Will new regulation destroy the crypto rebound?

In the wake of the crypto exchange meltdown FTX (FTT -0.80%)it is almost certain that more regulation will come to the crypto industry in 2023. Almost everyone agrees that this new arena needs a comprehensive regulatory framework that clearly outlines the rules of the road for the market players and also protects against bad actors.

The only question, of course, is how aggressive US regulators will be when it comes to reining in some of the excesses of the crypto industry. If regulators act too aggressively, it could destroy the crypto rebound.

Are cryptocurrencies actually securities?

The big question at the heart of almost every crypto debate is what type of financial asset cryptocurrencies actually are. This may sound like a simple question to answer, but it has confused the industry for years. Are cryptocurrencies an entirely new type of asset? Or is crypto similar to existing assets, such as foreign currency and securities?

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If cryptocurrencies are currencies, they should be regulated by the Commodity Futures Trading Commission, which has regulatory oversight over the derivatives market, including currency derivatives such as futures, options and swaps. However, if cryptocurrencies are securities, they should be regulated by the Securities and Exchange Commission (SEC) under existing securities laws. The SEC has already deemed that just about all cryptocurrencies — with the possible exception of Bitcoin (BTC 1.09%) — should be regulated as a security.

As JPMorgan pointed out in a recent research report, the SEC has taken a leading role on this issue, and that means it looks more and more like the cryptocurrency-is-value argument is going to win. Most notably, the SEC has suggested that even Ethereum (ETH 1.00%), the second largest crypto by market capitalization, should be regulated as a security. That would have potentially profound implications for other coins and tokens, given the SEC’s broad ability to take enforcement action against unregistered securities.

Impact on crypto innovation

In addition, new regulation could have a chilling effect on crypto innovation. Right now, regulators are evaluating various products and services offered by crypto market intermediaries. For example, the SEC has taken the position that crypto-staking products—a new form of passive income made possible by proof-of-stake blockchain technology—are actually a form of securities offering. Recently, it led the SEC to crack down on cryptocurrency exchange Kraken, which offered crypto staking services to its retail client base.

And crypto betting may not be the only innovation at risk. The $137 billion stablecoin market is under more regulatory scrutiny than ever. Stablecoins are key to bridging the worlds of traditional finance and decentralized finance (DeFi), which is why regulators are concerned they could provide a path for financial contagion to spread from the crypto market to the stock market and beyond.

In 2022, stablecoin venture Terra Luna (LUNA 0.49%) collapsed, and the prevailing feeling now is that perhaps some stablecoins are not as “stable” as originally thought. Recently, the SEC has hinted that it may initiate an enforcement action against cryptocurrency exchanges Binance (BNB -0.24%) and its stablecoin, Binance USD (BUSD -0.18%).

What to do with regulatory risk?

For retail investors, investing in cryptocurrency has always involved a certain amount of volatility and risk. Now there is also a lot of regulatory risk. It is more important than ever to invest in cryptocurrencies that can minimize that risk. It’s also important to pay attention to what’s happening in Washington, where lawmakers and regulators are trying to figure out the way forward for the crypto industry.

Of course, the worst case scenario would be an outright ban on crypto. In a recent The Wall Street Journal op-ed piece, Berkshire Hathaway (BRK.A 0.35%) (BRK.B 0.17%) Deputy Charlie Munger argued for exactly this scenario, so a ban is not out of the question. The best-case scenario would be to transfer crypto regulation to the CFTC, which has taken a much more crypto-friendly approach to regulatory oversight.

For now, however, the most likely scenario seems to be that the SEC takes the lead on crypto regulation and that lawmakers in Washington will follow the SEC’s lead. This means that the crypto-ecosystem may begin to look much more like the traditional financial system, and that cryptocurrencies will be largely regulated as securities. If you have a long-term view of the crypto market, it’s time to prepare accordingly.