What’s in Store for Crypto Regulations?

Journal of Financial Planning: March 2023

Ivory Johnson, CFP^®, ChFC, is the founder of Delancey Wealth Management, LLC. Mr. Johnson has a B.S. in finance from Penn State University, has been certified by the Digital Asset Council for Financial Professionals, and is a member of the CNBC Financial Advisor Council.

Regulations are the double-edged sword of commerce, a complicated mix of necessary safeguards and infuriating bureaucratic mandates that make the markets go ’round. Last year, cryptocurrencies found themselves thriving in a world of innovation and get-rich-quick bonanzas that captured the imagination of institutions and bitcoin bros alike. Investors have since learned that the devil is indeed in the details and that the devil charges one hell of a hard bargain. What we can expect in response are regulations that corral behaviors that government agencies find harmful to the consumer.

The most recent crypto calamities that highlight the need for regulations are not restricted to digital assets, so it’s worth reviewing past indiscretions to add context. Despite numerous regulations from the Securities and Exchange Commission, Commodity Futures Trading Commission, FINRA, and other agencies intended to protect the public from morally bankrupt actors, impropriety still flourished in the traditional markets.

Pre-Digital Asset Indiscretions

MFS Global was a commodities brokerage firm headed by Jon Corzine, a former United States senator and state governor. It boasted both farmers and hedge funds as customers and financed its balance sheet by posting European bonds as collateral while paying back the creditors when the debt matured. As luck would have it, inadequate capital coupled with a short time horizon limits one’s ability to profit from mispricing, and once the margin calls came in, $1.2 billion in customer money went missing.¹

Long Term Capital Management was a bond arbitrage shop that believed changing interest rates were not priced in and engaged in interest rate swaps. Apparently, small spreads require leverage, and before its collapse, the firm had about $5 billion in assets under management, borrowed money to control over $125 billion, and with the use of derivatives had invested positions worth an estimated $1 trillion.² By the time Russia defaulted in 1998, LTCM had 5 percent of the global fixed income market³ that required a $365 billion bailout.⁴

Despite these historic collapses, other traditional markets were subsequently tainted by leverage and poor risk management protocols. After Lehman Brothers underwrote billions of dollars in mortgage-backed securities worth more than its shareholder value and wiped out $46 billion,⁵ the sort of thing that happens when you’re leveraged 30:1,⁶ greater oversight was warranted, and the Dodd-Frank Act was born.

Crypto Crash

The cryptocurrency market is still in its infancy, lacking the infrastructure and compliance procedures to protect customers from bad business models and theft. The first canary in the coal mine came in the form of Celsius, a crypto lending company that allowed investors to stake their coins and generate a yield on the asset. During the bull market, they could offer customers extremely high returns because borrowers were massively interested in borrowing cryptocurrencies. Bulls and bears made money, but this pig got slaughtered once the value of cryptocurrencies dropped and the company didn’t have enough liquidity to satisfy withdrawal requests. It turns out that high yields for the customers delivered razor thin margins and not enough cushion for Celsius to withstand the storm.⁷ As a consequence, regulators are becoming more aggressive, with the SEC recently charging Genesis Global Capital and the cryptocurrency exchange Gemini for selling unregistered securities to investors through Gemini’s Earn crypto asset lending program.⁸

If these sordid business models are starting to sound familiar, it’s because they are. FTX was an unregulated centralized exchange that minted an unlimited supply of a token that was not backed by anything of value. These instruments were owned by very few investors, leveraged, and then used as a reserve on its balance sheet.⁹ Misappropriating client funds to invest in other projects was just the icing on the cake.

So where does all of this leave the digital asset space? It’s worth noting that European and Russian bonds were not outlawed any more than mortgage-backed securities were laid to rest. What will likely ensue is a set of guardrails and government oversight that will make the industry more palatable to politicians, government agencies, and institutional investors.

The most pressing task is to define the character of each coin and determine the most applicable government agency. To be clear, the Office of the Comptroller of the Currency (OCC) supervises all national banks and would oversee digital assets that are considered currencies, the SEC supervises securities, the Financial Crimes Enforcement Network (FinCEN) is a bureau of the United States Department of the Treasury that collects and analyzes information about financial transactions in order to combat domestic and international money laundering, terrorist financing, and other financial crimes, and the Commodities Futures Trading Commission (CFTC) regulates the U.S. derivatives markets, including futures, options, and swaps. This first order of business is to decide what bucket each digital asset belongs in.

An investment is considered a security if it passes the Howey Test, which states that an investment contract exists if there is an “investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.” Bitcoin is decentralized and the SEC has already ruled that it is not a security. In fact, SEC Chair Gary Gensler has reiterated his claim that bitcoin is a commodity, likely because it has emerged as a store of value or tool for speculation. Others claim that because many commodities are mined, bitcoin fits the description.

Things are less clear for other well-known digital assets. The bitcoin blockchain operates on “proof of work,” a consensus mechanism where computers solve complicated math equations to validate a transaction and in turn receive bitcoin for their efforts. This requires a lot of computer power and takes additional time to execute a transaction relative to other methods.

Ethereum uses “proof of stake” because it is more secure, less energy-intensive, and better for implementing new scaling solutions. In this instance, cryptocurrency owners validate block transactions based on the number of staked coins. While proof of work requires miners to solve cryptographic puzzles, proof of stake requires validators to hold and stake tokens for the privilege of earning transaction fees.

This dynamic will challenge the way regulators see coins such as Ethereum that operate with proof of stake because the SEC may claim that investors who stake coins are making money from the efforts of others, making the case that its blockchain is not decentralized at all. For what it’s worth, the SEC brought a lawsuit against Ripple Labs, Inc., creator of the XRP token used predominantly to consummate international transactions, alleging that the company engaged in the unlawful offer and sale of securities in exchange for cash and other consideration because purchasers of XRP invested in a common enterprise.¹⁰

These matters have been addressed in the White House Executive Order on Ensuring Responsible Development of Digital Assets,¹¹ which contained clear indications that a regulatory framework was forthcoming. The order described the willingness of the White House to pursue a coordination of different agencies, protection against fraud, cyber securities risks, and anti-money laundering efforts.

The order also enumerated the benefits of a CBDC (central bank digital currency), stating a desire to “reinforce United States leadership in the global financial system and in technological and economic competitiveness, including through the responsible development of payment innovations and digital assets.” A CBDC is a digital representation of fiat currency and does not address the concerns of purchasing power in the face of profligate spending and subsequent borrowing, but in the words of the White House allows the United States to lead the way on innovation and maintain the dollar’s prominence in global transactions and “promote United States economic interests.”

It’s believed that a CBDC would also “support efficient and low-cost transactions, particularly for cross-border funds transfers and payments, and to foster greater access to the financial system, with fewer risks posed by private sector-administered digital assets.” This speaks specifically to the unbanked and underbanked who rely on costly alternative financial service options.

In a September amendment to the order,¹² the White House states that “roughly 7 million Americans have no bank account. Another 24 million rely on costly nonbank services, like check cashing and money orders, for everyday needs.” Theoretically, a CBDC would allow these individuals to circumvent expensive options.

Other areas that were addressed include privacy and the environmental impact of mining. Moreover, the president requested an assessment of whether legislative changes are required to pursue a CBDC, a strategic plan for the Federal Reserve, the pros and cons of amending the bank secrecy laws, and a report on the role law enforcement would play in detecting, investigating, and prosecuting criminal activity related to digital assets.

The Lummis-Gillibrand Responsible Financial Innovation Act addresses these concerns in addition to tax treatment, staking, custody protections, jurisdiction, bankruptcy treatment, enforcement, stable coins, and respective timelines. The bill, if passed, would favor the CFTC as the industry watchdog, and would make purchases under $200 tax-free—potentially paving the way for crypto to be used more like digital cash than digital gold.

FTX may be a blessing in disguise having laid bare the need for rules that benefits the space as it matures into an asset class embraced by more households. Regulations are likely to be welcomed by investors because it creates public confidence and offers more certainty to prospective institutional participants. This, in turn, may pave the way for a spot bitcoin ETF that replaces today’s clumsy and inefficient retail options.

This ball is now in the hands of Capitol Hill, the deathbed of common sense and compromise. Fortunately for the digital asset market, there is money on the table, or in this case the computer, that should motivate all parties involved. 

Delancey Wealth Management and Vanderbilt Financial Group are separate and unaffiliated entities. Vanderbilt Financial Group is the marketing name for Vanderbilt Securities, LLC and its affiliates. Securities offered through Vanderbilt Securities, LLC. Member FINRA, SIPC. Registered with MSRB. Clearing agent: Fidelity Clearing & Custody Solutions. Advisory Services offered through Consolidated Portfolio Review. Clearing agents: Fidelity Clearing & Custody Solutions, Charles Schwab & TD Ameritrade. Insurance Services offered through Vanderbilt Insurance and other agencies. Supervising Office: 125 Froehlich Farm Blvd, Woodbury, NY 11797. 631-845-5100. For additional information on services, disclosures, fees, and conflicts of interest, please visit www.vanderbiltfg.com/discl.

Bitcoin and other cryptocurrencies are a very speculative investment and involve a high degree of risk. Investors must have the financial ability, sophistication/experience, and willingness to bear the risks of an investment, and a potential total loss of their investment. Information provided here is for informational purposes only and is not intended to be, nor should it be construed or used as investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest in cryptocurrency. An investment in cryptocurrency is not suitable for all investors. Past performance is no guarantee of future results. All investments involve risk and may lose value. There is no assurance that the objectives of any strategy will be achieved. No strategy can guarantee a profit or fully eliminate the risk of loss.

Endnotes

1. Hilzenrath, David S. 2012, February 6. “Trustee Says MF Global Sustained Itself on Customer Funds.” Washington Post. www.washingtonpost.com/business/economy/trustee-says-mf-global-sustained-itself-on-customer-funds/2012/02/06/gIQAHFQCvQ_story.html.
2. Lowenstein, Roger. 2001. When Genius Failed: The Rise and Fall of Long-Term Capital Management. Random House trade paperbacks.
3. Hastert, J. Dennis. 1999, April 28. “Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management: Report of The President’s Working Group on Financial Markets.” www.cftc.gov/sites/default/files/tm/tmhedgefundreport.htm.
4. Yang, Stephanie. 2014, July 10. “The Epic Story of How a ‘Genius’ Hedge Fund Almost Caused a Global Financial Meltdown.” Business Insider. www.businessinsider.com/the-fall-of-long-term-capital-management-2014-7.
5. American Bankruptcy Institute. 2019, January 22. “Total Estimated Cost of Lehman’s Chapter 11 Comes to $46–63 Billion.” www.abi.org/newsroom/chart-of-the-day/total-estimated-cost-of-lehmans-chapter-11-comes-to-46-63-billion.
6. Berman, Karen, and Joe Knight. 2009, September 16. “Lehman’s Three Big Mistakes.” Harvard Business Review. https://hbr.org/2009/09/lessons-from-lehman.
7. Kharif, Olga. 2022, July 5. “What’s Crypto Lending, and What Happened With Celsius?” Washington Post. www.washingtonpost.com/business/whats-crypto-lending-and-what-happened-with-celsius/2022/07/05/945bb104-fc56-11ec-b39d-71309168014b_story.html.
8. Michaels, Dave, and Vicky Ge Huang. 2023, January 12. “SEC Sues Crypto Firms Genesis and Gemini Over Lending Product.” Wall Street Journal. www.wsj.com/articles/sec-sues-crypto-firms-genesis-and-gemini-over-lending-product-11673561423.
9. Sigalos, MacKenzie. 2022, November 8. “FTX’s Token Plunges 80% On Liquidity Concerns, Wiping Out over $2 Billion in Value.” CNBC. www.cnbc.com/2022/11/08/ftxs-ftt-token-plunges-80percent-wiping-out-over-2-billion-in-value.html.
10. U.S. Securities and Exchange Commission. 2020, December 22. “SEC Charges Ripple and Two Executives with Conducting $1.3 Billion Unregistered Securities Offering.” SEC Press Release. www.sec.gov/news/press-release/2020-338.
11. The White House. 2022, March 9. “Executive Order on Ensuring Responsible Development of Digital Asset.” www.whitehouse.gov/briefing-room/presidential-actions/2022/03/09/executive-order-on-ensuring-responsible-development-of-digital-assets/.
12. The White House. 2022, September 16. “Fact Sheet: White House Release First Ever Comprehensive Framework for Responsible Development of Digital Assets.” www.whitehouse.gov/briefing-room/statements-releases/2022/09/16/fact-sheet-white-house-releases-first-ever-comprehensive-framework-for-responsible-development-of-digital-assets/.