automated system of arbitrage to maintain its valuation at the 1:1 level. This mechanism relies on two coins: the TerraUSD stablecoin and the Luna governance token. It involved swapping TerraUSD coins with this free-floating cryptocurrency Luna to control supply.

The value-protecting transactions are executed by smart contracts on the Terra network. A computer algorithm thereby creates (mints) and destroys (burns) both TerraUSD and Luna to bring the price back into equilibrium. When the price of TerraUSD drops below $1, traders can burn TerraUSD—removing it from circulation, thereby reducing the overall supply —and raise the price back up. If the value of TerraUSD goes higher than $1, traders can burn Luna for TerraUSD, increasing the overall supply and lowering the price. This creates trading margins and supply and demand models that help keep the coin pegged to $1.

Another key part of the Terra ecosystem is the interest rates on TerraUSD deposits. These are offered through Anchor Protocol, a decentralized finance (DeFi) platform, which can garner annual percentage yield rates of 20 percent on TerraUSD tokens that could be borrowed by investors in need of dollar-like capital. The Terra decentralized finance (DeFi) network incentivized traders, holders, and users to either use, lend, or stake these crypto assets. This system worked reasonably well in practice from the inception up till early May.

Regulations

As things stand nowadays, stablecoins are very lightly regulated. A significant part lays outside the control of regulators. Given the explosive growth of the $130 billion market and its potential to affect the broader financial system, it is not strange that stablecoins have come under growing scrutiny by regulators. The recent turmoil has reignited calls in virtually every major financial market in the world for increased regulation of the crypto asset market in general and of stablecoins in particular.

Common themes in the discussions are the volatility, the lack of transparency with regards to crypto operations and the reserves they are supposed to hold, the overly optimistic promised returns and investors that are not well informed with regards to what is being purchased.

 

Reactions
Politicians have increased calls for tighter regulation of stablecoins. The falls in cryptocurrencies and the collapsing value of TerraUSD have further alarmed policymakers in both the EU and the US such as Treasury Secretary Janet Yellen and Securities and Exchange Commission Chair Gary Gensler.

US Treasury Janet Allen
US Secretary of the Treasury Janet Yellen has cited risks to broad financial stability due to stablecoins. She told a Senate Committee that the TerraUSD debacle has reinforced the need for proper oversight and for a “consistent federal framework” for regulating stablecoins and said that stablecoin guidance could come as early as this year.

“A stablecoin known as TerraUSD experienced a run and declined in value” “I think that this simply illustrates that this is a rapidly growing product and there are rapidly growing risks.”
 Janet Yellen

Fed semi-annual Stability Report
In its recent published semi-annual Stability Report, the Fed discussed the uncertainty of what is actually backing stablecoins and the lack of oversight in that market. The Fed repeated its concerns that stablecoins are vulnerable to investor runs because they are backed by assets that can lose value or become illiquid in times of market stress. The increasing use of stablecoins to meet margin requirements in leveraged crypto trades may further heighten redemption risks. A lack of transparency around the assets may exacerbate those vulnerabilities. A run on the stablecoin could therefore spill over into the traditional financial system by creating stress on these underlying assets, according to the report.

 

What sort of regulation

There are however still different visions on how to regulate stablecoins. Some regulators are preparing rules for stablecoins to make them look and function more like banks. Some others come up with proposed regulation that will look like more as governance tokens being considered securities. According to them, as tokens have claims against assets, or claims against cash flows, they are looked at the easiest target for regulators.

The International Organization of Securities Commissions (IOSCO) said stablecoins should be regulated as financial market infrastructure like banks alongside payment systems and clearinghouses. The proposed rules should focus on stablecoins deemed systemically important by regulators, with the potential to disrupt payment and settlement transactions.

The ECB is also increasingly worried about the risks for the financial stability of crypto investments. They are urgently calling for accelerating the implementation and acceptance of regulation to implement constraints to crypto currencies and stable coins. The EU’s Markets in Crypto Assets regulation, that would enter into force from 2024 onwards, is expected not not permit the issuance of algorithmic stablecoins and would require crypto providers to have a (bank-like) license and systemic stablecoin issuers  be backed by enough reserves.

What issues for regulators to consider?

There are important lessons to be learned from this crypto collapse, that regulators should keep in mind when designing legal frameworks for cryptocurrencies in general and for stablecoins in particular.

Like all new technologies, these assets — including dollar-backed, crypto-collateralized and algorithmic models — deserve a smart and thoughtful conversation around potential regulation, in order notto  frustrate financial innovations.

Regulators should thereby be aware that this collapse of TerraUSD is not a reflection of all stablecoins, because they weren’t all built the same under the same philosophy. As has been described before algorithmic stablecoins are very different compared to the collateralised stablecoin types.

Stablecoins in general should therefore not be forbidden but should be firmly regulated to prevent that a collapse like TerraUSD will happen again.  Buyers should understand what the risk are especially of these algorithmic stable coins. It therefore needs standards

Factors to keep in mind for regulators

There are a number of important factors policymakers and investors should keep in mind as stablecoins continue to develop and mature. This latter group take deposits without any insurance that customers rely upon to know their money is protected.

Regulators should likely pay more scrutiny to the risks surrounding stablecoins and their reserve attestations especially algorithmic stablecoins, given that UST’s problems have sparked wider crypto market volatility.

Stablecoins backed by reserve assets with clear fiat currency value however face a fundamentally different set of credit issues to algorithmic stablecoins, in our view. In such cases, the stablecoin’s stability risks can be more manageable, depending on various factors, notably the safety and liquidity of the reserve assets.

Asset-backed stablecoins therefore should become transparent about what is in their reserves. With traditional stablecoins, regulators also want to know that their operators have sufficient assets to pay out customers in the case of a run on the system.

Factors relevant to the credit profiles of issuers of reserve-backed stablecoins should include regulatory risk, counterparty risk (including reserve custodians), transparency over reserves and the extent to which the underlying assets are truly uncorrelated, the legal rights of stablecoin holders, as well as governance and operational risks.

In the case of algorithmic stablecoins, they should, in regulatory terms, not be [backed] one-to-one, but being over-collateralized because these are inherently more risky. Other issues to keep in mind that are relevant for regulators are:  what are the permissible reserves?;  who can issue a stablecoin?; how should an issuer and the reserved be audited?; and, what kind of disclosures are made to consumers?”

Factors relevant to the credit profiles of issuers of reserve-backed stablecoins should include regulatory risk, counterparty risk (including reserve custodians), transparency over reserves and the extent to which the underlying assets are truly uncorrelated, the legal rights of stablecoin holders, as well as governance and operational risks.

Final remarks

It is clear that regulation of stablecoins is urgently needed to prevent collapses like that of TerraUSD. There are still many open questions.

It is however still unclear how this new regulation will look like and what impact this new upcoming regulation will have for the future of stable coins in general and algorithmic stablecoins specifically. But also what would it mean for the further development of underlying technologies.

What is clear is that stablecoins are here to stay but in a more regulated framework. It does seem very likely that many more investors will choose collateralized stablecoins in the future. This will most likely result in a growing number of stablecoins with lower risks.

In the end this may further benefit the crypto industry as thanks to lower risks and increased transparency it may attract more players from the traditional financial world.


 

Carlo de Meijer

Economist and researcher

 

 

 

 

Source

Treasury & Banking in India

20-06-2022 | treasuryXL | ComplexCountries | LinkedIn |

This call took place against the background of the war in Ukraine – but it was a useful chance to catch up on the ever-improving situation in India.

India has always been complex, with many regulations and poor clarity. This is clear from the comments below, where participants often have different experiences on the same topic. But, overall, the economy is working well, people are making profits (this was not always the case), and regulations are becoming more user-friendly, even if they remain challenging.

Source



Business structure: most participants have one legal entity which faces customers, and a different one which acts as an international shared service centre, invoicing other companies in the group on a cost plus basis. This can lead to inefficiencies in cash management: everyone struggles with domestic cash pooling and intercompany loans, while the shared service centre has guaranteed profits and cash generation. One participant has all activities in the same legal entity, which makes life easier.

Intercompany loans within India create transfer pricing and tax challenges: there is a required or recommended interest rate of 8%, compared to deposit rates of 4% to 4.5%.

Cross border cash pooling and intercompany loans are generally very difficult: many approvals are required. Dividends are subjected to withholding tax of 15%, which is sufficient to deter some, but not all, participants from paying dividends. However, this is an improvement on the previous 22% dividend tax, which was often not creditable against tax in the receiving country.

Netting of intercompany invoices is not allowed. However, one participant is using an Indian entity to centralise all invoices within the country using a POBO/ROBO process, and limiting the transactions to a single, large, gross in/gross out settlement. They are also looking at a non resident INR account.

Participants mostly use deposits for investing their excess cash. One is using the TIDE deposit: the bank automatically sweeps fixed amounts of cash above a defined threshold into deposits. These receive a higher rate if they remain for more than two weeks, but can be released if needed, with a lower interest rate being paid.

Most participants use international banks, mainly Citi and BNPP. Most complained that Citi are reluctant to use automated FX platforms, and are behind on the electronic transmission of import documentation – but one participant had a more positive experience. JPMorgan again received positive comments for their approach.

The participants who use local banks generally had positive comments about them, and found they were a big help with pricing, especially on loans and letters of credit.

Tax remains complex and challenging.

 

Bottom line: the – excellent – report below reflects the significant complexity of doing business and managing treasury in India. But it is an important market, and one which is improving. So it is definitely worth the effort!

To access this report:

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Winding Down Russia: Treasury Challenges

23-05-2022 | treasuryXL | ComplexCountries | LinkedIn |

 

This was our third call on the situation in Russia. It focused on the practical challenges people are facing: nearly all participants are either running down their businesses or continuing on humanitarian grounds for products which are exempted from sanctions, particularly in the healthcare sector. However, as one participant put it, winding down is easier said than done.

This report was compiled by Monie Lindsey. based on a Treasury Peer Call chaired by Damian Glendinning.

We are happy to share a copy of the full report FREE, please contact us and mention ‘Russia Report’ in your message.

Source



Chair’s Overview

This was our third call on the situation in Russia. It focused on the practical challenges people are facing: nearly all participants are either running down their businesses or continuing on humanitarian grounds for products that are exempted from sanctions, particularly in the healthcare sector. However, as one participant put it, winding down is easier said than done.

  • Many businesses operate through franchises in foreign countries. Terminating the franchise agreement may not be enough to stop them from continuing the business and using the brand name – some high-profile companies which have stopped operations still have franchisees who are continuing to trade, using the name.
  • In some cases, the name remains on the business. This makes it difficult for the brand owner to walk away, as the reputational risk remains.
  • People in the healthcare sector feel a need to carry on for humanitarian reasons. For them, there are significant logistical challenges getting new shipments into the country: no flights, very little sea freight, so heavy dependency on road transport, with limited willing suppliers. They are encountering an additional issue: sanctions apply based on customs codes, and some health care products have not been appropriately coded.
  • In other sectors, companies continue to sell down their existing inventory – but even this can be complicated, as fresh inputs can be required to make goods saleable.
  • Still, other participants have operations that are purely local, and do not require imports. These will typically continue to function, though moves are being made to make them fully independent.
  • Despite all the above, most participants continue to be able to pay down intercompany debt, pay dividends and settle outstanding intercompany invoices.
  • Cash operations are complicated by the need to segregate payments emanating from sanctioned banks. Again, this seems to work, and customers are usually willing to transfer their payments to non sanctioned banks.
  • Many Russian entities have taken steps to disguise their real ownership as a means of evading sanctions: some participants are using a database to identify the true beneficial owners to see whether sanctions apply.
  • Most international banks continue to function, but SocGen recently announced it is selling Rosbank. This raises the concern it may be sanctioned in the future.
  • Most international banks are refusing to open new accounts, and none is interested in taking deposits. This is a concern for participants who are building up cash balances as they sell down inventory. Raiffeisen seems to be the major exception to this.
  • It continues to be possible to convert RUB into hard currency – as long as you are not using a sanctioned bank. Hedging is also possible, but liquidity is limited and deliverable forwards are not available. NDFs seem to work.
  • Several participants have had to remove their Russian subsidiaries from their centralised treasury structures and in-house banks. This has resulted in the hiring of new local staff to manage the newly independent operations.
  • One participant raised the concern that Russia may be branded as a state sponsor of terrorism. This would complicate matters even further.

Bottom line: despite the length of this summary, there are still further details in the report below. Please read it. The overwhelming feedback from the call was that everyone is trying to comply with the sanctions, and business is either being scaled back, or completely localised. People have stopped looking for ways round sanctions – but compliance is complicated.

The full report on Winding Down Russia: Treasury Challenges is available to subscribers. Please get in touch for details. Enquire


Central Banks Digital Currencies: what may it bring for banks?

18-05-2022 | Carlo de Meijer | treasuryXL | LinkedIn |

 

The future of money is digital, according to a new global CBDC index from Price Waterhouse Cooper (PwC). This year’s Index shows that central banks are “ramping up” activity in the digital currency space. It is estimated that more than 80% of central banks worldwide are considering launching a central bank digital currency (CBDC), which some have already done so.



Before introducing their CBDC there are however many challenges and considerations to cover, ranging from cybersecurity and privacy concerns to the impact on financial markets and legislation. But the most fundamental one is: what may CBDCs bring for banks? Should they worry or is this an opportunity for them?

Introducing CBDCs may pose potential risks to the banking sector. How are central banks acting to mitigate those risks. What design is most suited for banks? And if well designed how would the future of banks look like.

 

Challenges and risks for banks

Despite having potential advantages, there are also various risks associated with CBDCs that could harm financial stability if not well designed. According to research, risks to financial stability depend on the take-up or rate of adoption, of a CBDC as well as bank funding, lending and resilience. If take-up is too fast, it could throw the existing financial and banking systems out of balance, a recent BIS report says.

Banking system disintermediation
The question of whether – and to what extent – CBDCs could pose risks to financial intermediation is central to the present debate. With the ability to provide digital currency directly to its citizens, it is widely viewed that if not well designed CBDCs could crowd out bank deposits and payment activities, as depositors would shift out of the banking system.

Bank runs
But there is also the possibility of digital bank runs. CBDCs would provide consumers access to a safe asset that – unlike cash – could potentially be held in large volumes, in the absence of safeguards, and at no cost. In the event of a banking crisis consumers could withdraw their savings from commercial banks and put them into safer CBDCs. If a bank has problems (be they technical or financial), customers with easy access CBDC wallets could trigger a run on the bank even if the problems are temporary. Such runs could even be self-fulfilling, leading to savers reducing their bank deposits and thereby amplifying volatility in normal times too.

Increase in funding costs
And there is the prevailing fear that the use of any CBDC would require a shift of funds out of bank deposits and into digital cash. Should CBDCs rapidly replace bank deposits, they could reduce banks’ ability to lend, leading to instability in the financial system. Without bank deposits, banks won’t have the funds to issue loans that help them make money. If customers move their money from commercial banks to CBDCs then this reduction in the deposits at commercial banks could make the cost of funding loans more expensive with knock-on impacts to the availability of credit for retail and corporate customers.

Weaken balance sheet position
While customers may deem the safety, liquidity, solvability, and publicity of CBDCs to be more attractive, this may weak the balance sheet position of commercial banks. An unconstrained CBDC could potentially have an impact on the funding structure of banks, with potential implications for financing conditions.

CBDCs could thereby interfere with the way in which nowadays credit lines and deposits complement each other. This would make funding more unstable and costly, reducing a bank’s profitability. Replacing deposit funding with central bank funding could exacerbate frictions. Greater recourse to central bank credit could increase collateral scarcity. This could affect banks in asymmetric ways, with a potentially greater impact on those that rely more on deposit funding. And the impact on yields could vary across the different segments of the yield curve. Research shows that the magnitude of these effects depends on the take-up of the CBDC, which in turn hinges on design features such as payment convenience and remuneration.

CBDCs should be carefully designed

According to research by various international financial organisations including IMF and BIS most central banks are committed to minimizing the impact of CBDCs on the stability of the financial system. It is for this reason that they are moving slowly on CBDC adoption and experimenting with CBDC design to mitigate them.

It is a growing conviction amongst central banks that the introduction of CBDC should follow a set of core principles in both design and implementation, that should minimise the impact of CBDCs on financial disintermediation, system-wide bank runs and credit provision as well as limit competition between CBDCs and bank deposits.

One of these main principles is that CBCDs must not harm. In particular, they should not become a source of financial disruption that could impair the transmission of monetary policy in the euro area. For that central banks worldwide have an intense dialogue with various parties in the payments market, technology providers and the general public.

 

Collaborative partnership public-private sector

Introducing a CBDC is a complex process requiring appropriate resources and capacity. Banks are recognizing that the adoption of CBDCs could enhance the efficiency, resilience, and effectiveness of money flows and capital markets, but for a CBDC to be a valuable instrument, it must be part of a collaborative partnership between public and private sectors, to ensure successful adoption, or the building of additional features.

Any CBDC ecosystem should involve the public and private sectors in a balance, in order to deliver the desired policy outcome and enable innovation that meets users’ evolving payment needs. Central banks that contributed to the BIS report envision CBDC ecosystems based on a broad public-private collaboration, or a “tiered system” where the core roles are assigned to the central bank and other more public-facing roles to private financial institutions like banks.

 

Two-tier structure

The risks that CBDCs may pose to bank intermediation depend crucially on the choices that central banks make. Most central banks are opting to follow the current two-tier structure which places central banks at the foundation of the payment system, while assigning end-user-facing activities to financial institutions and other payment service providers (PSPs). This cooperation has proven itself over many decades.

 

It is key in this relationship that central banks issue the value of CBDCs and grant its authenticity, while commercial banks as well as financial services providers issue the wallets that handle CBDC and are responsible for the application. This would allow central banks to benefit from the experience of intermediaries – especially banks – in areas such as onboarding of consumers and anti-money laundering checks. And it may preserve the role of financial intermediaries in providing front-end services.

Commercial banks are the best players to take on a customer-facing role in the CBDC ecosystem and be responsible for the distribution – just as they are now with physical money. Central banks can therefor entrust financial intermediaries with distributing CBDCs, while central banks take care of macroeconomic aspects, such as money supply management and currency stability. The commercial banks are thereby responsible for services such as customer advice, lending or corporate financing. But more than that, since CBDC offers the opportunity to develop new financial products and services.

 

CBDC design features and tools

Careful design and policy considerations will be crucial in allowing to maximise the benefits of CBDCs and manage any unintended consequences, thereby underpinning trust in CBCDs. So it is important to undertake in-depth research regarding the tools and design features, which are found to be strong drivers of the potential demand for CBDCs, that could be introduced to limit such risks.

To be successful, CBDCs will need to add value for users, support competition rather than crowd out private innovation, and avoid risks to financial intermediation. Central banks thereby need to strike a balance so that the digital euro is not “too successful” – by limiting its use as a form of investment – but is “successful enough” – by avoiding such restrictions becoming inconvenient and by ensuring that the CBDC adds value for those using it.

CBDC Design options

The BIS report lays out a number of design options that could help control CBDC take-up and the crowding out of banks including setting holding and transactional limits on CBDCs, and considering different ways of remuneration.

There are various options available including the issue whether to pay out interest. This as a way to limit competition between their and existing bank deposits. The curbs are designed to avoid heightening the risk of bank runs and crowding out depository banks.

Another option is implementing quantitative limits. These latter are also meant to cap competition with depository banks, and can entail limits on CBDC balances that people can hold.

Not interest bearing CBDC

Research from the BIS and the IMF on the various CBDC projects world wide shows that most are not interest-bearing like cash, which makes CBDCs useful, but not as attractive for savings as traditional bank deposits, to ensure they do not compete.

If central banks issue a remunerated interest-earning CBDC it would prove to be a more attractive substitute for cash, low interest-bearing deposits or other cash-substitutes, risking rapid emptying of deposits.

Tiered remuneration
Another option would be to make remuneration on CBDC holdings less attractive above a certain threshold. Up to that threshold, CBDC holdings would never be subject to negative interest rates, ensuring that it is a means of payment that is as attractive as cash. Above that threshold, however, remuneration would be set below the main policy rate in order to reduce the attractiveness of the CBDC as a store of value relative to bank deposits or other short-term financial assets.

Soft limit
One way round this is to set a soft limit with penalties if the upper limit is exceeded: for example, a negative interest rate on all amounts above the upper limit or a penalty amount for every day the limit is exceeded. This would work for temporary balances (for example between the payment of wages and the day the rent is paid) but may not be effective in safeguarding against a bank-run.

Setting a ceiling on individual CBDC holdings
There are also a number of active CBDC projects that have put ceilings on the amount of holdings that a customer can hold in CBDC, to prevent sudden large outflows of bank deposits into CBDC, thereby mitigating undesired effects on monetary policy and/or financial stability. But such a cap would risk reducing the scale and scope of CBDC use and, its usefulness as a means of payment. To address this issue, solutions linking CBDC accounts to private money accounts could be implemented, allowing large(r) banking to be made. This would require funds in excess of users’ limits to be redirected to or from their commercial bank accounts.

Time-period
Another alternative could be expiring money. Any CBDC tokens loaded onto a wallet would need to be spent within a time-period otherwise they would expire. While this could ensure that any money loaded on a CBDC wallet is for day to day spending it however could penalise people who are unable to use their wallet.

Ease liquidity conditions
Central Banks could also ease liquidity conditions, for instance by providing abundant and favourable central bank funding if required to limit strains from possible changes in the composition of bank funding.

ECB and IMF research: findings

ECB and IMF analysis suggests that the impact on the aggregate banking sector in normal times could be manageable overall, subject to safeguards. Adequately designing and calibrating CBDC safeguards could help to counteract the adverse effects of CBDCs on bank run and mitigate potential risks to bank intermediation.

All CBDCs that are currently circulating, either as official currency or through a pilot, are designed with restrictions that limit the competitiveness of CBDC versus bank deposits. By limiting the amount of CBDCs that can be held and not offering interest on them, they don’t compete with bank deposits.

A notable finding is that a CBDC could itself be used as a tool to counter the risks of bank runs. This is because it could provide real-time information on deposit flows, complementing the information on liquidity available to supervisors every day. This would enable the central bank to respond more swiftly if needed, which in turn would help to stabilise expectations by increasing depositor confidence.

 

How should financial institutions react

It is especially important for financial institutions to understand where central banks are with digital currencies, because ultimately CBDCs will start flowing through the payment system and start to hit bank balance sheets.

Careful consultation with central banks is critical in clarifying the business case for CBDCs, from an inclusivity, financial performance and interoperability perspective.

However, it would be wise for commercial banks to track these design features and model potential impacts on their business so that any mitigating actions, such as increasing interest rates on savings accounts or providing CBDC wallet overflow accounts, can be planned well before they are needed.

 

Future thinking: digital opportunities for banks

Looking at the various CBDC projects there is no need to fear competition from central banks.

The proven division of roles and tasks between central banks, customer banks and financial service providers, in which consumers are supplied and serviced in a decentralised manner, may remain intact.

In this future scenario, commercial banks may not only retain their previous role and function, they can even expand their position as service providers.

With the basic currency infrastructure delivered by central banks, this provides a driver for digital innovation. The introduction of a general CBDC may pave the way for new digital business models and additional revenue and growth opportunities.

Commercial banks can also use the introduction of a digital central bank currency to bind customers even more closely to themselves with special apps for the use and custody of CBDC and to link them with new CBDC-based customer services.


 

Carlo de Meijer

Economist and researcher

 

 

 

 

Source

HR Challenges of Global Treasury

26-04-2022 | treasuryXL | ComplexCountries | LinkedIn |

 

The twin challenges of being a people manager and handling essential cross-function communications have always added to the technical and strategic demands of being a treasurer – and these have become more difficult with COVID and remote working. This report explores the approaches of five senior treasurers from Europe.

The peer group discussion was chaired by Damian Glendinning.

This report was compiled by Monie Lindsey.

We are happy to share a copy of the full report FREE, please contact us and mention ‘HR Report’ in your message.

Source



Chair’s Overview

This session was suggested by a member and produced a thoughtful discussion. The twin challenges of being a people manager and handling essential cross-function communications have always added to the technical and strategic demands of being a treasurer – and these have become more difficult with COVID and remote working.

The shared input from all participants was that we have put a lot more effort into communications. When you don’t see people in the office all the time, you have to make the effort to pick up the phone and talk to them. The result has been an even greater emphasis on communications skills – and it is even harder to motivate and support employees who are working in different countries, as it is very hard to go and visit them. These skills are required, not only within the team, but when dealing with other functions such as Sales, and external providers, like banks.

A lot of emphases was put on the ability to keep things simple, and avoid confusing partners with technical jargon.

Initially, the impact of the pandemic was to reduce staff mobility, and cause people to stay in their jobs for longer. This is now giving way to increased mobility, and the need to hire and train people without physically meeting them. This has placed an even greater emphasis on the quality of procedures and process documentation. It has also led to an increase in remote learning, and, potentially, increased the available talent pool, since geographic proximity may no longer be required.

Finally, there was a lot of discussion about areas where the pandemic has simply accelerated trends that were already present – notably an increase in automation, and a reduction in the amount of manual transaction processing work. Again, this has resulted in an even greater emphasis on analytic and communications skills, with a reduced focus on operational ability. As an aside, there was a discussion about whether treasury staff still need to actually understand how the underlying systems work.

Bottom line: the pandemic has accelerated trends that already existed: more remote working and learning, more automation. This has put even more emphasis on the need to communicate well, especially as the phone and video conferencing, while they have undoubtedly saved us, make communications more difficult. The result is a need to put in more effort, and spend more time on it. Paradoxically, this may even prove to be beneficial.