2021 was a thrilling year for crypto, and we expect this year to be similarly full of plot twists and cliff hangers. And while the only constant in this industry is a never-ending series of surprises, the Shipyard team has some thoughts on where the tides will take us in 2022.
Countries will begin to aggressively legislate or regulate crypto head-on, which will unlock a new wave of growth in crypto.
More countries will apply existing corporate laws to DAOs
Today, DAOs tend to avoid incorporating. Many of them don’t see the need — after all, they don’t need to do so in order to operate. Smart contract code can enforce bylaws rather than the courts, bearer-tokens represent voting rights rather than legal ownership rights, and assets can be governed in multisig contracts rather than in bank accounts with authorized users.
However, the case for why DAOs should incorporate as legal entities is becoming more clear. In 2022, we expect at least one DAO member-to-member lawsuit. The recent SushiSwap leadership drama may end up being the impetus for this industry shift. Even multisig holders and DAO members that do not need to incorporate will begin to appreciate the benefits of limited liability protections of the governing individuals.
When this becomes clear, a lobbying effort will emerge with the backing of the $11 billion of DAO AUM. Many countries will quickly respond by adapting existing laws to support the DAO corporate form; namely, bylaws encoded on the blockchain. Forward-thinking legislation like Wyoming’s DAO Law will be adopted by small, fast-moving nations competing to become the Cayman Islands of DAOs.
The US will pass stablecoin legislation and/or regulation, enhancing confidence in them and encouraging their use as an alternative to traditional payment and settlement rails.
The US President’s Working Group has already recommended a framework for regulating stablecoins, which begins by recognizing them as banks. The most legitimate stablecoin issuers, like Circle (USDC), Paxos (USDP), and GMO Trust (GYEN, ZUSD) will quickly do so. However, more questionable issuers, such as Tether, will find it impossible to establish a strong position under the US’ evolving stablecoin framework.
As regulations are further clarified, traditional institutions that are able to comply with these evolving laws will be much more willing to use stablecoins. This will finally enable crypto to be used for many long-awaited use-cases like remittances and day-to-day purchase payments.
New DeFi regulations will diverge from existing laws governing the traditional financial services sector
DeFi is growing fast, with over $100 billion locked in Ethereum-based DeFi smart contracts as of December 2021. However, existing laws were not written with its unique capabilities in mind. Current laws generally assume that a responsible party facilitates virtually every financial market. Since the power of regulators is limited by laws, they have struggled to create common-sense regulations for DeFi despite their desire to do so.
To address this, we believe that in 2022 regulators and the DeFi lobby will finally convince US legislators to propose new legislation written with DeFi in mind. This legislation is unlikely to pass in 2022, but this will mark a promising first step that gets the ball rolling.
More blockchain applications will enact mandatory AML practices
There has long been talk of institutional capital entering DeFi to chase yield. The main thing holding it back is the lack of anti-money laundering protections in on-chain environments such as DeFi liquidity pools. More specifically, when a liquidity provider (LP) provides liquidity, its funds intermingle with the funds of all other LP’s in the pool. With no AML policy in place, those funds could be from an individual or entity on the US sanctions list, such as a criminal or terrorist organization. While individual investors and crypto-native funds are likely to be comfortable with that risk, investment advisors and traditional money managers will not be, as they are legally liable for ensuring their clients’ funds do not intermingle with sanctioned money.
To attract institutional LP, DeFi projects will begin offering some sort of AML protection. For example, this may include blocking addresses on the Office of Foreign Assets’ Control (OFAC) sanctions list, though it will probably not include Know Your Customer (KYC). In late 2021, Israel began implementing crypto-specific AML policies to make it easier for local banks to accept clients from the crypto sector. We expect other regulators to follow suit in 2022.
If a new Cryptowinter comes, here’s how it could happen:
The crypto economy becomes more fragile as leverage increases, and the high yields from liquidity mining has encouraged substantial leverage. If a Minsky moment happens, here are the likely triggers.
The solvency of Tether has long been unclear. Its leadership has admitted to past inside dealing, and they persistently dodge questions about their reserves by claiming they have already released enough information. If the US passes stablecoin legislation in 2022, Tether will be unable to adhere and as a result all US entities will be blocked from using Tether (a trend that has already begun, as many onshore US brokerages refuse to trade Tether). The pressure will become too great for Tether to effectively manage, and the market will consequently lose confidence in the project. Once this happens, Tether will de-peg and uncertainty regarding its asset value (which currently stands at $75B+) will spook the market, cause liquidations and a run on its redemption window. We see this as the likeliest trigger for another cryptowinter.
A mainstream crypto lender goes bankrupt
Huge amounts of money have been borrowed in the cryptomarkets. Much of this is through decentralized lending services that are fully collateralized, like Compound. However, much is through centralized lenders such as BlockFi and Genesis who make discretionary decisions borrower-by-borrower. As a result, the quality of their underwriting is largely unknown, and DeFi lending platforms like Cred and Celsius have been roiled by a series of unexpected events. While these service providers employ smart, hardworking teams that likely have the best intentions, smart teams have imploded before (see Lehman Brothers and Long Term Capital Management in the 90’s).
More specifically, the lending agreements of centralized lenders allow them to make uncollateralized loans whenever they deem it appropriate and to engage in rehypothecation, which is the practice of relending out posted collateral. Rehypothecation in particular can be done repeatedly, increasing risk each time. Excessive rehypothecation in the crypto markets could cause uncollateralized or undercollateralized borrowers to become insolvent, forcing one of the centralized lenders themselves to go under. This could cause a major pullback from crypto.
A layer 2 network experiences a major security breach
The only certainty in DeFi is that exploits will happen. As Ethereum’s rising gas costs have pushed away developers and traders, other Layer 1s (L1s) and Layer 2s (L2s) have exploded in popularity. Their TVL today is $80 billion. Each L1 and L2 project is designed with different tradeoffs with respect to security and scalability. While no major hacks have happened yet, the past is not necessarily indicative of the future. For instance, a white hat hacker was recently awarded $2.2 million for identifying a multi-billion dollar exploit in one of Polygon’s smart contracts, and many other crypto projects have a much shorter and less credible track record than Polygon. Another popular project, Solana, also recently identified a coding error that would have allowed hackers to rapidly drain funds from multiple projects built on Solana.
As a result, a major exploit of an L1 or L2 is likely a matter of when, not if. When it does come, it will instantly reset the risk calculus of investors and traders throughout the crypto market.
The future remains bright
While these doomsday scenarios may sound scary, a wide variety of market disruptions can be positive for the crypto industry in the long-run. The risks in crypto are real, but the sooner they are properly internalized the healthier the crypto markets will be. In other words, identifying DeFi bug exploits and allowing unscrupulous actors to fail are necessary steps on the path towards mainstream adoption and long-run success. Moreover, a cryptowinter will cull the herd by weeding out low quality or ill-intentioned market players with less substance. This will give legitimate projects more access to the talent and money needed to fuel their innovative efforts. And of course, we’ll be hiring!