Why the Crypto World Should Embrace the Fed’s Crash
That’s how it feels inside the cryptocurrency industry these days, as US authorities hit many players with indictments, lawsuits, fines and orders to shut down various offerings. Even stablecoins, the relatively simple assets backed by the US dollar, have been targeted.
After a year in which the crypto market lost about two-thirds of its value and failure of FTX shattered the confidence of investors, the blow breaks the industry. Yet this may be just what the industry needs if it is to shed its grandiose dream of technological revolution and become something viable – a business, or more precisely, a reliable business.
Fourteen years after the introduction of Bitcoin, the cryptocurrency industry is still struggling to prove its utility. Bitcoin did not become new “rails” for processing payments, and due to its correlation with stocks, it failed as a hedge against inflation and monetary policy during the last interest rate cycle. Meanwhile, Ethereum, the “smart contract” network set to reshape finance, will needs a number of upgrades over the next few years to demonstrate that it can process transactions at volumes anywhere near what Visa does.
It is becoming increasingly difficult to see cryptocurrencies as anything other than a haven for charlatans. Or at least that’s the prevailing narrative. So regulators, cursed by crypto people like a scourge, could do the industry a huge favor by cleaning it up.
But what does a cleaner crypto industry look like? If you take the drama out of crypto, what are you left with? A day trading game? A hobby for Bored Ape lovers? Or does the original claim that blockchain technology can change financial infrastructure still hold true? If so, perhaps that’s why the likes of Fidelity Investments, Apollo Global Management and Andreessen Horowitz are still investing serious money in the space. And why traditional finance can be the source of stability crypto needs.
But first, the regulatory onslaught. This moment has been long overdue. Gary Gensler, chairman of the US Securities and Exchange Commission, has urged the industry to get straight with securities laws and get “within the perimeter” by 2021. He’s not bluffing. By no means has the Biden administration done what crypto-guys have long feared: It has defined cryptocurrencies in virtually all of their forms as securities or investment contracts. As any CFO knows, this means that issuers of digital assets must register their offerings with the SEC and adhere to the same disclosure and client protection requirements that govern traditional capital market participants. In other words, cryptocurrencies are the same as stocks and bonds.
“It’s really not that complicated,” says John Reed Stark, the former head of the SEC’s Office of Internet Enforcement. “Register like everyone else.”
It may sound rather prosaic, but for the crypto community this is fire-and-brimstone stuff. The whole industry was based on not needing the state or, for that matter, central banks, commercial banks and other “intermediaries”. Ever since Bitcoin picked up its mojo a decade ago, crypto leaders have insisted that their industry should flow outside the conventional controls of the traditional marketplace. Thanks to a decentralized network model, blockchain-based businesses were “permissionless” or self-regulating.
That conceit vanished when Sam Bankman-Fried, the indicted co-founder and CEO of FTX, allegedly looted client deposits to cover billions of dollars in losses at his hedge fund. Even seasoned pros were horrified. At a recent crypto conference in St. Moritz, Switzerland, Philippe Bekhazi, head of crypto trading firm XBTO Group, said putting money into an exchange like FTX was no different than giving the company an interest-free loan with no liability, or recourse. save the bankruptcy courts.
Stark says the lack of controls in the crypto industry was bound to trigger a bill. “Trust is non-existent; there are no oversight, no audits, no inspections, no net capital requirements and no rules against commingling client funds,” notes the former SEC official, who is now a consultant.
This month, the Feds dropped two markers that will change the direction of cryptocurrencies. On February 9, Kraken, the No. 3 crypto exchange worldwide, agreed to pay a $30 million penalty and end one of its products in a settlement with the SEC. The problem: The company hadn’t registered its staking service — a budding business that lets investors earn returns by giving their tokens to “validators” who tend blockchains. Kraken undoubtedly believed that stakes should not be treated in the same way as a share or interest offer. By determining that staking-as-a-service, as the business is known, required registration, the SEC sent the industry a message: No matter how you slice or dice digital assets, they are securities.
Now crypto companies can try to get the toothpaste back in the tube. “Staking service providers, including many cryptoasset exchanges, should consider whether to stop or restructure their staking programs,” Wilson Sonsini, a Silicon Valley law firm, said in a notice this month.
On February 16, the SEC expanded its definition of cryptocurrencies when it accused an entrepreneur named Do Kwon and the company he co-founded, Terraform Labs, of defrauding retail and institutional investors with “a series of interconnected tokens.” In a footnote in the 55-page complaint, the SEC defined a “crypto asset security” as any product issued or transferred on blockchain technology. That includes Terraform Labs’ doomed stablecoin, UST.
(The meltdown of this “algorithmic stable coin” is what triggered the cascade of toxic debt and margin calls that sank a number of crypto platforms last summer and ultimately plunged Bankman-Fried’s hedge fund and FTX into distress.)
The New York State Department of Financial Services jumped into the picture by ordering a venture called Paxos to stop minting a stablecoin known as BUSD after finding “several unresolved issues” related to oversight of the offering. And SEC veteran Stark claims the regulatory push is just getting started because it’s so easy to make cases against crypto platforms that have failed to register their offerings. “It’s like shooting fish in a barrel,” he says.
No surprise, outrage is heating up across the industry. Crypto Twitter is abuzz with accusations that the Feds are trying to stifle the sector or drive it offshore. Last year, the industry’s Washington lobby pushed hard for a bill that would create a statutory and regulatory regime that recognizes the sector’s special qualities. That effort appears to be dead in the water, especially given that FTX’s devastating campaign spending on Capitol Hill over the past two years has embarrassed many members of Congress.
As it happens, the most high-profile bill in Congress is the one co-sponsored by the unlikely duo of Senator Elizabeth Warren (a Massachusetts Democrat) and Senator Roger Marshall (a Kansas Republican). The two found common ground in casting cryptocurrencies as a threat to national security. Their bill would impose new restrictions on digital assets to combat money laundering and terrorist financing.
Crypto entrepreneurs also suspect that the SEC’s requirement that they register their tokens is a ploy to trap them on a bureaucratic treadmill.
One of the SEC’s top officials says this is a big problem. Commissioner Hester Peirce, a longtime supporter of crypto, disagreed with the agency’s decision on Kraken’s stake product.
“Whether one agrees with that analysis or not, the more fundamental question is whether SEC registration would have been possible,” she wrote in a statement posted on the commission’s website. “In the current climate, crypto-related offerings are not making it through the SEC’s registration pipeline.”
Regardless, traditional financial institutions may be the biggest beneficiaries of the Fed’s dragnet. As crypto firms struggle, so-called TradFi companies are leveraging their compliance expertise and practices to move in. On the asset side of the sector, Fidelity Investments is putting together a waiting list of US clients for Fidelity Crypto, a platform that will offer commission-free trading in Bitcoin and Ethereum. The exchange can compete with the likes of Coinbase and Kraken.
On the software side of crypto, Apollo Global Management, an alternative asset investment firm with $548 billion under management, is making a push to invest in and develop blockchain as new “technological rails to automate capital distribution.” Christine Moy, the head of digital assets at the firm and a JPMorgan Chase blockchain veteran, explains that the software could make the distribution of securities in the market more efficient, among other applications. Indeed, it would be ironic if a company like Apollo, which symbolizes Wall Street, made a breakthrough in rebuilding the IT infrastructure of the markets with blockchain technology.
And of course, venture capitalists are betting that Ethereum has the power to usher in an era of decentralized finance, or DeFi. Perhaps no one has made a bigger effort than Andreessen Horowitz, who has raised a staggering $7.6 billion to invest in crypto startups. The funny thing is, for all the revolutionary fervor of startup founders and their venture capital benefactors, DeFi is leaning on TradFi for growth. Leading DeFi lenders such as Aave and MakerDAO, which have a combined $12 billion in deposits, are pouring resources into putting bonds, loans and other “real-world values” on blockchain networks. In January, Société Générale’s crypto unit made a $30 million loan to its parent bank using a stablecoin issued by MakerDAO.
On February 23, a Berlin-based crypto exchange called Swarm Markets did them all one better by releasing tokens representing the shares of Apple, Tesla and US Treasury bond exchange-traded funds. Swarm, which is regulated by BaFin, Germany’s regulatory authority, plans to add more “tokenized” shares to its offerings in the coming months.
It remains to be seen whether the mix between DeFi and TradFi will catch on and become industrialized. But the result is that, despite crypto’s annus horribilis, institutions are still hungry for DeFi. This is a boon for a difficult industry, but the strategy will not work without compliance with anti-money laundering and know-your-customer regulations, as well as registration with the likes of the SEC.
If crypto entrepreneurs can make peace with this reality, it could mark the moment when the industry transforms from a lawless playground to a sustainable business.
