INTRODUCTION:
There are people in the DeFi sector pushing for tighter regulation as the collapse of FTX shocks the crypto industry. Deputy Governor of the Bank of England Sir John Cunliffe is one of them. However, as Ledger Insights writes in this article, Sir John continues to believe that the continued development of tokenization and smart contracts will reduce risk in the financial system and lead to more secure transactions in our digital lives.
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Sir Jon Cunliffe, Deputy Governor of the Bank of England, highlighted why the collapse of FTX supports the need for legislation of cryptocurrency firms. While some consumers might move from centralized cryptocurrency exchanges to use DeFi instead, Cunliffe also expressed misgivings about DeFi. However, he is supportive of the innovative potential of smart contracts and the tokenization of real world assets.
Anyone familiar with the FTX bankruptcy filings will be aware of the lack of a board of directors, accounting department and any financial controls.
Talking about the role of regulation, “The first are fundamental issues around how financial institutions should be organised, by which I mean their corporate structure, governance, internal controls and record keeping,” said Cunliffe. “Regulation in the conventional financial sector imposes stringent/substantive requirements. Supervision aims to ensure that these are implemented.”
Financial institutions need to be regulated because they represent risks to consumers, other financial firms and the broader financial system.
FTX former CEO Sam Bankman Fried controlled entities that took on different roles, such as market making for Alameda and exchange and custody for FTX. “FTX, along with a number of other centralised crypto trading platforms, appear to operate as conglomerates, bundling products and functions within one firm,” said Cunliffe. “In conventional finance, these functions are either separated into different entities or managed with tight controls and ring-fences.”
Cunliffe’s third observation was around collateral. The trigger for the FTX run was the collapse in the price of its FTT token. The Deputy Governor noted that for collateral to play its role in managing credit risk, it needs to have low volatility and high credit quality. Compounding the issue was FTX’s willingness to accept its own ‘unbacked crypto asset’ as collateral resulting in extreme ‘wrong way risk’.
Not convinced by DeFi
He acknowledged that some see the alternative to regulation as embracing Decentralized finance (DeFi) with code managing risk and removing the dependence on centralized entities.
Cunliffe noted that driverless cards are only as good as the code used to drive them. It depends on the code quality. He questioned whether most DeFi protocols are decentralized with doubts about their governance.
Additionally, in a volatile market, he believes there’s a need for liquidity providers “to avoid the amplification of fire sale dynamics.”
This led to his belief that regulating crypto firms is necessary. The most obvious reason, as highlighted by FTX, is to protect consumers and investors. Particularly so those who want to engage in crypto are not left with the only option of using unregulated entities.
The Deputy Governor chairs the international Financial Stability Board, so it’s not surprising that his second motivation is to ensure financial stability. While there is limited interconnectedness between the crypto sector and mainstream finance, he doesn’t want to wait until there is greater connectivity before imposing regulation.
The third driver is to support innovation because Cunliffe sees the benefits of smart contracts and the tokenization of real world assets. He used the analogy that people don’t fly in unsafe planes.
“Tokenisation, encryption, distribution, atomic settlement and smart contracts, not only seem unlikely to go away as our everyday lives become more ‘digital’, but may well have the potential to improve efficiency, functionality and reduce risk in the financial system,” said Cunliffe.
He also touched on UK stablecoin legislation currently before parliament and plans to consult on the details of the regulatory framework. Additionally, Cunliffe mentioned that the central bank and HM Treasury will shortly share their next steps on their work on a digital pound or retail central bank digital currency (CBDC).
