JP Morgan believes regulation will lead to convergence of crypto, TradFi

Wallstreet banking giant JP Morgan & Chase believes there are significant changes coming to the crypto industry in 2023 in the form of regulation, which will likely cause a convergence between crypto and the traditional financial industry, according to its latest Global Markets Strategy report.

Major changes coming to the crypto industry in 2023 pic.twitter.com/qW6cHLyc6N

— Alex Krüger (@krugermacro) November 28, 2022

JP Morgan reflected upon the FTX and Alameda Research debacle in the document and the “cascade of crypto entity collapses” — questioning how the crypto ecosystem is set to change, and the main changes the firm envisions for the time ahead.

Expedited regulation

The document explores the expediting of existing regulatory initiatives already underway such as the European Union’s Markets in Crypto Assets (MiCA) bill.

Having already passed most of the EU’s legislative processes except final approval by the EU parliament, JP Morgan expects final approval is likely going to come before the start of 2023.

The bank added that there will likely be a transitional period of up to 18 months before the new regulation “takes effect at some point in 2024.”

Custody-focused Regulation

JP Morgan documented the suggestion that new regulatory initiatives are likely to emerge focused on “custody and protection of customers’ digital assets as in the traditional financial system.”

The firm noted the exponential growth of hardware wallet providers Ledger and Trezor following the FTX collapse, as it sparked “an increase in crypto self-custody.”

Unbundling Activities Regulation

The document noted the likelihood of new regulatory initiatives being introduced focused on the unbundling of broker, trading, lending, clearing, and custody activities.

JP Morgan said:

“[These regulations will have the] most implications for exchanges which like FTX combined all these activities raising issues about customers’ asset protection, market manipulation and conflicts of interest.”

Regulations on Transparency

The investment bank also noted the likelihood of new regulatory initiatives focused on transparency entering the crypto space, such as mandates for regular reporting and auditing of reserves, assets, and liabilities on “exchanges, brokers, lenders, custodians, Stablecoin issuers etc.”

The firm said these regulations are likely to be imported from the traditional financial system, which would in turn lead to:

“Convergence of the crypto ecosystem towards the traditional financial system.”

Crypto Derivatives Shift Towards Regulated Venues

The document explained that the crypto derivative market is likely to see a shift to regulated venues with the Chicago Mercantile Exchange (CME) emerging as a winner.

With several institutional investors such as hedge funds getting trapped via their derivative positions at FTX, there is likely to be a greater shift towards regulate venues such as CME for both futures and options.”

JP Morgan noted that such a shift would likely increase the role of the Commodity Futures Trading Commission (CFTC) in crypto markets — given that U.S. derivative markets are regulated by the CFTC.

Shift Away from CEX to DEX

JP Morgan concluded the Nov 24 document stating that the firm is “skeptical of a structural shift away from centralized exchanges (CEX) into decentralized exchanges (DEX).”

As decentralized finance (DeFi) becomes mainstream, the firm noted several hurdles that the budding sector will face:

• Price discovery — mainly provided by exchanges via oracles for now
• Smart contract risks (hacking/protocol attacks)
• Management/audits and governance without compromising security
• Systemic risks arising from automated liquidations if collateral drops below certain levels
• The over-collateralization disadvantage of DeFi over traditional finance
• Front running in DEXs
• No limit order/stop-loss functionality
• Risk/return trade-off being harder to assess in DeFi
• Pooling of assets into liquidity pools (LPs) may make institutional investors uncomfortable

“As a result we believe that centralized exchanges will continue to play a big role in the crypto ecosystem in the foreseeable future, in particular for larger institutional investors, despite the FTX collapse.”

JP Morgan said.