Aug 18, 2023

Guardrails, Progress and Regulation–What's Next?

Bitcoin Macro

Will crypto develop with prudent guardrails, or will overzealous oversight stifle progress? The coming months will prove pivotal in determining the optimal path forward. Part 2 of our look into regulation, with thoughts on Ether ETFs and more.

The past year has seen hashtag#securities hashtag#regulators dramatically escalate oversight and enforcement actions against the hashtag#crypto industry. This crackdown gained momentum after the collapse of major players like hashtag#FTX, hashtag#Celsius, and hashtag#Voyager Digital. However, critics argue some cases demonstrate overreach and may ultimately harm investors.

Recent charges against exchanges like hashtag#Coinbase and hashtag#Kraken over staking services highlight the SEC’s expansive interpretation of securities laws. In February, Kraken paid $30 million to settle claims its staking offerings were unregistered securities. Likewise, the hashtag#SEC sued Coinbase in June over its staking products. Crypto advocates argue staking is a network utility, not an investment vehicle. But the SEC maintains platforms like Kraken emphasize profit potential, requiring securities registration. While investor protection has merits, a lack of legislative clarity on crypto staking creates uncertainty.

The SEC has also targeted specific crypto projects and founders for allegedly illegal token sales. In July, it sued Richard Heart, founder of Hex and PulseChain, over $1 billion raised through purportedly unregistered offerings. Heart claimed Hex was the "highest appreciating asset ever," prompting charges he offered unlicensed securities. Similarly, the SEC sued Celsius CEO Alex Mashinsky in July. It alleges Celsius ran an unregistered securities scheme, while Mashinsky faces criminal fraud charges. This exemplifies the SEC’s aim to hold individuals accountable alongside corporate entities.

Targeting individuals signals an aggressive stance by regulators, which we think is a positive move. The SEC sued Terraform Labs founders Do Kwon and Daniel Shin over allegedly misleading claims related to failed stablecoin hashtag#TerraUSD. This expands accountability beyond corporate entities to personal liability. Similarly, charges against FTX founder Sam Bankman-Fried for defrauding investors highlight this trend of pursuing individual accountability. The SEC and DOJ are building cases against Bankman-Fried after FTX's collapse caused billions in investor losses. DEBT Box operators were accused of defrauding investors of $49 million and barred from soliciting more funds, in the SEC's ongoing effort to stamp out crypto investment schemes.

The regulator has also pursued lending platforms like BlockFi. While it argues these cases protect investors, imposing large fines right before bankruptcies may actually reduce creditor recoveries. For example, BlockFi agreed to pay a $50 million SEC fine in February 2022. But after BlockFi filed for bankruptcy in November, it became clear this penalty would subtract funds from reimbursing customers. The SEC wisely postponed collecting the remaining $30 million until after clients receive repayments. However, rigidly enforcing fines assessed before collapses seems counterproductive. The SEC should consider prioritizing creditor recoveries over disciplinary penalties with troubled firms. We argue that the same should apply to Genesis, Gemini, Celsius and others, with the SEC seeking to take all money from the founders and return it to investors.

In addition to exchanges and projects, the NYDG is investigating the Digital Currency Group and its CEO Barry Silbert. This relates to DCG’s lending arm Genesis and its dealings with failed hedge fund Three Arrows Capital. Probes like this demonstrate the US' intent to regulate the entirety of crypto finance. Likewise, reported DCG investigations over potential conflicts of interest and unregistered securities dealings indicate increased scrutiny of crypto corporations' practices. As regulators expand oversight, companies face growing pressure to ensure diligence and compliance.

The SEC's probes into smaller crypto sector players like BarnBridge and Quantstamp highlight the wide net regulators are casting across the digital asset industry. For example, the SEC recently charged blockchain auditing firm Quantstamp over $3 million for raising 28m in an allegedly unregistered token sale in 2017. Likewise, the SEC investigation into the tiny DeFi protocol BarnBridge demonstrates that no corner of crypto finance is immune from potential enforcement actions. While BarnBridge and Quantstamp seem odd targets given their small scale, these cases signal SEC intent to comprehensively police crypto by holding even minor startups accountable for compliance. They underscore the reality that in the current regulatory environment, the entire crypto sector faces enhanced oversight.

These cases exemplify coordinated regulatory pressure across the SEC, CFTC, DOJ and IRS to rein in crypto markets. Supporters argue oversight protects investors and deters fraud. But critics contend "regulation by enforcement" lacks clarity and stifles innovation. More tailored legislative frameworks could allow crypto to thrive responsibly onshore rather than continuing offshore. For example, IRS guidance treating staking as taxable income provided helpful clarity. Compliance-minded rules like this aid adoption versus rigid statutes.

However, questions persist on applying dated statutes versus modern legislative frameworks tailored to digital assets. The SEC relies on broad existing authorities to claim jurisdiction. But crypto firms argue these decades-old laws don't explicitly empower regulation of areas like staking. While judges have sided with the SEC so far, calls remain for balanced regulations promoting responsible innovation.

The key issue right now is that for years the SEC has done nothing to deal with real fraud, while massive fraud happened under its watch. The space desperately needs clear regulation, as other countries are much further ahead, while US investors are continuously hurt by the inaction and indecision of US authorities. We don’t think that dealing with small but legitimate projects will help investors. The real issue is going after extremely fraudulent projects, not pursuing projects that haven't exit-scammed.

In our opinion, we expect the SEC and CFTC to sue many more companies, essentially all non-US exchanges that allowed US individuals to trade on their platforms. More recently, Kucoin and Bybit shifted toward compliance by imposing KYC on their exchanges. We believe more exchanges will follow suit, and we believe that US authorities have been monitoring all these exchanges. We believe that most of them have conducted some sort of illegal activity, and most of them will have to deal with the consequences of that, the same way Binance is dealing with it. It just happens that the US agencies are moving at a glacial pace, however we think they will accelerate soon, in order to pave the way for a Bitcoin ETF. Once they sort out extreme crime, fraud and they have dealt with the most high profile cases, we think an ETF will be approved.

The SEC has not only failed to adequately address fraud, but its actions have actually harmed the public by approving problematic products. The Grayscale Bitcoin Trust was an example of a concerning product that ended up damaging some investors. Similarly, the SEC initially approved Coinbase's business model but later began fining and suing the company over the same model, which hurt Coinbase investors. The approval of Bitcoin futures ETFs near market tops rather than spot Bitcoin ETFs also cost investors, as the futures ETFs dropped 10-20% more than spot Bitcoin. Now the SEC is poised to make a similar mistake with an Ethereum futures ETF. While some argue an Ethereum futures ETF would provide institutions exposure, it is inferior to a spot ETF. However, the futures ETFs may pave the way for eventual spot ETFs. We believe that after a spot Bitcoin ETF is approved, along with an Ethereum futures ETF, an Ethereum spot ETF will follow.

Overall, the regulatory reckoning will likely require balanced legislation alongside continued aggressive enforcement. Crypto advocates seek tailored rules allowing responsible innovation, but regulators remain intent on subsuming digital assets under traditional frameworks.

How this clash unfolds will profoundly shape cryptocurrency's future trajectory in the United States. Will crypto develop with prudent guardrails, or will overzealous oversight stifle progress? The coming months will prove pivotal in determining the optimal path forward.

Bitcoin Macro

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