Last month’s market anarchy, where two-million-plus (at the time), day-trading individual investors unleashed the peer-to-peer power of social media to crush some of Wall Street’s top hedge funds, may indicate a coming use of existing legislative and regulatory methods to not only mitigate the ability of small investors to disrupt markets, but, according to our research, spell increased regulations for the world of decentralized finance (DeFi).

The ‘wallstreetbets’ forums on Reddit and Discord allegedly sparked the madness as mostly young investors pumped share prices in companies hedge funds have shorted (like video game retailer GameStop) over 1,625% last month. Market mania swept online message boards, as GenY and Z traders piled into online brokerages like Robinhood and TD Ameritrade en masse to squeeze institutional short sellers like a vice.

Braving retaliatory social media bans by Discord and legally dubious, ‘meme stock’ trading stoppages imposed by multiple online brokerages, this activity left many short sellers nursing year-to-date losses in excess of $70 billion by the end of January, according to financial data firm Ortex.

The hardest hit fund was Melvin Capital Management. Helmed by ex-SAC Capital portfolio manager Gabe Plotkin, Melvin is known for its aggressively bearish market bets. Plotkin is a protégé of controversial fund manager Steve Cohen. Melvin began the year with $12.5 billion in assets under management.

Despite a combined $2.75-billion bailout last week from hedge funds Point72, Cohen’s new and nominally reformed entity, and Citadel LLC, Melvin continued to nosedive. Late last month, Melvin appeared to capitulate to the WSB rally, saying it had closed its short position in GameStop, according to CNBC reports that were widely trolled by the Reddit boards. Melvin finished January down 53% YTD.

Other quantitative hedge funds like Two Sigma Investment, DE Shaw, and Renaissance Technologies also took a hit last month, as the ‘wolves of Reddit’ supposedly disrupted their carefully placed institutional positions.

Even though Redditors focused most of their pump on three run-of-the-mill equities – GameStop, BlackBerry, and AMC – initially, the mania eventually engulfed dubious cryptocurrencies like Dogecoin and Ripple. Therein lies the rub.

DeFi Zeitgeist

But more than speculative wagers on meme stocks and junk crypto assets, it is the P2P nature of this uprising that belies the zeitgeist of modern finance. Specifically, it is decentralized finance, or DeFi, that has emerged from the crypt as the bestial spirit of plague-era capital markets.

Crypto hedge fund Pantera Capital noted this precise trend in its February investor letter. “GameStop is a colorful indicator of the tremendous desire for the decentralization of finance,” wrote Pantera.

“This is the same underlying impulse in the rise of blockchain – and Decentralized Finance (DeFi) in particular. The power of the individual and open-source software over the centralized for-profit companies.”

Growing regulatory suspicions of market manipulation during the wallstreetbets rally – and concerns over market stability in general – could thus serve as a pretext to crack down on the DeFi boom. Here’s why.

What is DeFi?

Before wading into emerging regulatory regimes for peer-driven, financial market infrastructures, it’s important to explain how DeFi platforms function in crypto ecosystems.

While Bitcoin, unveiled in 2008 by anonymous cypherpunk Satoshi Nakamoto, presented a novel, distributed, and immutable ledger-based system for storing and transferring value, DeFi applies the same, underlying cryptographic architecture to more complex financial market transactions.

DeFi platforms enable a much more comprehensive universe of finance, including peer-to-peer (P2P) asset swaps, loans, securitization, crowdfunding, staking, ‘yield farming,’ and even powering the technology stack underpinning exchange services themselves.

Most DeFi applications and smart contracts are built on the Ethereum blockchain. The Ether token is Ethereum’s built-in cryptocurrency and most altcoins are programmed for this chain, using the ERC-20 token standard.

Crypto hedge fund Pantera Capital described Ether as “the base money collateral” for the DeFi ecosystem in an investor letter it published last month. In its February letter, Pantera co-chief investment officer Joey Krug writes that Ethereum-based revenues have grown over 400x since January 2020.

Like Bitcoin, Ether also hit new, all-time highs this year, with the crypto-asset doubling in value in January alone. This is after the crypto asset appreciated by over 260 percent last year. Ether reached its most recent ATH on Tuesday when it surpassed the $1,800 mark.

Additionally, cryptocurrency miners on the Ethereum blockchain, or people who run nodes that computationally validate transactions for Ether-based tokens to mint new coins, earned a record $830 million in January as “network activity, fees and ether’s price all surged,” according to Coindesk.

In its January investor letter, Krug, wrote that the new parallel system established by Ethereum will eventually progenerate a “more globally-accessible” and cheaper financial-market ecosystem. DeFi topped $35 billion in market value this month, according to Pantera data.

Rapid Experimentation

Emerging DeFi architectures are thus bound to disrupt finance, enabling “rapid experimentation on the level that the internet saw with information consumption,” writes Krug. “With Ethereum, anyone can participate in or even create a new financial market in a few clicks,” he adds.

One popular Ethereum-based DeFi platform is Uniswap. Uniswap is a decentralized exchange, or DEX, that “empowers developers, liquidity providers and traders to participate in a financial marketplace that is open and accessible to all,” according to the Uniswap website. Another growing one is SushiSwap which provides even more advanced features and capabilities.

In general, DEXs “built on the Ethereum platform utilize smart contracts to enable users to undertake cryptocurrency-to-cryptocurrency exchanges in real time,” according to a 2019 “Money Laundering & Terrorist Financing Typologies in Cryptocurrencies” report authored by British blockchain compliance firm Elliptic.

Unlike Robinhood and other allegedly “free” trading apps that “auction the ability to front-run their customers to the highest bidder,” typically hedge funds and high-frequency traders, DEXs’ are “just code,” writes Pantera in its February investor note.

Platforms like Uniswap, 1inch, Injective, Balancer, and DODO “don’t front-run their customers,” Pantera said. They are just autonomous smart contract-based systems.

Uniswap enables more sophisticated crypto-financial services like staking, where users pledge their crypto-tokens as collateral for other crypto projects to help the latter validate new transaction blocks in their network. Staked users receive cryptocurrency rewards in exchange for their willingness to have some proverbial ‘skin in the game.’

Uniswap also allows users to conduct transactions known as yield farming. Yield farming is a form of staking that entails users loaning crypto-assets to blockchain liquidity pools in exchange for crypto-interest payments.

Since its launch in 2018, Uniswap has processed over 29-million trades and more than $83 billion in all-time volume, according to the protocol website. Last month alone, Uniswap exchange volumes surpassed $30 billion, according to research from crypto news publisher, The Block.

Krug anticipates that with Ethereum having finally found its “product market fit,” growth will only continue this year. He also says that Ether-based DEXs like Uniswap have grown 100 percent in the last 12 months. “Ethereum itself now has more daily transaction fees than Bitcoin,” notes Krug.

In January, “the DEX ecosystem reported more than $60 billion in monthly trade volume, led by Uniswap. SushiSwap, and Curve reported $13.48 billion and $5.92 billion in monthly volume, respectively,” according to data from The Block.

Don’t Know Your Customer (dKYC) is the new YOLO

One notable, new entrant into the DEX space is the controversial Denver-based exchange ShapeShift. Last month, the exchange issued a press release titled, “ShapeShift Integrates Decentralized Exchanges, Removes KYC Requirements.”

According to the press release, this integration will enable exchange “users to trade directly with these external protocols, rather than trading with ShapeShift as an intermediary, for an easy and seamless user experience.”

This change, continues the press release, “means that ShapeShift customers will no longer need to provide personally identifiable documentation to meet “Know Your Customer” (KYC) regulatory requirements for trading.”

ShapeShift said this integration will give its “customers greater privacy, security and transparency over their order flow.” The thing is, as Elliptic noted in its money-laundering typologies report, “DEXs can offer criminals the advantage of bypassing compliance controls.”

As such a highly respected, ex-anti-money-laundering (AML) executive at a bulge-bracket Wall Street bank, and who requested anonymity, said: “I thought the ShapeShift press release was a needlessly stupid thing to do. It was basically a ‘f**k you, come and get me’ to the SEC, DOJ, FBI, Secret Service from Erik Voorhees.”

Voorhees is the outspoken chief executive officer of ShapeShift. The anonymous AML source noted Voorhees’s attack on a 2018 Wall Street Journal hit piece that inflated the amount of money ShapeShift laundered for North Korean hackers.

Voorhees’s “response was that ShapeShift only laundered a little bit for the North Koreans,” said the source. “I loved that! It’s like Jeff Bezos writing ‘only $700 million of Amazon’s Business Might be Illicit!’ Great defense.”

DEXs offer one key advantage to criminals, according to Elliptic: “They lack a central administrator with active oversight of user accounts, records, identities, or activities.” ‘KYC, Not Me’ is one website that has indexed all of these exchanges, largely DEXs, that do not require customer identification.

Elliptic said that in many jurisdictions, it still remains unclear whether DEXs fall within the scope of anti-money-laundering (AML) and counter-financing-of-terrorism (CFT) regulations.

“DEXs therefore provide a useful mechanism for the laundering of criminal proceeds – and particularly for undertaking cryptocurrency-to-cryptocurrency swaps – while avoiding exposure to regulators or law enforcement,” according to Elliptic.

Thus, as the Treasury, the Securities & Exchange Commission, and other financial authorities begin to probe the volatility that engulfed meme stocks targeted by the P2P Reddit rally, the DeFi ecosystem could also find itself targeted in an enforcement environment marked by vaguely articulated regulatory mission creep.

Regulatory Scrutiny on Meme Stocks

Last week, Treasury Secretary Janet Yellen held a meeting with the heads of the SEC, the Federal Reserve, the Federal Reserve Bank of New York, and the Commodity Futures Trading Commission to discuss the volatility allegedly caused by the WSB army. The WSB Reddit board has swelled to 8.8-million degenerates in the wake of last month’s pump.

Financial regulators are continuing to review whether market volatility in WSB’s meme stocks and online brokerages’ trading stoppages “are consistent with investor protection and fair and efficient markets,” said the Treasury in a statement.

On Sunday, Secretary Yellen gave an update to her position on the meme stock saga, saying that it is still too early to determine whether new regulations are needed to address the recent volatility.

“We really need to understand exactly what happened and the Securities and Exchange Commission is working hard to assemble a report that gives us the facts, and when we have them, we can look at whether or not there were issues that need to be addressed through new policy or regulations,” Yellen told CNN’s “State of the Union” program.

But while amateur traders dominated media coverage of the rally, GameStop was only the fifteenth-most-purchased retail stock last month, according to a client note authored by JPMorgan global quantitative and derivatives strategy analyst Peng Cheng.

“Although retail buying was portrayed as the main driver of the extreme price rally experienced by some stocks, the actual picture may be much more nuanced,” wrote Cheng. That is to say, other hedge funds may have been the real drivers of the memestock bonanza.

Devin Ryan, an analyst for middle-market investment bank JMP Securities, told CNBC, “I think that it’s reasonable to say that institutional investors were also very active in those stocks last week because there are institutional investors that participate in names that have elevated volume.”

Despite growing countervailing evidence, however, regulators still plan to investigate the role Redditors may have played. Authorities are likely interested in how the dynamic of free online margin trading and social-media-driven network effects precipitated wild swings in prices of individual securities.

DeFi Contagion?

The unfolding fallout will also likely give the SEC and the Treasury greater leeway to entertain stronger oversight controls over the peer-driven crypto ecosystem, including DeFi.

With regards to market manipulation concerns, Dogecoin – the meme-cryptocurrency that began as a joke but has since gained the Twitter endorsement of Elon Musk, Gene Simmons, and now, Snoop Dogg – has soared over 2,400% in the last year.

Dogecoin’s ‘irrational exuberance’ echoes the pump and dump mania that defined the initial coin offering craze of 2017. The ICO bubble eventually sparked a wave of SEC enforcement actions.

As for mitigating the financial-crime risks posed by DEX entities, the stalled rule on so-called ‘unhosted’ wallets proposed by the Treasury’s financial intelligence unit last December is high on Secretary Yellen’s agenda, given her apprehensions about crypto as a conduit for terrorism finance.

Secretary Yellen’s comments on crypto-terrorism links came just weeks after the Capitol siege, following crypto-compliance firm Chainalysis’ discovery that $500,000 in Bitcoin was sent by French programmer Laurent Bachelier to far-right groups in December. Bachelier committed suicide the day after the transfer was made.

But these transfers reportedly had nothing to do with unhosted wallets, which the Financial Crimes Enforcement Network defines vaguely in their proposal. In this context, it is generally accepted that FinCEN is referring to user’s personal wallet service providers that operate independently from exchanges and custody crypto assets on desktop, mobile, and other offline devices.

If enacted, FinCEN’s proposed rule will thus mandate the same KYC, currency transaction reporting (CTR), and recording keeping requirements on exchange transfers involving personal crypto wallets that are imposed on money service businesses (MSBs) under the Bank Secrecy Act.

This means that banks, MSBs, and most crypto exchanges will have to report all fund transfers and relevant customer-identification data between exchanges and personal crypto wallets for all transactions totaling $10,000 or more between participants.

FinCEN will also expect covered entities to keep records “if a counterparty uses an unhosted or otherwise covered wallet and the transaction is greater than $3,000.” Incidentally, DeFi is the sector that would be most impacted by this rule, critics say.

Not only would DEXs’ like ShapeShift be forced to comply with standard KYC rules, but so would startup DeFi applications that rely on smart contracts to store or escrow funds that are used in staking, yield farming, and other lending transactions, for example.

Additionally, these smart contract platforms don’t register physical addresses, nor are they operating under the umbrella of an official legal entity, for example. Furthermore, smart contracts don’t always have ‘counterparties.’

As such, Amy Davine Kim, chief policy officer of the Chamber of Digital Commerce advocacy group, told CoinDesk that the lack of physical addresses means that some DeFi smart contracts “may be unable to interact with the U.S. financial system.”

DeFi funds in the U.S. may thus be frozen within their own ecosystem, unable to be transferred back to a hosted exchange wallet. A heightened sense of regulatory urgency around disruptive, P2P financial models, combined with Secretary Yellen’s concerns over crypt-terrorism finance, could thus sabotage DeFi innovation and growth in the U.S.

Assessing what the developing WSB drama might mean for DeFi, Ari Redbord, the head of legal and government affairs at digital-asset compliance firm TRM Labs, said the following.

“I think ultimately regulators will not focus on the centralized or decentralized nature of an exchange or whether or not it’s on a smart contract. Regulators will focus on the business and will view the business as that of an exchange regulated under the Bank Secrecy Act and other legislative and regulatory schemes.”

But Redbord also cautioned that “there are challenges to even attempting to regulate peer-to-peer transfers or decentralized exchanges. I am hopeful that those who set up DeFi protocols and decentralized exchanges will also understand the importance of stopping illicit actors from taking advantage of their technology.”

Meanwhile, Tesla chief executive and meme-crypto-Twitter influencer Musk tweeted earlier this morning that hosted wallets “should be avoided at all costs”

 

Additional Reading on these topics:

https://oodaloop.com/archive/2021/01/29/oodacast-camila-russo-on-ethereum-and-the-future-of-decentralized-finance-defi/

https://oodaloop.com/archive/2020/12/15/can-hacker-sigint-help-buy-side-firms-generate-alpha/

https://oodaloop.com/briefs/2021/01/13/rg-coins-cryptocurrency-exchange-owner-lands-10-years-behind-bars-for-money-laundering/