Crypto’s Illness: Regulatory Reluctance

The U.S. crypto industry has been learning a rough lesson in regulatory compliance in the past few months. With fines, cease and desist orders, agency warnings, and traditional finance counterparties withdrawing from the industry, it is becoming increasingly apparent that crypto has a compounding problem.

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The origin of this isn’t FTX, Voyager Digital, Terra Luna, or any other of the business failures or frauds of 2022. Those are symptoms of another disease. The sickness that’s causing crypto to fumble in front of U.S. regulators and counterparties goes all the way back to the founding principles of Bitcoin and  some of its most prominent industry players.

Crypto, from its inception, was built as an anti-regulatory, anti-enforcement, censorship resistant technology. It’s debatable whether it achieves any of these goals, but this was its founding philosophy and it drives a lot of the decision making in crypto board rooms to this day — that is the sickness that needs to be cured.

What crypto decision makers are finding is that governments and regulators don’t appreciate attempts to subvert established norms. They’re also finding that established laws and norms apply to their novel forms of transactions and regulators are not shy about enforcing these rules and doing what they must to protect what they view as their turf.

For example, in recent months, we’ve seen the sanctity of decentralization challenged in the CFTC vs. Ooki DAO case; staking challenged in the SEC settlement with Kraken; and stablecoin issuance being challenged by the SEC as of mid-February’s disclosed investigation into Paxos.

More pillars will fall. Pending lawsuits will clarify whether token issuance is a regulated activity. The little-noticed CFPB investigation into Nexo will likely prove that crypto providers are regulated under the Consumer Financial Protection Act and Regulation E – which means they must comply with UDAAP (UDAP) requirements under The Dodd-Frank Act and transaction settlement requirements under the Electronic Funds Transfer Act. This investigation could be the CFPB’s first crypto related enforcement action and would set a precedent for every crypto company’s marketing, disclosure, and consumer protection frameworks as well as their transaction processing.

The collapse of FTX and others—including Celsius, where I worked and which I have harshly criticized—may not have been the origin, but it is a spasmodic symptom. What was missing with FTX can be found in existing U.S. regulations: e.g. capital controls, regulatory monitoring and oversight, consumer protections, reporting requirements, bookkeeping requirements, governance requirements and other controls that would have either made the fraud more difficult or made it more evident. FTX, however, could have been perpetrated without crypto. As its new CEO said, it was a case of “old fashioned embezzlement.” But it was the company’s desire to evade stricter regulations that drove it to set itself up in a jurisdiction with lightweight regulatory controls.

Again, the sickness is the anti-regulation mindset.

Crypto was meant to foster financial inclusion and promote a path to financial openness via the publicly available blockchains. However, it contradicts these goals by resisting adequate financial disclosures – this excludes anyone who wants to clearly understand a financial product before using it. Opacity leaves room for abuse, like in the FTX fraud. One would think crypto industry leaders would reconcile this reality and try to do better.

Crypto decision makers who pay lip service to the need for regulatory clarity don’t seem to want to actually be regulated or know what the purpose of financial regulations are. To put it briefly, financial regulations are meant to prevent the abuse of the financial system – either by actors who provide inadequate and inappropriate financial services or by those who intend to use it for criminal means.

We’ve seen this recent resistance from the largest U.S. crypto provider, Coinbase. Both the CEO and Chief Legal Officer have attempted to contradict the SEC’s conclusions in the Kraken case. The CEO tweeting his opposition before the charges were made public and displaying his ignorance of the facts of the case and the law. This wasn’t accidental. It’s clear that he doesn’t want to be regulated under securities laws.

As the SEC Chairman stated in interviews following the Kraken settlement, it is simple for companies to register with the agency to provide what they call staking. Staking is paying interest on deposits, and Coinbase provides this staking service. They try to explain away their unregistered investment product with crypto buzzwords like decentralization, but it seems to be very provable that Coinbase staking is an investment contract and as such is a security.

Given that Coinbase is a public company and already beholden to SEC reporting requirements, it’s difficult to understand their resistance to registering, reporting, and providing public disclosure regarding how the yield on their staking product is generated. One can only conclude that they don’t want to do it, not that it would be any sort of operational or cost-inefficient burden.

Crypto will have to continue to learn expensive lessons until it realizes that it is providing regulated services in the United States. While other countries, and one specific regulator in the U.S., FinCEN, have provided regulatory clarity via specific frameworks or documented guidance, the broader U.S. regulatory apparatus has spoken with one clear voice and said, no new rules, no guidance, just comply with existing rules. It would be in the crypto industry’s best interests to take this hint. It is far less expensive to pause an offering, assess it and apply to register with agencies than it is to absorb multi-million-dollar fines. The problem is that the decision makers in crypto do not want to do this.

It is a problem to ignore regulation because the regulators aren’t ignoring the industry. They are issuing fines, cease and desist orders, and threatening crypto’s ability to exist as a normal financial service. Crypto’s anti-regulation sickness may prove to be a terminal disease if they do not change this mindset.