Bitcoin (BTC): Regulatory Paradox, Changing My Rating To Hold

Thesis Summary

Bitcoin (BTC-USD) is once again in the cross-hairs of regulators. Europe is proposing a landmark set of regulations, some of which have caused concern in crypto enthusiasts. The USA also continues to legislate crypto, and a seemingly trivial change could mean the end of DeFi. Lastly, stablecoins are also being targeted, with regulators trying to force them to be backed by currency and government debt. Bad news for the increasingly popular algorithmic stablecoins.

Paradoxically, the efforts to regulate Bitcoin and crypto could end up having the opposite of the desired effect. Regulations could make crypto trading less safe.

All in all, Bitcoin has its fair share of obstacles to surpass, but with each hurdle it jumps, it gets one step closer to becoming a legitimate and accepted financial instrument.

State Your Name and Occupation

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 is possible this move was linked to the recent vote held by the European Parliament, which aims to tighten regulation on cryptocurrency.

The latest proposal approved by the EU would make crypto service providers, like exchanges, responsible for gathering and storing the personal information of people using “non-custodial wallets”.

Non-custodial wallets are those that don’t require third parties. Metamask and Phantom, are two of the most popular ones. Under the proposed legislation, an exchange like Coinbase, Inc (COIN) would have to store and require data from both the receiver and sender in each transaction. The information behind each transaction would also have to be shared with governing authorities.

This means that exchanges like Coinbase would have to ask for information from people who aren’t even their customers. This is hard to do in practice, not to mention legally questionable. Exchanges like Coinbase would have to limit transfers to third-party wallets that are linked to an existing customer. This is an expensive process, and smaller exchanges might have to eliminate these transactions.

The result of this is that vast amounts of very valuable information would be accumulated both in private companies and government agencies, and would likely be targeted by hackers. These hackers could obtain personal information like your name and address, and would also know how much crypto you have and where.

Paradoxically, this regulation could lead to a much less safe crypto market. The EU has stated, “that the EU financial services regulatory framework is innovation-friendly and does not pose obstacles to the application of new technologies.” Hopefully, the EU will reconsider this dangerous piece of legislation.

Death to DeFi

Over in the US, another blow has been dealt to crypto, this time in the Decentralized Finance space. The SEC has just proposed a rule change that would expand the definition of what is considered a “dealer” and would include anyone who is providing liquidity to the market or those who employ passive market-making strategies.

On the surface, this may seem innocuous enough, but depending on the interpretation, it could upend the entire DeFi system. The DeFi space is reliant upon AMMs and liquidity providers to enable decentralized exchanges, and this new rule could put anyone providing liquidity under the category of “unregulated dealer”.

This means that the SEC could force these liquidity providers to register with the SEC. Ultimately, this would have the effect of reducing the number of actual liquidity providers, therefore 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 harmful and create a much more fragile market, with a few big institutions that are “too big to fail”. Sound familiar?

Again, the SEC intends to try to protect users and promote a fair market, but the result might be the exact opposite.

Not all Stablecoins are created equal

Lastly, last week the Stablecoin Transparency Act was introduced by two legislators to ensure that all stablecoins are backed by US dollars or short-term government securities.

This is a reaction to all the fuss that was 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.

USDC (USDC-USD), which also came under fire, actually did already “comply” with this idea back in August, and it is now only backed by dollars and US Treasuries.

And lastly, we have algorithmic stablecoins, like those used in the Terra protocol, for example, the dollar-pegged USTerra (UST-USD). These coins rely on an automatic supply adjustment of their stablecoins and their native token Terra to maintain a stable peg. They don’t have reserves, although Terra has now begun to acquire Bitcoin.

The point I am trying to make here is that not all stablecoins are created equal. Above I have presented three different models of stablecoins, one of which already adheres to the proposed legislation.

So what is the point of it?

This legislation threatens to limit the types of stablecoins available, and also limits the stablecoins ability to provide liquidity and make a profit. Even under a gold standard, most Central Banks did not have a 100% gold reserve ratio, and there’s no reason stablecoins should today.

How does this all affect Bitcoin?

All in all, the proposed regulations above could cripple Bitcoin and cryptocurrency trading. Information is good, but too much information is bad, and the privacy laws proposed by the EU will limit the utility of crypto transactions.

This is especially relevant to Bitcoin now that the lightning network is taking off. This technology allows transactions to be settled off-chain at greater speeds and at less cost. The idea that we could all transact daily using Bitcoin wallets is not far-fetched, but if every transaction has to be recorded and stored, it would be an incredible cost to companies and a liability to all. Even regular banks are not required to report every single transaction to the authorities.

The move to regulate DeFi will also be detrimental to crypto and Bitcoin. Even though most DeFi is conducted on the Ethereum blockchain, wrapped Bitcoin (WBTC-USD) is used as a standard of value for a lot of smart contracts. WBTC, which is an ERC-20 token pegged to Bitcoin, is amongst the 20 largest tokens by market cap. If AMMs and liquidity pools become regulated, liquidity could dry up, and demand for Bitcoin would be affected.

Lastly, it will be very interesting to see what happens with stablecoins, especially as more and more countries prepare to launch their national stablecoins, CBDCs. Stablecoins are the on and off-ramp for Bitcoin. If USDT was somehow “illegalized” tomorrow, you can be sure that Bitcoin’s price would be negatively affected. It would also be a shame to see algorithmic stablecoins go, especially now that the hybrid algorithmic/bitcoin-backed system is being introduced.

Bitcoin is the standard of value for the crypto market and how this legislation affects Bitcoin will determine how the whole crypto market reacts. Ultimately though, we should appreciate that the current sentiment in politics is that Bitcoin should be helped, not hindered, and as long as this sentiment prevails, we will see Bitcoin reach its full potential.

Having said this, I am changing my rating to hold, though bear in mind I own Bitcoin. The current challenges pose a very real threat to Bitcoin and do show a certain degree of fragility in the system since it would only take a bit of misguided regulation to turn the system on its head. Investors should be aware of this risk.