Illustration by II
Under siege.
That’s how it feels inside the cryptocurrency industry these days, as U.S. authorities slap numerous players with indictments, lawsuits, fines, and orders to shut down various offerings. Even stablecoins, the relatively straightforward assets backed by U.S. dollars, have been targeted.
After a year in which the crypto market lost about two thirds of its value and the failure of FTX shattered the trust of investors, the clampdown is roiling the industry. Yet this may be exactly what the industry needs if it’s going to shed its grandiose dream of technological revolution and become something viable — a business, or, more precisely, a trustworthy business.
Fourteen years after the advent of Bitcoin, the cryptocurrency industry is still struggling to prove its usefulness. Bitcoin did not become new “rails” for processing payments, and owing to its correlation with stocks, it failed as a hedge for inflation and monetary policy during the latest rate cycle. Meanwhile, Ethereum, the network for “smart contracts” that is supposed to reshape finance, needs a series of upgrades over the next few years to demonstrate it can process transactions in volumes anywhere close to what Visa does.
It’s 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 folk as a scourge, may be doing the industry a mammoth favor by cleaning it up.
But what does a cleaner crypto industry look like? If you strip away the drama from crypto, what are you left with? A day-trading game? A hobby for Bored Ape aficionados? Or does the original proposition, that blockchain technology can change financial infrastructure, still hold up? 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 may be the source of stability crypto needs.
But first, the regulatory onslaught. This moment has been a long time coming. Gary Gensler, the chair of the U.S. Securities and Exchange Commission, has been urging the industry to get right with securities laws and come “inside the perimeter” since 2021. He’s not bluffing. In no uncertain terms, the Biden administration has done what crypto mavens long feared: It has defined cryptocurrencies in virtually all their forms as securities or investment contracts. As any CFO knows, this means issuers of digital assets must register their offerings with the SEC and comply with the same disclosure and customer protection requirements that govern traditional capital markets participants. In other words, cryptocurrencies are the same as stocks and bonds.
“It’s really not that complicated,” says John Reed Stark, the former chief of the SEC’s Office of Internet Enforcement. “Register like anyone else.”
It may sound rather prosaic, but for the crypto community this is fire-and-brimstone stuff. The entire industry was predicated on not needing the state or, for that matter, central banks, commercial banks, and other “intermediaries.” Ever since Bitcoin picked up mojo a decade ago, crypto leaders have insisted their industry should float outside the conventional controls of the traditional marketplace. Thanks to a decentralized online model, blockchain-based ventures were “permissionless,” or self-regulating.
This conceit evaporated when Sam Bankman-Fried, the indicted co-founder and CEO of FTX, allegedly plundered customer deposits to cover billions of dollars in losses at his hedge fund. Even seasoned pros were aghast. At a recent crypto conference in St. Moritz, Switzerland, Philippe Bekhazi, head of crypto trading firm XBTO Group, said depositing money in an exchange like FTX was no different than giving the company an interest-free loan with no accountability, or recourse, save the bankruptcy courts.
Stark says the dearth of controls in the crypto industry was bound to spark a reckoning. “Trust is nonexistent; there’s no oversight, no audits, no inspections, no net capital requirements, and no rules against commingling customer funds,” notes the former SEC official, who is now a consultant.
This month, the Feds laid down 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 discontinue one of its products in a settlement with the SEC. The problem: The company had not registered its staking service — a burgeoning business that lets investors earn returns by providing their tokens to “validators” who tend blockchains. Kraken undoubtedly believed staking should not be treated the same as an equity or fixed-income offering. 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 firms may scramble to get the toothpaste back into the tube. “Staking-service providers, including many crypto asset exchanges, should consider whether to halt or restructure their staking programs,” said Wilson Sonsini, a Silicon Valley law firm, in an alert this month.
On February 16, the SEC broadened 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 “an array of interrelated tokens.” In a footnote in the 55-page complaint, the SEC defined a “crypto asset security” as any product that is issued or transferred on blockchain technology. That includes Terraform Labs’ doomed stablecoin, UST.
(The meltdown of this “algorithmic stablecoin” is what triggered the cascade of toxic debt and margin calls that sank a number of crypto platforms last summer and eventually plunged Bankman-Fried’s hedge fund, and FTX, into distress.)
New York State’s 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 asserts that the regulatory crackdown 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, the outrage is running hot across the industry. Crypto Twitter is rife with accusations that the Feds are trying to strangle the sector or drive it offshore. Last year, the industry’s Washington lobby pushed hard for a bill that would craft a statutory and regulatory regime recognizing the sector’s special qualities. This effort appears dead in the water, especially given that FTX’s profligate campaign spending on Capitol Hill during the past two years 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 the financing of terrorism.
Crypto entrepreneurs also suspect the SEC’s demand that they register their tokens is a gambit 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 ruling on Kraken’s staking 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 published on the commission’s website. “In the current climate, crypto-related offerings are not making it through the SEC’s registration pipeline.”
In any event, traditional financial institutions may be the biggest beneficiaries of the Feds’ dragnet. As crypto firms struggle, so-called TradFi companies are leveraging their compliance expertise and practices to move in. On the assets side of the sector, Fidelity Investments is compiling a waitlist of U.S. customers for Fidelity Crypto, a platform that will offer commission-free trading of Bitcoin and Ethereum. The trading platform may compete with the likes of Coinbase and Kraken.
On the software side of crypto, Apollo Global Management, an alternative-assets investment firm with $548 billion under management, is making a push to invest in and develop blockchain as new “tech rails to automate capital deployment.” Christine Moy, the head of digital assets at the firm and a JPMorgan Chase blockchain veteran, explains that the software could make distribution of securities in the marketplace more efficient, among other applications. It would be ironic indeed if a firm like Apollo, which epitomizes Wall Street, made breakthroughs on rebuilding the IT infrastructure of the markets with blockchain technology.
And, of course, venture capitalists are wagering that Ethereum has the power to usher in an era of decentralized finance, or DeFi. Perhaps none has made a bigger bet than Andreessen Horowitz, which has raised a staggering $7.6 billion to invest in crypto start-ups. The funny thing is that for all the revolutionary fervor of start-up founders and their venture capital benefactors, DeFi is leaning on TradFi for growth. Leading DeFi lenders such as Aave and MakerDAO, which together have $12 billion in deposits, are pouring resources into putting bonds, loans, and other “real world assets” on blockchain networks. In January, Société Générale’s crypto unit made a $30 million loan to the 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 bringing out tokens that represent the stocks of Apple, Tesla, and U.S. Treasury bond exchange-traded funds. Swarm, which is regulated by BaFin, Germany’s supervisory authority, plans to add more “tokenized” stocks to its offerings in the months to come.
It remains to be seen if the mash-up between DeFi and TradFi will catch on and industrialize. But the upshot is that institutions, despite crypto’s annus horribilis, are still hungry for DeFi. This is a boon for an embattled industry, yet the strategy won’t 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 their peace with this reality, that may mark the moment when the industry morphs from a lawless playground into a sustainable business.
Read more crypto columns:
- Crypto’s Tax Shelter Problem
- VCs Poured $41 Billion Into Crypto in the Past 18 Months. Is There Any Hope for a Profit?
- The Death of Crypto Has Been Greatly Exaggerated, Again
- The Crypto World Is Raving About the Merge. Here’s the Real Story.
- America’s Much-Vaunted, Mythological CBDC
