Slouching toward Cryptocracy

Update 615 — Slouching toward Cryptocracy
Or Regulatory Reckoning for Neo-Wild West?

The 2022 Super Bowl this past February was an extravagant debut for the far-flung crypto family of securities, currencies, and platforms. But cryptocurrencies such as Bitcoin have plunged in value by more than 52 percent year to date, with pogo-stick volatility and sell-offs by spooked investors. Some big-name investors and firms have imploded grandly. Though cryptocurrencies have gone mainstream as an investment avenue, crypto remains the wild west: untaxed and regulated. 

Are these growing pains or signs of a problem? We have been assuming the former by deferring discussion on investor protections and other crypto regulations. Congress has taken note and has begun to unveil legislative proposals. Today, we analyze the crypto market and attendant problems and discuss the opening for regulatory and legislative options for remedy.

Good weekends, all…

Best,

Dana

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For those not familiar with the crypto market and to contextualize this analysis, here’s a taxonomy, inspired by the New York Times and other crypto commentators:

Assets

  • Cryptocurrencies: Since Bitcoin was first conceived in 2008, thousands of other cryptocurrencies have been developed. Among them are Ether, Dogecoin, and Tether; the latter of which is a stablecoin.
  • Stablecoins: A type of cryptocurrency that is designed to have a stable value (which is typically pegged to an existing government-backed currency). To promise holders that every $1 they put in will remain worth $1, stablecoins promise to hold a bundle of assets in reserve, often short-term securities such as cash, government debt, or commercial paper. There are also decentralized stablecoins with crypto reserves, such as DAI, and algorithmic stablecoins that have no reserves, such as Terra. 
  • Bitcoin: A Bitcoin is a digital token that can be sent electronically from one user to another, anywhere in the world.

Digital Technologies

  • Blockchain: A blockchain is a decentralized database maintained communally and that stores digital information. Blockchains are often used as the basis for creating and exchanging cryptocurrencies and other digital assets.
  • DeFi: The development of cryptocurrencies spawned a parallel universe of alternative financial services, known as Decentralized Finance (DeFi) allowing crypto businesses to move into investment and banking territory, including lending and borrowing.
  • DAOs: A decentralized autonomous organization (DAO) is an organizational structure built with blockchain technology that is often described as a crypto co-op. DAOs form for a common purpose, like investing in start-ups, managing a stablecoin, or buying non-fungible tokens.

Crypto Crash

In early May, the crypto industry felt shocking ripple effects as the TerraUSD (UST) stablecoin lost its pegged value. The reason for UST’s de-pegging is inextricably tied to the LUNA crypto token, which was used as an offsetting asset to help the stablecoin maintain its 1:1 value with the US Dollar. UST and LUNA relied on arbitrageurs to trade the tokens back and forth, but as demand for them fell, trading activity followed and broke the peg. The LUNA token’s value fell by 99 percent following massive transactions that some believe were a targeted attack on the digital asset, and UST’s value fell to as low as 35 cents on the dollar

The pressure against LUNA and UST cascaded to other parts of the crypto market with Bitcoin losing around a quarter of its value. This was exacerbated further when the broader crypto market fell $400 billion over the week. While the crypto industry temporarily stabilized in late May, it was not long before another crash sent the crypto market careening. The crypto crash earlier this week was triggered jointly by Celsius’s exposure to Terra and the Federal Reserve’s interest rate hikes that have tightened financial conditions across the economy by raising the cost of borrowing and exposing over-leveraged firms. 

Financial tightening, the Fed’s new monetary policy, has drawn money out of risky speculative assets like stocks, equities, and crypto compared to safer assets. With many crypto companies relying on ever-increasing asset values and over-leveraging as their business model, financial tightening can spark a death spiral when creditors force a run — exactly what happened with Celsius, which faced a liquidity crisis and was forced to halt withdrawals. The stoppage froze out customers from their crypto assets as they were forced to watch their portfolio values plummet, and they could become unsecured creditors in the event of a Celsius bankruptcy. 

The spiral spooked other crypto investors, causing the entire industry to shrink considerably. Just within the last week, crypto companies have had to lay off thousands of employees, pause merger activity, and prevent withdrawals. The spiral led to Bitcoin losing nearly another third of its value and $2 trillion vanishing from the industry in one week. 

Change in Value Since Nov. 9, 2021: All-Time Highs

Source: Kraken, Wall Street Journal

Ready for Regulation

Both crashes have reignited calls for the industry to face regulations, particularly regarding investor protections. The lack of investor protections in the industry has led to numerous people losing savings that could have gone toward building financial security for the investor and their families. While many knew the risks of the crypto market beforehand, the lack of these protections means those who did not understand the risks are facing severe consequences despite other financial assets having these protections. Multiple additional regulatory considerations need to be addressed:

  • CFTC/SEC Jurisdiction: The SEC can oversee multiple cryptocurrencies currently as securities, but the CFTC can be given spot price jurisdiction over cryptos that act more like commodities. 
  • Stablecoin Regulation: Regulators need to ensure entities that issue stablecoins are not exposing the financial sector to risk via over-leveraging.
  • Banking: The relationship between traditional banks and cryptocurrencies needs to be fleshed out to determine how intertwined traditional financial institutions are with digital assets as well as the privacy of transactions. 
  • Tax Treatment Of Digital Assets: Not taxing gains on crypto could result in hundreds of millions of dollars in missed revenues and provides a loophole for tax evasion, but this must be balanced with privacy safeguards as well. 

A pair of Senate bills have been introduced in the wake of the crypto market crashes to fill the regulatory gap that exists. The first of the bills, the ​​Responsible Financial Innovation Act introduced by Senators Kirsten Gillibrand and Cynthia Lummis is comprehensive, touching on most of the key regulatory issues facing the crypto industry.

The Responsible Financial Innovation Act has received extensive criticism from many public interest reform advocates for granting the CFTC more oversight power by classifying many digital assets as commodities when they should be securities falling under the purview of the SEC, tying stablecoins and the banking industry together, and exempting crypto gains from tax liability. The bill does little to assure investors while putting forward a bill that could be endorsed by industry. 

Meanwhile, taking a narrower approach led by Senate Agriculture Committee Chairwoman Debbie Stabenow and Senate Agriculture Committee Ranking Member John Boozman, a second bill will be dropped soon. It is expected to seek only to define the CFTC’s regulatory authority over spot prices in the digital asset market without intruding on the existing securities framework governed by the SEC. The narrower focus, both in terms of ambition and scope, could appeal to broader swaths of both caucuses without ruffling the feathers of advocates of investor protections. 

While a more progressive crypto regulatory bill would be desired, particularly one that addresses stablecoins, the Stabenow-Boozman bill may turn out to be the best Congress can pass before a Republican takeover of the legislative branch in the next Congress. Passing a bipartisan crypto bill that at least establishes proper agency jurisdiction is the first step toward creating a regulatory regime around crypto that protects investors, consumers, and the broader economy alike from the risks present in the currently unregulated industry. 

Financial regulators already have the authority to act by designating crypto-related activities as unsafe and unsound practices for banks, but legislation would go a long way toward creating a stronger regulatory framework. The necessity for strong crypto regulations is needed now more than ever as tightening financial conditions will create further volatility in the market, harming many investors and consumers alike who do not have the protections necessary to save them from financial disaster. 

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