Hiltzik: Regulators act to stamp out crypto fraud

The sun may be setting on the cryptocurrency craze. If you’re an investor or even just a curiosity seeker on the fringes of this financial segment, you might want to prepare for its demise.

In recent weeks, market and banking regulators in the United States have tightened the screws on crypto-related firms. Legislative initiatives in Congress aimed at liberalizing rules for crypto promoters appear to be running out of steam.

The entire crypto market, from the pioneering cryptocurrency bitcoin to fad cryptos like Dogecoin and obscure proprietary tokens like Stellar and Cardano has been in a prolonged slump.

The crypto market capitalization, which peaked at more than $3 trillion at the end of 2021, is now estimated at $800 billion, implying huge losses for late-stage investors. (Some cryptocurrencies have rallied recently, but the benchmark bitcoin is still down more than 60% from its peak in November 2011.)

For crypto’s legion of critics, these developments reflect the influence of gravity on a marketplace characterized by “frequent incidents of operational failure, market manipulation, fraud, theft and fraud,” as the US Treasury Department put it in a consumer advisory issued recently. September.

“There’s nobody there, and we have a ton of history to prove it,” Lee Reiners, a crypto expert at Duke and former regulatory official at the Federal Reserve Bank of New York, told the Senate Banking Committee at a hearing Tuesday.

Unlike stocks and bonds, which give their owners a claim on the issuer’s profits, or precious metals, which generally have inherent industrial or commercial value, cryptocurrencies represent no ownership of anything tangible and no claim to economic productivity.

Given that the first bitcoin transaction occurred in 2009, Reiners observed that despite “a 14-year track record to look back on,” no one has identified what crypto is good for, other than as something people can buy solely in the expectation that they can sell it to someone else at a higher price in the future – which is often described as the “bigger fool” theory.

US banking regulators have hardly been blind to this reality. In a joint statement issued on January 3, the Federal Reserve, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency a one-stop list of the biggest problems with crypto, many of which paralleled the concerns raised by the Treasury.

They cited “the risk of fraud and deceit”, “inaccurate or misleading representations and disclosures”, “unfair, deceptive or abusive” practices and the risk of “cyber attacks, business interruption, lost or frozen assets and illicit finance”.

The implicit goal of the joint statement was to warn regulated banks and their customers that they should probably steer clear of crypto at all costs.

The immediate trigger for the change of heart in Washington may be the implosion in November of FTX, a crypto firm whose founder, Sam Bankman-Fried, had been a prominent advocate for looser regulation of crypto firms. Bankman-Fried is free on bail while he awaits trial on criminal charges.

However, FTX’s bankruptcy was just one of a series of failures by crypto firms during 2022, and the precursor to further bankruptcies. Perhaps more importantly, many of the operational deficiencies allegedly found in FTX’s operations are common in the field, including inadequate record-keeping and security arrangements, and commingling of clients’ and firms’ assets.

Consumer interest in crypto was likely destined to wane even without the FTX collapse. Last year’s Super Bowl broadcast was full of high-priced ads from crypto firms featuring celebrities like Matt Damon and Larry David. Supernovas like 2022-vintage crypto are always destined to fade to some degree; this year’s Super Bowl was crypto-free.

In recent weeks and months, however, U.S. regulators have taken strong steps to inoculate the larger banking and financial system against the contamination of crypto firm failures.

In January, the Fed rejected an application by Custodia Bank for membership in the Federal Reserve System. Custodia, which is chartered by Wyoming, aimed to issue its own crypto token. “The company’s new business model and proposed focus on cryptoassets presented significant security and solvency risks,” the Fed said.

Last week, banking regulators in New York State ordered Paxos Trust to stop issuing crypto tokens with a brand associated with France-based Binance, the world’s largest crypto exchange, due to “several unresolved issues” related to the relationship between the two firms. The Securities and Exchange Commission has also informed Paxos that it may face an SEC lawsuit for selling unregistered securities – the crypto tokens.

Also last week, the SEC forced crypto exchange Kraken to stop marketing a so-called staking-as-a-service program in which it advertised financial returns as high as 21% to investors who transferred their crypto assets to Kraken. The firm paid $30 million to settle with the SEC, without admitting to the agency’s charge that it marketed an illegal security.

Crypto shills, including those on Capitol Hill, have typically made two main arguments. One is that crypto represents “financial innovation” that we stifle at our peril. The second is that it is a way to give sections of society that have traditionally been excluded from the financial system, such as “unbanked” minorities, access to the financial services that others enjoy.

Both are tough. Let’s take them in order.

During Tuesday’s hearing, committee ranking member Tim Scott (R.S.C.) declared that the reason the United States has “the strongest and most enviable capital markets in the world” is because “the sun never sets on American innovation.”

Scott was seconded by JD Vance (R-Ohio), a venture capitalist in his outside life, who asked “how people would have described the Internet in the 1970s and 1980s… If we had taken an overbearing approach then, we might has destroyed much of the upside that has come over the last three decades.” He asked how to regulate crypto now “in a way that protects the benefits of the technology right now.”

The flaws in this argument should be immediately apparent. One is that the virtues of a given innovation do not validate any other purported innovations. (Some “innovations” actually have qualities that society could very well have done without, such as the technological innovations that gave us thermonuclear weapons.)

Another is that to talk about the “upsides” of crypto is to assume facts that are not evidence, since no one has made a convincing case for crypto as a useful innovation – except as a tool for criminal activity.

During the hearing, committee member Elizabeth Warren (D-Mass.) mentioned “international drug traffickers who raised over a billion dollars through crypto, … North Korean hackers, who stole $1.7 billion and funneled that money into their nuclear program. . and ransomware attackers who took in nearly $500 million.”

She concluded: “The crypto market took in $20 billion last year in illegal transactions. And that’s just the part we know about.”

As for the alleged inclusiveness of crypto, it is an illusion. The most frequently cited statistic comes from a survey by Charles Schwab & Co. of 2,057 American adults, which concluded that 25% of black investors owned cryptocurrencies by 2022, compared to just 15% of white investors. (Yesha Yadav of Vanderbilt Law School, a witness at the Senate hearing, falsely claimed that these numbers applied to all black or white Americans, not just investors.)

One might question whether Schwab’s numbers are at all plausible, but it is important to note that the median income for black respondents was $99,000 and for white respondents $106,000.

These are not the unbanked Americans whose financial ambitions have allegedly been unleashed by crypto. “What unbanked populations really need are easy, safe and affordable ways to save money, as well as convenience,” Tonantzin Carmona of the Brookings Institution reported in October.

Unfortunately, crypto transactions tend to be just the opposite — “slow, expensive and inefficient,” Carmona observed — and fraught with “many hidden fees.”

A 2019 FDIC survey cited by Carmona reported that 29% of respondents without a bank account blamed their situation on not having enough money to meet minimum balance requirements. Taking a flyer on wildly volatile cryptocurrencies is hardly the most reliable way to fill the gap.

One should expect the crypto industry to fight regulation with the power that millions of dollars in lobbying spending can buy — $9 million spent on influencing Congress in 2021, the most recent year for which figures have been compiled.

Yet the lobbyists’ narrative is false. “Big crypto” blames the serial explosions of crypto firms on the failure of the SEC and the Commodity Futures Trading Commission to provide the sector with “regulatory clarity.”

Scott parroted this point in his opening statement Tuesday. “The regulators have allowed activity in this space without providing clear rules of the road,” he said. “Had the SEC provided anything other than hostility to the crypto industry, we may have been able to save investors from losing billions of dollars on FTX” and other such disasters.

The truth is that the agencies could not be clearer about where Big Crypto is breaking the rules.

Since 2013, the SEC has filed 127 enforcement actions in the crypto space in one form or another without ever losing in court. “They are time-tested rules,” SEC Chairman Gary Gensler told Bloomberg Television on Monday. But “this is largely a non-compliant field.”

What the crypto firms want is a “gigantic loophole written into the law,” Warren said at the hearing. She is right. The recent enforcement actions signal that regulators are less inclined than ever to help them find it.

Without a loophole that gives these firms an exemption from the rules that all other financial intermediaries must comply with, crypto will likely wither and die. It will be consumers’ best protection against losing their shirts in crypto scams.