The outsized impact of blockchain on finance

October 2022  |  SPECIAL REPORT: FINANCIAL SERVICES

Financier Worldwide Magazine

October 2022 Issue

Advances in blockchain distributed ledger technology have led to dramatic growth in the role of digital assets in finance. In recent years, we have seen the financial world abuzz with activity related to the tokenisation of assets, cryptocurrency investments, decentralised finance products and business structures, the trading and custody of digital assets, and even interest by the government to explore central bank digital currencies (CBDCs) or e-dollars. Despite recent cryptocurrency downtowns (often referred to as the ‘crypto winter’), there is still an increasing level of investment and development in finance-related digital asset initiatives. Of course, with these developments, come legal and practical issues related to consumer protection, regulatory oversight, cyber security, fraud and anti-money laundering (AML), financial stability and environmental, social and governance (ESG) concerns, among others.

Until the last few years, with a few notable exceptions, such as the New York state ‘BitLicense’, the digital asset industry in the US has been largely unregulated. While president Biden’s relatively recent executive order on digital assets features a very broad definition of ‘digital assets’, the characterisation of those assets as, among other things, a security, a commodity, a derivative or another financial product, is still unclear. That may be changing as Congress and federal and state agencies have undertaken serious efforts to enact regulation in the area.

Notwithstanding the regulatory uncertainty and the economic headwinds, however, the digital assets phenomenon continues to have an outsized impact on finance.

Decentralised finance

Decentralised finance (DeFi) generally refers to a variety of financial products, services and arrangements supported by smart contract-enabled blockchain technology. The intent of DeFi is to reduce inefficiencies in payments, clearance and settlement systems. Smart contracts – software applications which run on a blockchain platform – automatically execute, verify and enforce the performance of an agreed-upon transaction. The fully automated nature of execution provides for self-enforcing ‘automated trustworthiness’ with no counterparty risk of non-performance.

DeFi platforms use digital assets, such as stablecoins, instead of fiat currency, to provide banking and financial services. Decentralised applications – commonly referred to as ‘dapps’ – are available on DeFi platforms and offer products and services typically available from traditional financial markets, including lending and borrowing, asset management, fundraising, decentralised exchanges, savings and yield products, automated market makers, prediction markets and insurance. Despite the name, however, the degree of decentralisation across DeFi products can differ widely, as some have claimed a ‘decentralisation illusion’ in cases where a small group of developers or holders of ‘governance tokens’ might hold concentrated power.

Despite some asserted distinctions from traditional finance, DeFi arrangements raise comparable investor and consumer protection, market integrity and policy concerns. This is in addition to what the President’s Working Group on Financial Markets called risks resulting from unique aspects of distributed ledger-based arrangements, including governance issues, interoperability, protocol and smart contract vulnerabilities, cyber security, and other operational issues. Moreover, DeFi arrangements can present regulatory risks. Indeed, the US Securities and Exchange Commission (SEC), the Commodity Futures Trading Commission (CFTC) and the Department of Justice (DOJ), to name three agencies, have brought multiple enforcement actions alleging instances of fraud, misappropriation and securities law violations, including those arising from misleading disclosures, misuse of inside information and manipulative trading activities.

Stablecoins

Stablecoins are designed to maintain a stable value by pegging a value to a national currency or one or more other reference assets – thus seeking to become a less volatile payment mechanism than other digital ‘coins’. While ‘collateralised’ stablecoins maintain value by holding fiat reserves that approach a value in a 1:1 relationship with the value of the stablecoin, ‘algorithmic’ stablecoins are generally ‘under-collateralised’ and not backed (or only partly backed) by an off-chain asset reserve. Algorithmic stablecoins principally employ arbitrage mechanisms to control the value of the coin, such as algorithmic minting and burning of coins and the use of a linked cryptocurrency, to maintain their peg to a reference asset, such as the US dollar.

Stablecoins’ prominence stems from their use in facilitating DeFi transactions and digital asset trading. They allow market participants to easily convert volatile digital assets into a digital asset with more perceived stability, and vice versa. Proponents note that a well-designed stablecoin can enable more efficient payment options for customers. However, regulators, like the federal Financial Stability Oversight Council, have cautioned that stablecoins present potential systemic risk due to their lack of consistent risk management standards and operational complexity. Stablecoins can be subject to widespread redemptions and asset liquidations if coin holders become suspicious about the reserve assets backing the par value or other ‘run on the bank’ scenarios. For example, a failure or disruption to the digital asset trading platform, or excessive leverage made possible by the use of stablecoins as collateral on unregulated trading platforms could threaten the stablecoin (and, conversely, a failure or disruption of the stablecoin could threaten the digital asset trading platform). In some cases, algorithmic stablecoins have temporarily lost their peg or, worse, collapsed, though these events have not caused broader market distress.

Notably, the New York Department of Financial Services (NYDFS), was the first state regulator to release a guidance meant to set foundational criteria for US dollar-backed stablecoins issued by any DFS-regulated entities on the issues of redeemability, assets reserves and attestations about such reserves. Congress is also pushing to enact stablecoin regulation this year, but passage is uncertain.

Central bank digital currency

A central bank digital currency (CBDC) has been defined by the US Board of Governors of the Federal Reserve as a “digital liability of a central bank that is widely available to the general public” and further, a “digital form of paper money”. In this respect, a CBDC such as a US digital dollar would be like a stablecoin because a CBDC also seeks to maintain a stable value and become an alternate payment mechanism for low-cost trading and lending and cross-border payments, as well as a tool to foster financial inclusion. However, unlike a privately issued stablecoin backed by reference assets, a US digital dollar would be backed by the full faith and credit of the US in the same way as a physical dollar. As described in a recent Federal Reserve report, the development of a US CBDC “could spur innovation by banks and other actors and would be a safer deposit substitute than many other products, including stablecoins and other types of nonbank money”. Still, the report suggests that CBDCs may bring their own risks to the safety and stability of the monetary system, particularly during times of financial stress, and otherwise affect the Fed’s ability to implement monetary policy. The Federal Reserve is currently studying the issue while both the Biden administration and Congress see merit in US leadership on this issue.

401(k) plan accounts

During the past year, some firms considered, or began in some capacity, to market investments in cryptocurrencies to 401(k) plans as potential investment options for plan participants. In response, the US Department of Labor (DOL) Employee Benefits Security Administration released ‘Compliance Assistance Release No. 2022-01’, advising that plan fiduciaries should “exercise extreme care” before they consider adding a cryptocurrency (or “other products whose value is tied to cryptocurrencies”) as an option to a 401(k) plan’s investment menu for plan participants. Beyond citing the fact that digital assets, in some cases, can be speculative and volatile, the DOL raised multiple concerns associated with offering these types of investment options, including: (i) the obstacles and lack of traditional data that can inform cryptocurrency investment options and the lack of an industry standard digital asset valuation model; (ii) the non-traditional custodial and record-keeping challenges faced by fiduciaries; and (iii) the uncertain regulatory landscape governing crypto markets.

ESG issues

The increase in investments in blockchain-based products and services by varying shareholders and appearance of cryptocurrencies on corporate balance sheets has resulted in renewed due diligence on compliance with ESG mandates, as certain blockchain networks or cryptomining practices can be energy intensive. These considerations became more salient after the SEC proposed a rule in March 2022 that would require registrants to include certain climate-related disclosures in their registration statements and periodic reports, including information about climate-related risks that are reasonably likely to have a material impact on their business, results of operations, or financial condition, and certain climate-related financial statement metrics in a note to their audited financial statements. The proposed rulemaking would enhance and standardise climate-related disclosures for investors, where such transparency might indirectly incentivise cryptominers, blockchain platforms and DeFi providers to transition to greener options.

Supply chain finance

Even before the coronavirus (COVID-19) pandemic snarled worldwide commerce, companies were already exploring the promise of blockchain to modernise their supply chains. Traditional supply chains can be inefficient, data intensive and costly, and are often characterised by burdensome paperwork, conflicting records and delays resulting from manual reconciliation processes. Blockchain offers substantial benefits in this context, including the secure and auditable validation of transactions, streamlined trade finance, automated documentation to support legal and customs compliance, and enhanced end-to-end transparency such as for financing or verifying sustainability ethical sourcing standards, for example. As society moves toward Industry 4.0 –  which is increasingly characterised by the greater implementation of automation, the internet of things (IOT), big data, smart solutions and data exchange – blockchain seems to have earned a spot in the next digital revolution. With a track record of successful blockchain use cases to modernise the supply chain and, in particular, supply chain finance, the practice seems likely to increase, as businesses see first-hand the potential benefits of cost reduction, improved security of transactions and the increased ability to use data analytics to optimise distribution and logistics networks.

While the news is replete with the ups and downs of cryptocurrency trading, there is still much interest in deploying blockchain to replace or streamline existing financial transactions or clearance, or create new opportunities alongside traditional finance. Though, as noted in the ‘Gartner Hype Cycle for Blockchain and Web3, 2022’, some developing financial applications are still in their nascent stage and have yet to see widespread adoption or success, many are about to change the way traditional finance industry functions have been handled for many years.

 

Jeffrey D. Neuburger is a partner and Jonathan Mollod is an attorney and content editor at Proskauer Rose LLP. Mr Neuburger can be contacted on +1 (212) 969 3075 or by email: jneuburger@proskauer.com. Mr Mollod can be contacted on +1 (212) 969 3393 or by email: jmollod@proskauer.com.

© Financier Worldwide

BY

Jeffrey D. Neuburger and Jonathan Mollod

Proskauer Rose LLP

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