Cryptocurrencies are volatile assets because their price is a bet on future adoption. Future adoption depends on a number of uncertain factors, one of the most important being the potential impact of regulation. So what exactly are the risks to crypto from regulation and to what extent have they increased as a result of the bear market failures such as Terra/Luna? Learn Crypto breaks it down into a clear set of themes.
- The environmental case for crypto regulation
- Regulating the very nature of cryptocurrency
- Joe Biden’s attempt to nail regulation of digital assets
- Regulating exchanges, unhosted wallets & Stablecoins
Crypto & the Environment
One of the biggest and most pressing challenges that human civilisation faces is climate change. 200 countries met for the COP26 Climate Change Conference in November 2021 trying to lay down a framework for limiting temperature increases to no more than 1.5 degrees and net-zero carbon emissions by the middle of the century.
Failure to meet that commitment is expected to produce more extreme weather and rising sea levels, with dire outcomes for the environment, food production and low-lying communities.
Though no specific agreement was reached at COP26, efforts are ongoing and there is no doubt that the issue of global warming is more relevant than ever on a political, commercial and individual level.
In this context, any industry seen as a significant contributor of C02 emissions will be in the crosshairs of regulators, even more so if the energy consumption is to secure a decentralised form of money that challenges the power of central banks.
Narrowing the issue to Proof of Work
In order to understand the risk of regulation to crypto we have to start with a better understanding of what it is about crypto that is perceived as being so bad for the environment because in truth, it really is only a specific aspect of crypto that creates the issue – Proof of Work Mining.
A core feature of cryptocurrencies is their absence of any controlling authority. They exist as distributed independent computer networks, reaching agreement on accurate balances of digital assets – like new forms of money – through Consensus Mechanisms, encapsulated in software run by participating Nodes..
Proof of Work (PoW) is the Consensus Mechanism used by the largest cryptocurrencies by market capitalisation – Bitcoin and Ethereum (though the latter is due to change later this year).
PoW is an energy-intensive process because it requires a specific network participant – a Miner – to prove they have committed sufficient work in order for the transactions they submit to be accepted in a new block by the wider network.
That work boils down to consuming electricity in a race to solve an arbitrary maths puzzle with the winner earning a block reward. The collective work of the network is measured by the Hash Rate which is often regarded as a proxy for value as it provides the foundation of Bitcoin and Ethereum’s security.
But given the environmental concerns, it is also an achilles heel, one reason why Ethereum is switching to Proof of Stake, which is the dominant consensus approach for new blockchains.
What is the level of regulatory threat due to Proof of Work?
The scale of carbon emissions from Bitcoin and Ethereum have been compared to that of medium-sized countries, because that makes great headlines, but even though the reality is far more nuanced this has inevitably led to calls for regulation, or outright bans, of Proof of Work mining.
A vote by the EU in March 2022 to ban PoW mining as part of the wider Markets in Crypto Assets process (MiCA) was narrowly defeated but that might be just one battle in an ongoing war. There is a chance that in the future the EU might classify PoW as unsustainable, making it less likely for Bitcoin derivatives to be investable from an ESG perspective.
The effectiveness of this campaign of misinformation is evident from the words one EU parliament member backing the ban:
“The carbon footprint of a single bitcoin transaction equals a transatlantic return flight from London to New York. This is 1.5 million times the energy used up by a VISA transaction.”
In the face of this FUD the Bitcoin community is self-organising to provide a counterpoint. For example, the Bitcoin Mining Council and Bitcoin Policy Institute are trying to shift the focus to the growing use of renewables by PoW and positive impact mining has on the efficiency of the energy generation process, but mud sticks.
In January there was the first hearing in the US Congress on Bitcoin Mining where the usual misconceptions were evident. There will be no specific action from that hearing but the information gathering will feed into the broader process ongoing in the US to get a grasp on the regulatory concerns posed by cryptocurrencies.
Regulating the nature of crypto
One of the biggest existential threats to cryptocurrencies is currently being fought in US courts with two separate cases that centre on what, fundamentally, cryptocurrencies are.
In March 2021, the Securities and Exchange Commission sued LBRY, a decentralised media platform for allegedly offering and selling an unregistered security in the form of its LBC token.
The SEC’s decision to pick on LBRY is a strange one, as they are a very small fish in the crypto pond, ranking #835 on Coinmarketcap at the time of writing, but the outcome could have huge implications for the thousands of similar crypto projects out there.
The SEC is a powerful US regulator who’s three-part mission includes protection of investors. That remit covers anything that they consider a ‘security’ the definition of which stems from a famous Supreme Court Case of the SEC vs W.J.Howey. What is now known as the Howey Test seeks to establish whether there is:
“a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party.”
LBRY argues that LBC is a token with limited utility specific to its platform, whereas the SEC argues that investors were led to expect a profit.
At the same time as LBRY is arguing the case for themselves, and countless similar crypto projects, there is another, much more high-profile case, being fought between the SEC and Ripple, the organisation behind the cryptocurrency XRP, which ranks #7 by marketcap.
There is some precedent here with the SEC successfully winning a case against Kik, a blockchain based messaging app, over the ICO for its token Kin. A year-long case ended with a $5million fine being issued in October 2020.
The outcomes of the XRP & LBRY cases could have a huge bearing on the future of crypto as it could mean that the majority of the 16,000 tokens out there are unregistered securities. If this wasn’t scary enough there is another legal battle currently being fought in New York courts which could undermine a key element of the way DEFI protocols are structured..
Can DEFI Protocols be segregated from companies?
PoolTogether describes itself as prize linked savings protocol built on Ethereum but a case has been brought in New York alleging that is in fact an illegal lottery.
The case was filed specifically in New York (because of its lottery laws) on the basis of a $10 contribution to the PoolTogether fund by Joseph Kent, an associate of Senator Elizabeth Warren, known for to be an anti-crypto crusader.
Kent’s actions show that crypto’s critics are prepared to fight dirty but the reason why so many eyes are on this case is the precedent it might set. The claim is trying to prove that there is no distinction in law between a company run by people that manages a website, and the protocol running on the blockchain (outside of normal legal boundaries) which is offering the actual service.
If the idea that company and protocol are one and the same becomes enshrined in law, and replicated elsewhere, the whole basis of DEFI could be under threat.
Pulling the regulatory strands together in the US
The debate over whether cryptocurrencies are securities has hung over the industry for many years. If they aren’t securities, what are they? Commodities, virtual currencies or property even? Each classification has its own set of regulations in the US and worldwide with implications for businesses, and individual holders in terms of taxation.
In American the SEC and CFTC – which regulates commodities and futures – have at least agreed that Bitcoin and Ethereum are commodities, but the regulatory fate of all other types of cryptocurrency remains in the balance as evidenced by the various battles mentioned above being fought in the courtroom or Whitehouse Hearings.
On March 9th 2022 Joe Biden issued a long awaited Executive Order which should hopefully pull all these diverse regulatory strands together.
Executive Order on Ensuring Responsible Development of Digital Assets, MARCH 09, 2022
Outlines the First Whole-of-Government Strategy to Protect Consumers, Financial Stability, National Security, and Address Climate Risks
Biden has asked Federal Agencies to report back urgently on the crypto industry and provide guidance on where regulatory authority should sit across:
- Illicit activity
- Financial Stability
- Consumer/investor protection
- Responsible Innovation
- US Competitiveness
- Financial Inclusion
The move was welcomed by the markets as a positive step, balancing the benefits of innovation that crypto offers, with the need for oversight. The EU is expected to finalise MiCA in June, summarising its attitudes to most aspects of crypto, but not all. MiCA 2.0 is already being discussed to cover lending and staking, hugely topical given the liquidity crises experienced by CEFI lending services.
Though the EU is important, where the US leads, much of the world is likely to follow, so what comes out of the Executive Order and MiCA could have a huge bearing on the future of crypto and one area of particular interest relates to US competitiveness and specifically the case for a digital dollar.
Crypto as a threat to national currencies
It hardly seems possible, but barely 13 years since the Bitcoin Network went live, starting with just a solitary Node, it has been adopted by two countries as legal tender; El Salvador with a population of 6.5 million people and the Central African Republic with just under 5 million people.
That news sent a shockwave through Central Banks and those international institutions that are designed to support the financial status quo – fiat money. In simple terms money is power, and governments want to retain their power by retaining control over money creation.
El Salvador and CAR buck this trend because they don’t have sovereign national currencies, like many other developing nations they rely on powerful Western currencies – the US Dollar and the Euro – which bring their own sets of issues. Dollarised countries like El Salvador essentially have their monetary policy set in Washington, by the Federal Reserve, while CAR has monetary policy dictated by the EU as the CFA France is pegged to the Euro.
So this sets up a tension between those countries that have something to gain from making Bitcoin – or other cryptocurrencies – legal tender and those that feel they have everything to lose.
The former group doesn’t just include countries under the yoke of the US Dollar, but those countries pushed outside the international financial system altogether, through sanctions, which includes Iran, Syria, North Korea, and more recently Russia.
Those countries and federations (such as the EU) that feel their sovereign currencies threatened, will use regulations as a form of defence, one of the tactics used to stifle Facebook’s failed Libra project.
Central banks are also going on the attack by picking certain elements of cryptocurrency that may improve aspects of how fiat money works – such as financial inclusion or transaction speed – but also give them greater control. This is happening through what are known as Central Bank Digital Currencies – CBDCs for short, with nine out of ten central banks currently investigating a CBDC.
China, as the most extreme example, has banned Bitcoin mining and essentially outlawed cryptocurrency ownership, pushing ahead with a CBDC and digital version of the Yuan.
The US is now playing catch-up, hence the reference in Joe Biden’s executive order (already mentioned) requesting urgent research into national competitiveness as a matter of ‘national interest’.
How much this particular threat of regulation to crypto plays out will depend on how much countries have to gain in terms of the sovereignty of monetary policy, controlling how their citizens use money and their position in a new environment to be the dominant world digital currency.
The war in Ukraine has added a whole new dimension to this discussion with Russia now actively looking for alternatives to SWIFT and dollar/euro-denominated payments, suddenly changing its attitude towards cryptocurrencies as a result.
Regulating exchanges & money transfers
Last September China applied the most severe regulations to mining and trading cryptocurrency, effectively banning its use.
Though China accounted for a significant share of global Bitcoin Mining, its decision to outlaw it only had a temporary effect, because of the ease with which mining operations can switch locations. Many Miners quickly relocated to Kazakhstan or the USA, which may actually have improved the decentralised nature of the Bitcoin network.
There is however a significant element of the wider crypto ecosystem that is less fluid, and much more susceptible to regulation – centralised exchange and services.
Given exchanges are the entry point for almost all new crypto users, governments could significantly slow adoption by blocking or throttling those on-ramps.
You can see the impact that regulatory pressure has had for example on Binance, which has invested heavily in compliance, while the SEC even stopped a new Coinbase Lending product dead in its track before it had even launched.
Centralised exchanges can either sit offshore and take their chances at dodging country-specific regulations, or be based onshore, complying with all regulations in the hope that they can reap the benefit, but equally at risk from that regulatory environment becoming so restrictive as to impact their ability to function.
That might seem like an extreme scenario but Bitcoin Maximalists will point you to the US Executive Order 6102 which in 1933 mandated the sale to the government of all gold coins, bullion and certificates at a fixed rate. They make a similar argument for the confiscation of crypto from centralised exchanges.
The world has changed almost beyond recognition after the Russian invasion of Ukraine, so rule nothing out.
The regulation of exchanges isn’t necessarily all bad news for crypto, it may provide a basis for broader adoption, but what could really hurt the industry is another attack vector, clamping down on transfers between unhosted wallets aka the Travel Rule.
Understanding the Travel Rule is very complex, as much of it comes in the form of guidance from FATF (the Financial Action Task Force) which individual countries can choose to implement. The proposals being considered in the US and EU have the potential for making transactions to and from unhosted wallets above a very low threshold illegal.
All eyes on Stablecoins
In a similar way that centralised exchanges facilitate new adoption, Stablecoins are a crucial element in facilitating trading. USDT and USDC together account for a massive $125 billion in circulating supply of synthetic dollars, yet there is no fully audited proof that all those digital dollars are backed by real greenbacks.
Tether paid a $41 million fine in October 2021 to CFTC (Commodities & Futures Trade Commission) for misleading claims that its reserves were fully backed at all times, having previously been fined $18.5 by the New York Attorney General for covering up a huge loan to its parent company, Bitfinex.
Tether is the largest and most important Stablecoin but they are a centralised organisation that operates with a great deal of secrecy. To many analysts Tether, and to a lesser extent, USDC, are ticking time bombs, but the first Stablecoin to implode was one of the algorithmic variety, UST Terra which lost its peg in May 2022 bringing down Luna, which was supposed to ensure its stability.
The damage from Terra’s collapse is yet to be fully understood but anecdotal evidence suggests a huge number of retail users invested in UST because of the 20% APY offered by the Anchor Protocol, a key component of the Luna ecosystem.
Though Luna 2.0 quickly emerged from the ashes Terraform Labs, the entity behind UST and the Luna blockchain is being investigated in various countries, notably Korea and Singapore, with potential criminal charges to follow. Similar cases both civil and criminal are expected around the world, including the US.
On its own, the Terra/Luna debacle was likely to intensify the existing focus on crypto regulation in Europe and the US. Given its been followed by multiple failings of large retail and institutionally focused crypto service providers, all collateral damage from the worsening bear market, a significant regulatory backlash seeking to protect consumers is probably the safest prediction you could make for the crypto industry right now.