Trade activity is fundamentally changing, and as a result, the inherent risks that financial executives faced in the past have evolved. Increasing market volatility—coupled with a higher frequency of trading and the wider adoption of digital assets—has introduced a greater degree of complexity and pushed the industry toward a precipice.

As we look ahead, large financial institutions (FIs) must consider the risks and rewards of the digital assets they are beginning to explore, as well as the financial, regulatory and reputational reverberations that will undoubtedly extend across capital markets to retail banking and beyond.

But First, The Digital Asset Dilemma

Charlie Munger famously stated, “I wish they’d [bitcoins] never been invented.” Nevertheless, 14 years since the publication of Satoshi Nakamoto’s white paper, Bitcoin—and more broadly, decentralized finance (DeFi)—continues to enjoy growing mainstream popularity.

In June 2020, the total value locked (TVL) or value of all funds locked in DeFi sat at about $1 billion. In a report from December 2021,¹ data from DeFi Pulse showed that the TVL figure peaked at over $86 billion in mid-May and continued to exceed the $60 billion mark at the end of the year. Despite the opportunity, this rise presents a real risk to FIs in the form of illicit activities like cybercrime, money laundering and terrorist financing.

Trading in virtual assets does not have to rely on a centralized “regulated” authority. This takes away several controls that traditional finance (TradFi) has been able to rely on to reduce risk within the system. The only tools required to trade in virtual assets are a smartphone and WiFi access. So, in many respects, DeFi is borderless and always active. It can be immune to designations that other assets must adhere to in “high-risk” jurisdictions. Unsurprisingly, rapidly evolving technological innovations make it considerably advantageous to bad actors. In fact, a report from Chainalysis states that out of the total cryptocurrency stolen in 2021 (approximately $3.2 billion), 72% was stolen from DeFi protocols.² The same research found that DeFi was an increasingly popular way of laundering money, which increased by 1,964% between 2020 and 2021.

The cost of compliance within a well-regulated jurisdiction can be extremely high and regulatory arbitrage is rampant as various virtual asset trading platforms select the most economically beneficial jurisdiction. Yet the universal, borderless and virtual nature of these digital assets is poised to create a tremendous impact. Not only will local “nontraditional” jurisdictions be able to grow their local economies by taking advantage of the economic benefits offered by Tier-1 FIs, but the customer base of these FIs will significantly expand. Moreover, thanks to global regulatory advisory bodies such as the Financial Action Task Force (FATF) and the Organization for Economic Cooperation and Development (OECD), pressure is being placed on these “wild west” jurisdictions with advisory pronouncements. The OECD and FATF can bring penalties—such as threats or onerous sanctions—to disconnect substandard regulatory regimes from the TradFi “rails” that all virtual asset-related entities will eventually have to engage with to survive in the long term.

For these reasons, it behooves all TradFi entities to—at the very least—better understand what this technology offers.

The Big Picture

The pandemic forced many in the financial sector to question their existing playbook fundamentally. As 2022 unfolds, traditional financial services institutions must look beyond their four walls to better prepare, especially as cryptocurrency use continues to soar. Even those firms with a limited investment in digital assets would be wise to remember the details below.

• TradFi and DeFi: In the financial arms race, both TradFi and DeFi must be in the arsenal. To ignore or believe that DeFi is a passing fad or a Ponzi scheme will not serve FIs well in the long term. TradFi will be reliant on DeFi and vice versa. Sooner or later, DeFi entities—and those service firms that deal exclusively in them—will have to rely on legacy rails to stay afloat. Similarly, as the DeFi infrastructure grows, TradFi firms will find that their dependence on DeFi will grow more in-depth and intricate. The regulators know this and will continue to make it clear through examinations. Entities in denial will become examples of why it is important to understand this phenomenon and could potentially face greater financial and reputational risk with financial penalties and media scrutiny.
• Risk exposure: Financial firms must adapt risk exposure for virtual assets. Capabilities unique to blockchain technology can be applied to risk processes across the spectrum, again with significant cost savings. Securities settlement and other intermediaries cost FIs a lot of money to employ. Blockchain can provide for trustless peer-to-peer interaction, saving those institutions money by eliminating these same intermediaries. For example, digital identity on blockchain may also significantly change the labor-intensive know your customer (KYC), customer due diligence (CDD) and enhanced due diligence (EDD) operations and help avoid significant compliance costs. The use of this technology holds the additional promise of a portable and verifiable digital identity for instantaneous entity verification. This would greatly decrease the associated KYC, CDD and EDD costs and expedite transacting of new businesses, such as account openings, extension of credit products, retail loans, insurances and more.
• Technology and talent: Firms must invest in innovative technology and talent to meet this moment. The complexity of the algorithms DeFi trading platforms rely on to operate is growing, driven by record-breaking volume and velocity of activity. In 2021 alone, cryptocurrency transactions grew to $15.8 trillion, an increase of 567% from 2020, according to Chainalysis.³ TradFi and DeFi companies would be wise to invest in technology that is robust and comprehensive enough to accurately capture data and provide a thorough view before that figure continues to grow. In turn, this will require additional expertise and skillsets for emerging areas such as cryptography and blockchain engineering—skills that are in high demand and in short supply.

Who Says You Cannot Teach an Old Dog New Tricks?

According to a report by CipherTrace, “in 2020, major crypto thefts, hacks, and frauds totaled $1.9 billion.”⁴ By comparison, the United Nations estimates that $1.6 trillion in fiat is laundered each year.⁵

Criminal entities have always been the first to utilize new technological developments as they have little operational overhead and do not suffer from the constraints that institutions face. For example, when the automobile was created, organized crime used this new technology to assist in bank robberies, prohibition violations and kidnapping.

Certainly, those operating within TradFi need to be aware of these risks, but they should not be dissuaded from understanding how this emerging technology functions and, more importantly, how it might revolutionize otherwise antiquated processes, policies and technology.

John Dalton, CAMS, senior vice president, global head of Financial Services Product and Solutions Strategy, KX, North Carolina, USA, jdalton2@kx.com

Doug McCalmont, CAMS, co-founder/chief compliance officer, Chrysalis Digital Asset Exchange, Massachusetts, USA, dmccalmont@chrysalisdae.com, Twitter: @DougMcCalmont

1. Alex Behrens, “The Growth of DeFi,” Circle, December 6, 2021, https://www.circle.com/blog/the-growth-of-defi
2. Isabella Lee, “The stunning growth of cryptocurrency markets in 2021 also came with an 80% rise in crypto crimes, new analysis shows,” Insider, January 6, 2022, https://markets.businessinsider.com/news/currencies/crypto-crimes-2021-defi-scam-stolen-funds-rug-pull-chainalysis-2022-1
3. “Crypto Crime Trends for 2022: Illicit Transaction Activity Reaches All-Time High in Value, All-Time Low in Share of All Cryptocurrency Activity,” Chainalysis, January 6, 2022, https://blog.chainalysis.com/reports/2022-crypto-crime-report-introduction/
4. “Cryptocurrency Crime and Anti-Money Laundering Report, February 2021,” CipherTrace, https://ciphertrace.com/2020-year-end-cryptocurrency-crime-and-anti-money-laundering-report/
5. “Tax abuse, money laundering and corruption plague global finance,” United Nations, September 24, 2020, https://www.un.org/development/desa/en/news/financing/facti-interim-report.html