Crypto: Regulators crack down as FTX fallout casts shadow over digital assets

New York (CNN) When FTX collapsed in November, it was a seismic event for the crypto industry. Many called it the “Lehman moment”.

The comparison applies broadly: An industry giant collapsed, contagion spread, and regulators who had been reluctant to act suddenly had a clearer target and a wave of public outrage to bolster their case.

And now we can officially enter the Dodd-Frank era of crypto. (Dodd-Frank, of course, is the 2010 legislation that Congress passed in response to lax oversight in parts of the banking industry that plunged the world into one of the worst financial crises in history.)

As the crypto market has exploded into a trillion-dollar industry, advocates contend with a regulatory infrastructure ill-equipped to handle it and largely suspicious of its fundamental pitch as the future of finance.

In the three months since FTX filed for bankruptcy, state and federal regulators have escalated both their rhetoric and their actions to keep the fast-growing digital asset industry in check — a shift that, unsurprisingly, isn’t going over well with crypto companies.

On Tuesday, the Senate Banking, Housing and Urban Affairs Committee held a hearing titled “Crypto Crash: Why Financial Safeguards are Needed for Digital Assets.”

“While the crypto contagion did not infect the broader financial system, we glimpsed the damage it could have done if crypto migrated into the banking system,” said the committee’s chairman, Senator Sherrod Brown, in his opening remarks. “These crypto disasters have revealed what many of us already knew: Digital assets — cryptocurrencies, stablecoins and investment tokens — are speculative products run by unscrupulous companies that put Americans’ hard-earned money at risk.”

Stablecoins in the spotlight

The hearing came a day after a regulatory attack on one of the world’s most popular stablecoins. On Monday, New York regulators ordered blockchain firm Paxos to stop issuing BUSD, also known as Binance USD, citing “several unresolved issues” related to Paxos’ oversight of its relationship with crypto exchange Binance.

So-called stablecoins are digital tokens that maintain a one-to-one support with the US dollar or other fiat currency. Investors typically buy them to store money and facilitate transactions within the cryptocurrency infrastructure, making them a cornerstone of the crypto ecosystem.

The New York Department of Financial Services did not immediately respond to CNN’s request for comment. Paxos told customers that they would be able to redeem their BUSD through February 2024, with options to redeem funds in US dollars or to convert their tokens to Pax Dollar, another stablecoin issued by the company.

At the same time, the Securities and Exchange Commission plans to sue Paxos, alleging that BUSD should have been registered under federal securities laws.

Paxos “categorically disagrees” with the SEC, it said in a statement Monday, “because BUSD is not a security under the federal securities laws.” The firm said it would “engage” with the SEC on the matter and is prepared to “vigorously litigate if necessary.” The company declined to comment beyond the statement.

The BUSD News have clearly restless investors. Binance, which partnered with Paxos to launch the stablecoin in 2019, on Monday suffered one of its worst days ever in terms of withdrawals with $873 million in net outflows, according to data provider Nansen.

Enforcement is increasing

The crackdown on BUSD and Paxos is just the latest instance of regulatory muscle flexing in recent months — actions that sowing confusion and frustration among crypto advocates, many of whom have sought regulatory clarity for years.

“Regulation by enforcement is confusing for crypto enthusiasts,” Marcus Sotiriou, market analyst at digital asset broker GlobalBlock, said in a note. “People are desperately trying to figure out how to offer a product legally without getting guidance.”

In recent weeks, the SEC has relied on an enforcement strategy that critics say unfairly targets the nascent industry.

Last week, the SEC reached a $30 million settlement with crypto platform Kraken that will force the firm to relax its “staking” practice, which allows investors to passively generate returns on their crypto holdings.

The settlement immediately raised questions about other exchanges offering stakes, which crypto advocates say are essential to supporting the healthy functioning of some virtual currencies.

In January, regulators warned US banks and other market participants about the risks of fraud, volatility and poor risk management in the crypto world.

“It is important that risks associated with the cryptoasset sector that cannot be mitigated or controlled do not migrate to the banking system,” they said in a statement – the first joint statement on crypto by the Federal Reserve, the Federal Deposit. Insurance Corporation, and the office of the Comptroller of the Currency.

-— CNN’s Michelle Toh and Brian Fung contributed reporting.