Stress Testing Crypto – A New Era of Regulators is About to Begin

I’ve always been bullish on crypto. Not necessarily as a short-term speculative investment strategy but because of its promise to accommodate many future aspects of personal finance. The industry and some of its products have had some pretty spectacular ups and downs in the past five years, but I tend to think of them as growing pains and learning experiences.

Recently, the crypto exchange FTX made a series of bad decisions that have blown up in its face, and almost instantly, it faced a run on its assets, a run it couldn’t accommodate. To be fair, FTX in the recent past, has stepped in to rescue lesser, smaller crypto organizations in similar straits, providing the liquidity these companies needed to weather their predicaments and protect their customers and investors. But in doing so, FTX founder Sam Bankman-Fried also put his own company at risk.

When FTX faced its own liquidity crisis due to those bailouts and some other questionable moves by its affiliated trading firm Alameda Research, FTX proved NOT to be too-big-to-fail, and saviors were nowhere to be found. Few exchanges were large enough to step in to save it. Binance, a fierce competitor of FTX, took some furtive steps in that direction but quickly backed off, realizing no doubt that they might be caught up in the same quicksand. Another exchange, OKX, declined to step in as well.

Like similar episodes in this market, the FTX tale provides lessons to build on. And one of the lessons is that there are regulatory gaps in the industry. But if these are addressed thoughtfully and correctly, the fixes can sustain this industry.

Ironically, the trigger for this whole debacle was Sam Bankman-Fried voicing a pro-regulatory stance and Binance CEO Changpeng Zhao taking exception to his position. This is a feud that practically guarantees a greater regulatory presence.

Regulatory reform can be good to a point, but it’s a very slippery slope away from turning crypto into something that looks like another heavily regulated banking industry.

Achieving Regulatory Balance

If crypto is going to become an everyday commodity for the majority of people in this world, which I think is inevitable and good, it will need to step out from the shadows and into the light of day.

Too many early crypto enthusiasts basked in the counter-culture aspect of it – a wild, wild west with supposedly foolproof systems of self-policing and security based on the immutability of the blockchain. They loved being smarter than the rest of us.

While we owe a lot to these early adopters, it’s still a long way from reaching everyday widespread use. For many, it still exudes geekish interfaces and a confounding vocabulary that keep the common people away.

The mainstreaming of crypto will never happen until the public stops reading scary stories about failing exchanges, crypto crashes, paper losses in the billions of dollars, and market hyper-volatility.

The U.S. and other world governments now feel that they need to step in and assume a more active role. That may be seen as an unwelcome intrusion into the libertarian-minded entrepreneurs’ world that currently manages cryptocurrencies and exchanges and want to take us to the next level.

The Challenge of Regulating Cryptocurrency

Regulating crypto will be tricky. FTX was based in the Bahamas, so more stringent U.S. regulatory standards, had they been in place, would likely not have made a difference. Ever since the days of Swiss bank accounts, investors have sought havens in low oversight, distant international environments.

But operating inside the regulatory gaps of other countries will work against crypto in the long run. Will the average novice crypto user, the kind that needs help with their mainstream financial tools, trust their transactions and retirement savings to a financial house of cards based in the Bahamas? Not likely.

If crypto is to be an accepted retirement savings tool, for example, it has to be seen as relatively safe, over a long period of time, by the average person, not just the crypto enthusiast. When a crypto organization can demonstrate it’s subject to and complying with the laws and rules of the U.S. government, it not only provides investor assurance, it can also be a selling point.

That’s why I find it so interesting that Abra, a well-known crypto exchange and lending platform, is planning to launch the first U.S.-regulated crypto bank early in 2023.

The Crypto industry in the U.S. is already more regulated than in most other countries. The Security and Exchange Commission has taken bites at that apple based on how crypto can be considered a security in some cases. The Commodities Futures Trading Commission also is very interested in this space, given the commission’s purview of regulating futures and commodities trading.

Policymaking is messy, to begin with, especially in cases where generalist policymakers try to keep up with technical innovation. Regulators are better informed on emerging crypto applications than all but a handful of members of Congress and committee staff. That’s why, in the world of Washington, things work best when policymakers give broad policy guidance and limited authority to specialized regulators who flesh out the details, subject to oversight.

Consumer Education

We’re seeing some progress in making consumers familiar and comfortable with cryptocurrency and exchanges, thanks to campaigns and products even a boomer can understand. But we need to be even more active on that front end as well.

Our K-12 education system and curricula are falling short in a number of areas – from history to civics to economics. Today’s fifth grader is tomorrow’s consumer and investor. They need to understand their currency and investment/savings options. That includes the underpinnings of cryptocurrency – not just how the app works.

And crypto companies need to accept the fact that their industry is only as strong and legitimate as their weakest link. U.S. regulators, whether the SEC or other appropriate agencies, need to act fast so that U.S.-based crypto products and exchanges are seen as the gold standard (no irony intended!) in the world and, thus, the most attractive for users and investors.

The major players in crypto are now far too beat up to truly resist the drumbeat of regulation, as a new era of crypto is about to begin. And if regulators aren’t able to rein in riskier players in this sector, the market will – as evidenced in recent weeks.

That said, we run the risk of over-regulating and potentially killing many of the emerging technologies in this space that are now percolating to the top.