Authors
Kate Goldman
In this newsletter
Decentralized Finance
Bitcoin ETF
Stablecoins
Buy Now, Pay Later
FinTech Cooperation
Global Developments
The Milken Institute released its “Taxonomy of Digital Assets” last week in an effort to address the significant confusion, disagreement, and misinformation in the digital assets ecosystem. Based on our engagement with public and private sector stakeholders, we found that there were key pain points in the understanding of terms like virtual currency and digital currency, which we categorize based on the legal tender status of the coins. In order to bridge this divide, we devised this taxonomy to facilitate a unified understanding of key nuances among some of the most critical technologies and currencies in the digital assets ecosystem. We hope that this taxonomy will be used to further frame conversations among regulators, investors, and innovators in the field, and we are excited about its ability to influence more transparent and inclusive guidance from the public sector.
Decentralized Finance
The Securities and Exchange Commission (SEC) subpoenaed Terraform Labs Founder Do Kwon at a cryptocurrency conference in New York, according to Decrypt. As I wrote several months ago, Terraform Labs powers the blockchain behind its stablecoin Terra USD and its native mining token LUNA, which has climbed almost 370 percent since the July 26 edition of FinTech in Focus. While Terra offers several services across staking and enabling quick payment settlements, the service the SEC is probably most interested in regulating is the Mirror Protocol, a decentralized platform to trade synthetic, tokenized representations of popular securities like Tesla and Apple. Just as the SEC fined cryptocurrency exchange platform Poloniex for offering unregistered securities, the agency could follow similar logic in arguing the Mirror Protocol essentially hosts tradeable investment contracts that are subject to securities regulations for US investors, as per the Howey Test. Kwon is fighting the subpoena, arguing that it was served improperly. Still, the matchup between the SEC and Terraform Labs sets up a crucial battle that will determine the possibilities and limits of decentralized finance (DeFi).
The main question is: Do synthetic, blockchain-based tokens that track United States securities count as investment contracts, even if they don’t represent any ownership in the companies being tracked? To evaluate this question, the SEC will likely analyze the following statement from the Mirror Protocol’s frequently asked questions section:
“mAssets are soft pegged to the oracle price, which means that the Mirror protocol does not directly rely on price oracles to determine the trading prices of mAssets. Instead, Mirror relies on a combination of the minting liquidation process, arbitrageurs, and governance changes to keep mAsset prices close to oracle prices.”
There are a few conclusions we can make here. First, there is an explicit connection between the real-world movements in shares on stock exchanges and the tokens traded on the protocol, as the mAssets are influenced by oracles, which are often used to incorporate external data to settle and validate smart contracts. However, the protocol uses a clear and separate process to arrive at a token price that closely tracks the oracle information. As such, both the SEC and Terraform Labs could have legitimate arguments to back up their claims here.
Bitcoin ETF
On October 19, ProShares debuted its Bitcoin Exchange Traded Fund (ETF) on the New York Stock Exchange, opening at around $42 a share. While the Bitcoin Strategy ETF(BITO) has mostly stayed flat since its inception, its debut marks a landmark win for the cryptocurrency movement and its integration with traditional financial systems; however, it still falls short of the spot market ETF that many Bitcoin enthusiasts desire. As The New York Times notes, BITO is an ETF linked to Bitcoin futures rather than the actual cryptocurrency itself, meaning its price movements are tied to futures contracts related to bets on Bitcoin price movements. No Bitcoin is being held directly by the ETF, which is an important distinction to make.
This model has already run into a critical issue, as Bloomberg recently reported that BITO is already on track to surpass the number of futures contracts the Chicago Mercantile Exchange allows it to hold. BITO can hold only 2,000 front-month contracts right now, so the strategy has been to begin distributing contracts across succeeding months, as seen by the 1,400 contracts owned for November already. However, the problem with this is that spreading more and more futures contracts out to later months to meet demand risks the ETF’s connection with the Bitcoin spot market. The further out BITO distributes the futures contracts, the less connection these contracts will have with Bitcoin price movements.
Stablecoins
The highly anticipated Treasury Department Report on Stablecoins was released on November 1, and the proposals and recommendations included could shake up how stablecoins are regulated and traded. The report recognizes stablecoins’ benefits in contributing to inclusive payments systems and efficient digital asset transactions. Still, it raises significant concerns about the “unregulated” nature of the market and how its growing influence could disrupt broader financial systems if protections aren’t put into place.
Much of the concern stems from the view that stablecoins are a gateway or on-ramp to the DeFi ecosystem, highlighting how significant portions of the stablecoin supply are locked into smart contracts on the Ethereum blockchain, which is currently the most prominent host for DeFi protocols. The report also references how stablecoins have been used to amass significant (and unregulated) leverage on DeFi platforms, since they are often used as collateral by borrowers on decentralized lending protocols. The popularity of stablecoins for DeFi and payments is a concern for the working group due to the lack of regulations around reserve requirements for stablecoin issuers like Tether. As seen in Tether’s recent controversies, stablecoins are often backed not just by cash, but by a mix of other less liquid investments like commercial paper and corporate bonds. For this reason, the working group has proposed regulating stablecoin issuers in the same way as depository institutions, which would provide the federal government with greater oversight and create more robust investor protections through depositor insurance. This is a significant proposal, as it goes beyond just regulating stablecoins as securities or commodities in an effort to protect the equivalent of bank runs on stablecoin issuers. The report mentions concerns about how a potential fire sale of assets in response to insufficient liquid reserves could disrupt financial markets due to the sheer amount of assets stablecoin issuers now hold.
Another major focus of the report is commentary on managing the “systemic risk and concentration of economic power.” In what seems like a direct message to Facebook’s Diem project, the working group called for greater regulation of potential crossovers between banking and commerce, which it believes would be anti-competitive and lead to unfair advantages in data collection for product marketing.
Buy Now, Pay Later
According to Reuters, financial authorities in the United Kingdom have moved Swedish buy now, pay later (BNPL) company Klarna into offering an option to pay in full upfront, demonstrating the gradual but emerging regulation in the space. Klarna has also added credit check requirements that safely examine users’ bank account history, leaving behind the old system that didn’t vet users' financials as thoroughly. The “pay now” option Klarna now has to incorporate on its platform may cause some head scratching because the whole point of its model was to avoid the traditional method of paying for a good or service by allowing users to acquire a line of credit to pay in installments. From the Financial Conduct Authority’s (FCA) perspective, however, the change makes complete sense, given that users could now feel less obligated or enticed to proceed with the BNPL option if they see an alternative to pay in full at the time of checkout. The FCA is attempting to prevent companies from persuading consumers into taking on more debt than they can handle, and forcing BNPL companies to advertise a “pay now” option is an effective way to make users think twice before making an expensive purchase.
FinTech Cooperation
Synctera, which develops integrated technology platforms for community banks and FinTechs, recently announced the launch of its new t-minus10 program, which will allow for the full creation of a FinTech application in just a few days, according to Yahoo Finance. It’s a significant development for the feasibility of building out a FinTech platform and will utilize Synctera’s know-your-customer, anti-money laundering, and know-your-business compliance capabilities. Moreover, t-minus10 will build upon Synctera’s automated clearing house and payments techniques by offering card issuance even before a FinTech fully finds a sponsor bank. This reduces the usual friction in the process by allowing FinTechs to focus on building out their platform before worrying about bringing on a sponsor bank. The t-minus10 program isn’t just beneficial for innovative FinTech entrepreneurs but also for community banks seeking to upgrade their technology, as Synctera also specializes in creating a marketplace for partnerships between FinTechs and community banks.
Global Developments
According to TechCrunch, Brazilian neobank Nubank has filed to go public in the United States, marking the next step in capital raising for the world’s largest digital bank after a round in June valued the company at over USD$30 billion. Now, after making a combined domestic profit from January to June for the first time in company history, Nubank is seeking a valuation of USD $50.6 billion at an initial price offering of around USD $10 to $11 a share, according to Pitchbook. Nubank’s revenue grew to USD $1.06 billion by the end of September 2021, which represents almost 99 percent growth year-over-year, reflecting the benefits of having 28 percent of the Brazilian population aged 15 and over as customers. As reported by the Financial Times, Nubank’s popularity largely comes from its divergence from Brazil’s costly banking system that bars many from basic services. The neobank has now eclipsed the customer base of traditional banks like Santander Brasil. Nubank’s emergence is rooted in the growing value being placed on financial inclusion, as its digital banking product services are finally providing the low-cost, transparent, and accessible financial services that have been missing from Brazil. Through organic growth and acquisitions, Nubank is creating a more competitive Brazilian banking industry that challenges the legacy financial institutions to adapt.