2023: Will it breathe new life into the Crypto World?
The objective is to regain trust and credibility
Decentralized finance offers concrete solutions for creating a financial environment that is open to all, but against the advantages, there are also certain risks, financial and otherwise. The cases of FTX and Tornado Cash are emblematic. The future will very much depend on the regulatory approach that legislators in the various countries in which crypto is involved will adopt
The year 2022 will certainly go down in history as the annus horribilis of cryptocurrencies; having opened under the best auspices, considering that in November 2021 the market had exceeded $3 trillion in capitalisation, and the queen of cryptocurrencies, Bitcoin, was worth over $60. 000 dollars, the market, starting in May, with Luna’s bankruptcy that dragged dozens of companies in the sector along with it, creating a real earthquake in the market, went into a perverse spiral that culminated in the bankruptcy of FTX and the arrest of its CEO Sam Bankman-Fried.
It is difficult to make predictions for 2023, although it is clear that the sector seems to have plunged into a deep crisis of confidence and credibility that for many people may even threaten the foundations of the DeFi market.
The comparisons between crypto-sceptics and DeFi champions
Looking for instance at the United States, which, at the moment of writing this article is still the most financially developed country in the world, and thus the leading country in many economic and legislative manners we are likely to see a sort of Redde Rationem in the coming years, a sort of heavy debate between two opposing camps destined to confront each other both in US courtrooms and before the US Congress.
On one side we find an army of crypto-sceptics, including prominent politicians and regulators, who are motivated by the desire to rein in an industry that many consider being characterised by constant fraud and therefore extremely dangerous for consumers, and to which the catastrophic demise of FTX has provided valid arguments in support of their thesis.
On the opposite side are the champions of ‘decentralised finance’, who firmly believe that cryptocurrency networks such as Bitcoin and Ethereum, since they are accessible to anyone with an internet connection and are controlled by public networks rather than by companies, governments or banks, are destined to play a vital role in the future of privacy and financial freedom.
In the eyes of these advocates, any attempt at regulation is tantamount to endangering these fundamental freedoms.
For the crypto-sceptics, the opaque growth is in many cases accompanied by a substantial lack of rules and controls thus leading to the emergence of very fragile financial giants, such as FTX, with the consequence that a new regulatory framework should be implemented in 2023, which could correct the distortions created by previous happenings in the field.
The FTX case and the risks of a self-referential ecosystem
On the contrary, supporters of cryptocurrencies see the FTX collapse as further proof of how centralised control is extremely risky, reiterating the need to create a blockchain-based financial system that is more accessible and private than the traditional one.
While many people are only looking at the failure of the crypto giant, very few of them are focusing on the facts of the matter: FTX was revealed to be a centralized institution joined with another centralized institution, led by a couple of bumbling buffoons with all the say in each possible direction that the company was taking.
There was no infrastructure, no control, no expertise and no regulation in the FTX architecture, and we argue that any kind of financial institution based on those premises is at its best destined to fail and at its worse destined to fail while dragging down an uncountable number of people with it.
We, unfortunately, now know that FTX gave its worse to really be sure that its failure would be felt throughout the entirety of the crypto ecosystem, but, once again, we want to point out that with each passing week, the new administration of the company seems to be creating miracles out of thin air while trying to juggle a myriad of problems.
And while ultimately all we can hope is that this story ends without too many people burned by the fall of this giant company, imagine what FTX could have been with a direction, a purpose and competent people spread throughout the entirety of its framework.
The premise of Utility-based crypto, and the lack of inherent value in the FTX case.
On closer inspection, the issue of centralised control is relevant in the FTX case, but what ultimately led to the downward spiral that resulted in the exchange’s collapse was FTX’s creation of its own cryptocurrency.
What triggered this momentous fall was in fact CoinDesk’s report in early November that FTX’s affiliated trading company, Alameda Research, held a significant portion of its assets in the cryptocurrency created by FTX, called FTT; a currency invented by an affiliated company, not an independent asset like a fiat currency or another cryptocurrency.
The revelation triggered a series of events that eventually brought down the value of FTT.
In other words, what many fear is that the entire industry seems to have built a sort of ‘self-referential ecosystem’ based on the creation of ambiguous tokens that have sprung up out of nowhere and are worthless. The ambiguity of these tokens is one of the main reasons why regulators are now focusing on decentralised finance, which while may be true for a small percentage of crypto projects, paints a very skewed and unrealistic picture of the DeFi world, a picture that couldn’t be further from the truth.
Pros and cons of decentralised exchanges
We all know that In the world of decentralised finance, a crucial role is played by decentralised exchanges which allow anyone with an Internet connection to buy and sell a wide range of cryptocurrencies, regardless of the classification that regulators might make of these currencies.
Supporters of DeFi have pointed to FTX as the ultimate proof that what we need is an alternative, ‘open’ and decentralised financial system. According to the vast majority of the crypto champions DeFi applications verify transactions using inaccessible and unbreakable cryptographic techniques and everything is recorded on the blockchain.
There is no need for intermediaries, and therefore corruption phenomena are impossible.
Paradoxically, however, it is precisely the lack of intermediaries typical of decentralised finance systems that are creating major problems for the regulatory authorities; in the absence of intermediaries, how can regulators supervise the exchange of securities on decentralised platforms? How can it be ensured that no illicit funds are used in the course of these exchanges?
There are also multiple sub-factions in this category, in which people are pointing out how the faults of FTX are the same as many other huge institutions operating in the mainstream market, and that regulators are using this particular case as an excuse to actually chain the more decentralized sectors of defi.
Regulation of ‘DeFi front-ends’: necessity or coup de grace for the sector?
It is in this paradox that the very hot topic in the United States of the need for the regimentation of the ‘DeFi front-ends’’, i.e. the Web-based user interfaces through which most people access DeFi protocols, is triggered.
In particular, the question has been raised as to whether it is really necessary, as argued by some, for the provision of DeFi front-ends to be restricted to licensed or authorised operators.
Proponents of DeFi argue that regulation of front-ends could be fatal for DeFi because it would have the effect of adding just one more type of barrier to entry that blockchain was supposed to eliminate.
Whatever one may think of it, it is likely that if regulators gain control of this important DeFi entry point they will be able to exert a profound influence on how the underlying technology evolves in the future.
The Tornado Cash affair and its effect on DeFi’s future
The development of the Tornado Cash case also seems to mark a crucial step in deciphering the possible future scenarios of decentralised finance. It is worth briefly recalling the facts here. Tornado Cash provides a so-called mixer service that allows owners of cryptocurrencies to protect their anonymity by mixing the consequential traces of information about individual transactions recorded thanks to blockchain technology.
On August 8 2022 the US Treasury Department banned Americans from using the service, claiming that Tornado Cash played a central role in the laundering of more than $7 billion dollars divided between multiple different cryptocurrencies.
The Tornado Cash affair is closely linked to the operation that characterises all applications based on blockchain technology. When a user sends a cryptocurrency from one account to another, a record of the individual transaction is engraved in the blockchain forever. Clearly, investigators can then use this public information to monitor the flow of money and learn about the financial activity of a person or company.
This transparency has given rise to the creation of so-called ‘blending’ services, the purpose of which is to conceal financial activities carried out using blockchain technology. In effect, a user can deposit cryptocurrency into a mixer, which uses complex technology to obfuscate the trace and origin of the money and then send it to a brand new wallet address.
From there, the user can retrieve the funds and eventually cash them in total anonymity. We don’t want to give our opinion on the matter, simply because this particular case goes beyond what our technical and foundational analysis can reach.
Our experts have extensively researched Tornado Cash, and we have also tried to check out other similar tools to understand how actually this substratum of DeFi works, and one of the many conclusions that we have reached is that nothing about the tools showcased makes money laundering as easy as the US congress seems to believe.
All while not even starting to consider that the major money laundering tools of the century are firmly in the hands of mainstream institutions, creating a further divide in what the facts are and what they are trying to paint them as.
That said, we don’t condone any criminal practice, be it outside or inside the DeFi ecosystem, and we feel that by giving a more thought overview of the case we would end up in a situation in which our stance may be taken as the problem as always existed, this additional tool does nothing to add to it, which isn’t in line with what we believe, and isn’t in line with what Synapse represents.
Our dream is to create a fair, free ecosystem in which everyone can safely create their own path to wealth, and, while we know that the DeFi world is far from developing into this vision, we won’t ever condone any kind of unlawful activity be it in our own Network or in the wider crypto ecosphere.
The controversy after the intervention of the US authorities
To get back to the Tornado Cash ruling, the Treasury’s Office of Foreign Assets Control in particular sanctioned 45 Ethereum addresses associated with the platform, effectively banning Americans from using it and decimating Tornado Cash’s user base.
The agency said it took the action because Tornado Cash had been used to ‘launder’ billions of dollars, including hundreds of millions embezzled by North Korean state-sponsored hackers.
This was the first case ever in which OFAC actually sanctioned a smart contract and this sparked a series of controversies. According to many, in fact, apart from the fact that the Treasury agency does not seem to have the power nor the authority to impose such sanctions, it is the nature of smart contracts themselves that does not allow these
Many of the contracts sanctioned by OFAC in fact cannot be modified, blocked or deactivated by any of the developers of Tornado Cash as they exist independently of any form of human intervention.
It has been pointed out that although OFAC has the legal power to sanction persons and certain foreign entities, it cannot prohibit Americans from using an instrument such as Tornado Cash.
On the basis of these arguments, Coin Center filed a lawsuit against the Treasury Department to lift the sanctions, claiming a violation of obvious and fundamental rights such as the right to privacy.
In its complaint, Coin Center argues that the OFAC does not have the authority to ban software tools and claims that fundamental rights guaranteed by the Constitution have been violated by their rulings.
A similar lawsuit against the Treasury was also brought by Coinbase, one of the first supergiants in the cryptocurrency exchange world.
The implications of possible regulatory interventions
The entire universe of cryptocurrency operators is closely monitoring the evolution of the Tornado Cash saga because whatever the outcome, it is certain to shape the future of decentralised finance.
According to many, it is clear that a developer cannot be treated the same way as a financial intermediary just for developing a code and making it available to the public on the Internet.
In other words, what is the precise moment when a financial application ceases to be a financial application and turns into the offering of a financial service? As one can easily guess, this is essentially the same question at the heart of the conflict over whether front-end services typical of decentralised finance should be regulated.
Wanting to go to extremes, one could argue that in both cases the freedom to use a service based on blockchain technology without having to ask permission from the government is at stake.
In conclusion, as 2023 has just begun, it is undeniable that decentralised finance still remains a niche market with ample room for growth. Presented by most as an alternative to traditional finance, it still has limited volumes and capitalisation.
However, it is undeniable that DeFi offers concrete solutions to create a financial environment that is open to all, transparent and unchangeable, and that does not require any relationship of trust with third parties, intermediaries and authorities.
Among the major advantages already evident today is the fact that the use of blockchain technology and smart contracts has made it possible to reproduce the main products and services of traditional finance in a decentralised manner, and the interoperability of protocols, which has enabled the development of innovative tools that can be customised according to users’ needs.
These innovations have had a major impact on the world of finance, especially in the context of a historical period that since the 2008 crisis has seen a growing distrust of banks and financial intermediaries.
The need of investors and savers to benefit from higher returns, instant loans and faster transactions has found a concrete answer in an accessible and transparent environment such as DeFi.
Against the advantages and significant potential expressed by the DeFi ecosystem so far, certain financial and non-financial risks also exist and cannot be underestimated.
One point that we want to make very clear is that the main financial risks are the same as in traditional finance, simply magnified due to the high volatility typical of the crypto world and the danger of possible liquidity crises, the negative effects of which may be more pronounced in DeFi than in traditional finance.
But, and it’s a big but, this can be said about futures, shorting, leverage trading and any kind of tool developed by the mainstream market that magnifies your investments to get higher ROI, leaving us with the age-old problem of actually defining where individual choice is the issue and where instead is the faulty architecture of a specific tool that causes troubles.
At the operational level, interoperability understood as the possibility for users to interact with different protocols to access a service or a customised financial product, could result in the creation of complex products built on a chain of tokens relating to different platforms, creating interdependencies that could give rise to systemic risk for the platforms involved in the event of failure.
But then you have hundreds of mainstream institutions being hacked by what amount to random groups of people with high mastery over cybersecurity-based tech, billions dollars company like Riot Games and governments breached in an even easier manner, and thus we go back to the realization that while this risk may be present, it’s the same risk that is actually being displayed by the failure of other mainstream institutions.
Certainly, the future of decentralised finance will depend a great deal on the regulatory approach that the legislators of the various countries will adopt and at the moment we can only hope that those regulators will base their decisions on solid facts and not on the limit cases that have singularly surfaced in the past year.
And on this regulatory issue, as shown above, the debate is still very much open: while it is indisputable that regulation is necessary, it is equally true that very restrictive regulation could prove excessively penalizing and limiting for the DeFi ecosystem.
However, finding the most suitable legal instruments to identify a more flexible regulation that is nevertheless able to protect users and bring greater serenity to the DeFi landscape, contributing positively to its expansion, is a necessity that we are aware of, and we also take pride in having recognized this necessity year before it presented itself.
About Synapse Network
Synapse Network is developing a cross-chain investment and start-up acceleration ecosystem based on blockchain technology to give everybody an equal chance to contribute to great upcoming projects and to do so early on. We are bridging the gap between the traditional & crypto market. The idea of the Synapse Network technology goes beyond the standard offer of launchpads available on the market, becoming a true technological brand providing tech solutions.
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