As most of the digital asset market has kicked off the year printing red daily candles, more uncertainty in the regulatory space could prove to be a further drag on prices in the short term. During the final months of 2021, US policymakers have largely signalled that greater oversight of the digital asset economy is in the works, predominantly looking at the DeFi sector and the stablecoins landscape.
It is likely that 2022 will see the emergence of a fully regulated DeFi ecosystem (ReDeFi) as a parallel sector to the decentralized pseudonymous DeFi world that expanded so rapidly since the boom in 2020. ReDeFi will offer many of the same innovative products that its more rebellious cousin offers, but supported by a regulatory framework that meets the requirements for greater participation from the traditional financial services industry. For example, ReDeFi will only be accessible through strict KYC and AML processes to satisfy the compliance standards.
Some of the leading DeFi applications have already launched, or announced the development of, ReDeFi versions of their platforms such as Compound Treasury and Aave Arc for regulatory compliant versions of Compound and Aave respectively. This development is likely to continue this year as more Tier 1 DeFi applications roll out ReDeFi versions, coupled with a greater range of centralized exchanges that already have compliance protocols in place offering their users access to DeFi applications, functioning as a regulated gateway.
It could be said that ReDeFi with strict KYC requirements goes against the original intent of DeFi, but this approach does not take away one of the key value propositions: this decentralized financial ecosystem operates on users-owned operations, assets, and data. Regulatory conditions do not change the economic model that underpins DeFi, and if anything, ReDeFi could have a dramatic positive impact on liquidity as it opens up the path to a new customer base such as regulated financial institutions who could not participate otherwise.
The demand and utility for stablecoins has been demonstrated and proven beyond any doubt the last few years. The market cap for the top 3 stablecoins combined totals over $185 billion, and without it much of the innovation that took place in DeFi could not have happened. However, stablecoins have largely operated in an unregulated environment and that will likely change this year as policymakers have begun to address the lack of a comprehensive regulatory framework to cover the sector. US officials across the board have been taking a closer look at stablecoins in 2021, and the trend will likely continue.
Against the backdrop of CBDC ambitions, regulatory agencies will need to focus more on stablecoins because they want to understand how well their regulatory regime would work. During a testimony before the House of Financial Services Committee in September 2021, Federal Reserve Chairman Jerome Powell commented that “Stablecoins are like money market funds, they’re like bank deposits, but they’re, to some extent, outside the regulatory perimeter and it’s appropriate that they be regulated. Same activity, same regulation.” Addressing the FUD, Powell made it clear he has no intention on banning stablecoins but still, markets generally don’t like uncertainty so we need to keep a close eye on the developments in this space as they unfold.
Stablecoins present a new challenge to regulators because they do not fit neatly within the existing regulatory structure and process as traditional financial products. To make things more complicated, we now also have a pretty strong selection of algorithmic stablecoins - a specific type of stablecoin that uses smart contracts to maintain the peg. Many projects have tried launching algorithmic stablecoins in the past only to stumble and fail somewhere along the way, but Terra’s UST, powered by the native LUNA token, has seen rapid adoption since its launch in September 2020. UST is currently the 4th largest stablecoin with a 10 billion market cap, and it has been instrumental to the success of Anchor Protocol, one of the leading decentralized applications on the Terra blockchain.
In terms of segments within the various tokens trading the markets today, the Layer 1 segment will remain front and center. Instead of a gold-like store of value play that BTC represents, investing in Layer 1 tokens such as ETH, LUNA, BNB, FTM, AVAX, SOL is a technology bet on the wider digital asset ecosystem and its innovative applications.
The most established player is still ETH, which outperformed BTC in 2021, representing just under 60% of all Total Value Locked across all chains. Ethereum was central to the DeFi boom in 2020, the rapid rise of NFTs that followed in 2021, and it will remain a critical component as the metaversal future unfolds in 2022. However, the high transaction costs remain an obstacle for the average user - especially newcomers - and it could spell a rotation within the Layer 1 segment.
High transaction costs have been a huge driver for investors to seek alternatives to Ethereum, resulting in sizable gains in 2021 for some Layer 1 protocols such as SOL and LUNA. This year, we expect that momentum to continue as more Layer 1 tokens outperform as added utility and usage will help to drive prices higher. But that’s not to say the game is up for ETH. The protocol has some meaningful upgrades planned for the year, and Layer 2 solutions such as Polygon can help drive down the cost of transactions which could siphon off some of the capital currently locked on other chains.
But even if transaction costs remain high, and say minting an NFT sets you back $60 to $200 without the guarantee of a successful transaction, Ethereum will more than likely remain the top performer in the Layer 1 category. Many institutional investors are increasing their exposure to digital assets, and after BTC the next stop is overwhelmingly ETH for most. The protocol has established itself firmly as a reliable platform, and when you’re moving sizable funds, $60 transaction fees don’t affect the bottom line so much. However, after the initiation into Ethereum-based DeFi, perhaps some of these investors venture to new horizons and explore the Layer 1 alternatives.
Since the sell-off in November 2021, the global market value of digital assets halved from $3 trillion to $1.5 trillion. It’s nothing new for a market with infamous volatility, but what might be different this time around is a perceived closer relationship between digital assets and traditional markets. The downturn seems to have more to do with traditional economic factors including high inflation, planned interest rate hikes (at some point), and a sell-off in the traditional stock market.
While it’s commonly said that digital assets do not move with traditional financial market fluctuations, and Bitcoin in particular acts as a hedge against inflation, more recent trends seem to show the two worlds are more related than we think. The uncertainty around the current inflationary period, and talk of interest rate hikes at some point in 2022, has already been reflected in traditional markets as the S&P 500 and the Nasdaq fell 10% and 16% respectively from their 52-week highs in December 2021. The sell-off in digital assets during that same time is now part of that very same broader risk-off dynamic.
In part, this is the other side of the coin when it comes to greater institutional adoption. Yes, it fuelled the meteoric rise of digital assets, but it also connects them to traditional markets in a way. When institutional investors sell as part of a risk-off play, they do so across asset classes and they won’t hesitate to cut losses - as opposed to diamond-handed retailers. In 2022, we will see whether the two markets become further intertwined and generally continue to follow the same direction as macro-economic factors influence decision making, or if digital assets set out on another breakout fuelled by innovation and an infinitely greater user base as GameFi draws in a whole new wave of first-timers.