Regs, Regs, and More Regs
February 2023 Commentary
After a strong January rebound, digital assets rose modestly by just under 2.2% in February. The appreciation was broad based with BTC gaining just 1.45%, while other assets posted larger gains. ETH gained 3.14% with much excitement continuing to build on expectations of its Shanghai upgrade. Macro conditions remain muted, which is a good thing these days after the deterioration the global economy experienced over 2022. For example, US CPI rose 6.4% yoy for January, slightly higher than expectations but eased from the +6.5% reading published for the prior month. Overall recession fears have been waning as anecdotally evidenced by S&P Global Intelligence’s 2023 updated global growth estimate of 2.0%, from a prior forecast of 1.4% made back in Oct 2022. While investors are not expecting central banks to be lowering interest rates anytime soon, hopes abound that the end is in sight for monetary tightening.
Given the shenanigans we witnessed in digital assets over 2022, it may be surprising to see the digital assets space post a strong January, followed by strong supported levels in February, despite the spate of regulatory announcements made globally over this past month. We should keep in mind that the markets did drop over 21% in the last two months of 2022, not only due to uncertainty about asset valuations and growth prospects, but also in anticipation of regulatory overreach. We previously outlined the state of global regulations, and view the recent regulatory announcements as emblematic of the tension the regulators and legislators face between trying to keep the public safe and promoting financial stability while not being seen as being behind the curve and not fully understanding the capabilities of DeFi.
Fast, Furious, and Far-Reaching
There has been a material increase in regulatory activity across the globe during February, ensnaring major cryptoasset service providers. In the US, the SEC issued a complaint against major crypto exchanges “engaging in the unlawful offer and sale of securities”, leading to a $30M fine and regional product impact. Separately, Paxos, a blockchain infrastructure company with a New York State Department of Financial Services (DFS) Trust Charter for Digital Assets, announced that it received a Wells Notice from the SEC stating that the regulator “is considering recommending an action alleging that BUSD [Binance USD, a stablecoin] is a security and that Paxos should have registered the offering”. Seemingly in support of the SEC, the NYDFS ordered Paxos to halt the further issuance of BUSD, to which Paxos promptly complied with.
North of the border, the Canadian Securities Administrators (CSA), a council of the provincial and territorial regulators charged with harmonizing securities regulations across the country’s capital markets, issued a notice requesting cryptoasset trading platforms (CTPs, including lending platforms) to meet higher standards, among which included the segregation and custody of customer assets, prohibition of leverage connected with cryptoassets, and enhancement of compliance and financial reporting. All this is in the spirit of enhancing Canadian investor protection.
In Europe, the transition to complying with the Markets in Crypto-Assets (MiCA) legislation is expected to take place over a period of 18 months. However, the French National Assembly wasted little time in passing new rulings for cryptoasset firms in late February. As picked up by several news outlets as well as a press release by Binance, the new rules require cryptoasset firms to register with the French Financial Markets Authority and set higher standards for improved governance, segregation of customer assets, and risk disclosure. Notably, the registration is a lighter requirement than licensing that was originally envisioned. Nonetheless, it is clear that French regulators felt compelled to take steps toward crypto regulations sooner rather than later by waiting for the firms to comply with MiCA.
Similarly, the Australian government is responding swiftly. In early February, the Australian Securities and Investments Commission (ASIC) announced that it is working to “to ensure that consumers are adequately protected and true innovation can flourish.” It outlined a multi-stage approach of “strengthening enforcement; bolstering consumer protection; and establishing a framework for reform.”
Operation Chokepoint 2.0 and Beyond
We’ve previously opined that regulations aimed at and investigations into centralized intermediaries are sensible. These are trusted agents who have access and control over investor assets. Investors rightly need to know how their assets are being custodied, segregated from a firm’s working capital, and hypothecated.
However, as if regulatory actions were not enough, the US government seems to be pursuing a multi-prong oversight on cryptoassets and its service providers, with the other prong being banking access. This seems to be best articulated in an essay penned by Nic Carter titled Operation Chokepoint 2.0 is Underway, and Crypto is in its Crosshairs. The thrust of the essay is that in the past, US legislators and regulators have successfully leaned on banks through warnings, policy statements, and investigations to dissuade them from providing banking services “to certain legal but politically disfavored sectors, chief among them firearms manufacturers and adult entertainment.” These efforts seem to be working. Signature, a crypto friendly bank that offers fiat-crypto on- and off-ramps, reported in their most recently released 10-K that “[the] goal is to reduce both individual client and overall digital asset deposit concentration levels to achieve a more granular and stable deposit base. As part of this plan, we are focused on reducing high-cost excess deposits within the digital asset ecosystem. As of December 31, 2022, the Bank's digital asset deposits totaled $ 17. 79 Environmental and billion, or 20% of total deposits.”
Progress or Impediment?
Within the US, digital assets seem to be a polarizing topic, and for all the heavy-handed approaches that have been meted out, the crypto community has its share of high-profile supporters. This is evident in SEC Commissioner Hester Peirce’s dissent to SEC complaint saying staking activities should have been registered with the SEC as securities offerings. She points out that enforcements are “not an efficient or fair way of regulating” and “[m]oreover, staking services are not uniform, so one-off enforcement actions and cookie-cutter analysis does not cut it.”
Over in Congress, the US House of Representative’ Committee on Financial Services recently formed the Digital Assets, Financial Technology and Inclusion Subcommittee. Similarly, the Committee on Agriculture, which has jurisdiction over commodities, recently formed its Commodity Markets, Digital Assets, and Rural Development Subcommittee. Tellingly, the first hearing to be held on March 9 is on the topic “Coincidence or Coordinated? The Administration’s Attack on the Digital Asset Ecosystem.” Both committees have its fair share of Congressional representatives who actively support and rally against the cryptoasset industry. How this will shape out remains anyone’s guess at this point. This is best summarized by the legal firm Baker Hostetler, “the prospects for comprehensive legislation face substantial challenges because of the committees that claim jurisdictional ownership: the House and Senate agriculture committees, the House Financial Services Committee, and the Senate Banking, Housing and Urban Affairs Committee. Negotiating complex policy between two committees is difficult; doing that among four committees is exponentially more challenging.”
We maintain our stance that centralized and decentralized services and platforms need to be distinguished and treated differently. Centralized services and platforms place trust in the hands of the few and need proper regulations, transparency, and disclosure to provide investors with comfort about the safety and soundness of their assets. Decentralized versions radically provide these. They’ve eliminated the intermediate agent; peers engage directly with each other; code is open-sourced; proper platforms have openly and clearly documented how their respective platforms work; many have decentralized governance to allow the public to vote on platform improvements. What these decentralized platforms need are regulatory sandboxes to experiment and innovate.
Perhaps what is needed in the digital assets ecosystem are decentralized self regulatory organizations (DSROs). SROs are non-governmental organizations which are empowered to enforce industry standards among its members. They work with the government to formulate those standards. Within the North American financial services, Financial Industry Regulatory Authority (FINRA), the New York Stock Exchange (NYSE), and the Investment Industry Regulatory Organization of Canada (IIROC) are a few prominent examples. Within digital assets, perhaps several DSROs can form to tackle specific issues ranging from code audits to financial stability and prudence.
The convergence of cryptography and blockchain have created a unique opportunity for the general public to participate in retooling our digital infrastructure. Governments have persistently tried to find ways to pay for infrastructure building, and this has always been with some form of taxation. How that money is subsequently allocated and spent is left to a heavily opaque process, quite often coloured by politics. The decentralization potential enabled by blockchains can make this transparent, and the economics of tokenization has the potential to provide the proper incentives for people to focus on public goods. Doesn’t this potential deserve proper experimentation and innovation, instead of being regulated out of existence?