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Summary of the thesis
Bitcoin (BTC-USD) is once again in the crosshairs of regulators. Europa is proposing a landmark set of rules, some of which have raised concerns among crypto enthusiasts. The US also continues to enact crypto laws, and a A seemingly trivial change could spell the end of DeFi. Finally, stablecoins are also being targeted, with regulators trying to force them to be backed by currencies and sovereign debt. Bad news for the increasingly popular algorithmic stablecoins.
Paradoxically, efforts to regulate bitcoin and crypto could end up having the opposite of the desired effect. Regulations could make crypto trading less secure.
All in all, bitcoin has its fair share of hurdles to overcome, but with every hurdle it overcomes, it takes one step closer to becoming a legitimate and accepted financial instrument.
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Bitcoin rallied towards $48,000 last week but was rejected at its 200-day moving average. Bitcoin fell as low as $44,500 on Thursday, and it’s possible the move is related to the European Parliament’s recent vote aimed at tightening cryptocurrency regulation.
The latest EU-approved proposal would make crypto service providers, such as exchanges, responsible for collecting and storing the personal data of people using “non-custodial wallets.”
Non-custodial wallets are those that do not require third-party providers. Metamask and Phantom are two of the most popular. Under the proposed legislation, an exchange like Coinbase, Inc (COIN) would need to store and request data from both the recipient and the sender on every transaction. The information behind each transaction would also need to be shared with government agencies.
That means exchanges like Coinbase would have to collect information from people who aren’t even their customers. This is difficult to carry out in practice and legally questionable. Exchanges like Coinbase would need to limit transfers to third-party wallets linked to an existing customer. This is an expensive process and smaller exchanges may need to eliminate these transactions.
The result of this is that huge amounts of very valuable information would be accumulated in both private companies and government agencies and likely to be targeted by hackers. These hackers could get personal information like your name and address and would also know how much crypto you have and where.
Paradoxically, this regulation could result in a much less secure crypto market. The EU has stated “that the EU regulatory framework for financial services is innovation-friendly and does not pose barriers to the application of new technologies.” Hopefully the EU will reconsider this dangerous piece of legislation.
Death to DeFi
Over in the US, crypto has been dealt another blow, this time in the area of decentralized finance. The SEC just proposed a rule change that would expand the definition of what counts as a “dealer” to include anyone who provides liquidity to the market or those who employ passive market-making strategies.
On the surface, this might seem harmless enough, but depending on your interpretation, it could turn the entire DeFi system upside down. The DeFi space relies on AMMs and liquidity providers to enable decentralized exchanges, and this new rule could place anyone providing liquidity in the “unregulated trader” category.
This means that the SEC could force these liquidity providers to register with the SEC. Ultimately, this would result in reducing the number of actual liquidity providers, making the market less liquid and more volatile.
The appeal of DeFi is that anyone can step in to facilitate a trade or provide liquidity. Regulating and effectively centralizing this process would be incredibly damaging and create a much more fragile market, with a few large institutions too big to fail. Sound familiar?
Again, the SEC intends to try to protect users and promote a fair market, but the result could be just the opposite.
Not all stablecoins are the same
Finally, last week, the Stablecoin Transparency Act was introduced by two lawmakers to ensure all stablecoins are backed by US dollars or short-dated government bonds.
This is in response to all the excitement made last year when it was revealed that Tether (USDT-USD) was not fully backed by dollars. It still isn’t, but at least we know what their holdings are.
The USDC (USDC-USD), which has also come under criticism, actually “accorded to” this idea in August and is only backed by dollars and US Treasuries.
And finally, we have algorithmic stablecoins like those used in the Terra Protocol, for example the USTerra (UST-USD) pegged to the dollar. These coins rely on an automatic supply adjustment of their stablecoins and their native token Terra to maintain a stable peg. They have no reserves, although Terra has now started acquiring bitcoin.
The point I’m trying to make here is that not all stablecoins are created equal. Above I presented three different models of stablecoins, one of which already adheres to the proposed legislation.
So what’s the point of this?
This legislation threatens to limit the types of stablecoins available and also limits the ability of stablecoins to provide liquidity and generate profits. Even under a gold standard, most central banks didn’t have a 100% gold reserve ratio, and there’s no reason stablecoins should do that today.
How does all this affect Bitcoin?
All in all, the regulations proposed above could cripple bitcoin and cryptocurrency trading. Information is good, but too much information is bad, and the EU’s proposed data protection laws will limit the usefulness of crypto transactions.
This is especially relevant for Bitcoin now that the lightning network is taking off. This technology makes it possible to process off-chain transactions at higher speeds and at lower costs. The idea that we could all transact daily using bitcoin wallets is not far-fetched, but if every transaction had to be recorded and stored it would be an incredible cost for businesses and a liability for everyone. Even normal banks are not obliged to report every single transaction to the authorities.
The move to regulate DeFi will also be detrimental to crypto and bitcoin. Although most DeFi is conducted on the Ethereum blockchain, Wrapped Bitcoin (WBTC-USD) is used as the standard of value for many smart contracts. WBTC, an ERC-20 token pegged to Bitcoin, is among the top 20 largest tokens by market cap. If AMMs and liquidity pools are regulated, liquidity could dry up and demand for Bitcoin would be impacted.
Finally, it will be very interesting to see what happens to stablecoins, especially as more and more countries prepare to launch their national stablecoins, CBDCs. Stablecoins are the ups and downs for Bitcoin. If USDT were somehow “illegalized” tomorrow, rest assured that the price of Bitcoin would be negatively impacted. It would also be a shame to see algorithmic stablecoins disappear, especially now that the hybrid algorithmic/bitcoin-based system is being rolled out.
Bitcoin is the standard of value for the crypto market and how this legislation affects Bitcoin will determine how the entire crypto market reacts. Ultimately, however, we should acknowledge that the current political sentiment is that Bitcoin should be helped, not hindered, and as long as this sentiment prevails, we will see Bitcoin realize its full potential.
Despite this, I am changing my rating to Hold, despite the fact that I own bitcoin. The current challenges pose a very real threat to Bitcoin and demonstrate a degree of fragility in the system as it would only take a little misguided regulation to turn the system upside down. Investors should be aware of this risk.
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