Blockchain and Crypto Regulations in the New Year
Blockchain and crypto had quite a year in 2022. A crash in digital assets and liquidity in the first half of the year and the FTX collapse in the second generated substantial negative press. A difficult year for stablecoins put the connections between crypto and the rest of the economy on shaky ground. While some of these problems were not without precedent, their happening in one year altered the general public’s perception of crypto and blockchain tech. Unlike previous issues, these will cause changes in the markets and institutions themselves.
However, the most important change, among many, which will affect crypto and blockchain in the near future will be new regulations. It is evident that more regulations, likely stringent ones, are going to be issued in the coming months in a number of countries, including the United States, the United Kingdom, and across the European Union. In this article, we will cover why 2023 will feature new regulations on crypto and what the effects of these might be.
The reason this is coming.
As mentioned, this year was rocky for many crypto and blockchain projects. In addition to the problems faced by those in the industry, the adoption of many cryptocurrencies by members of the general public and increasing interaction between the crypto economy and the rest of the global financial system meant that the problems facing crypto became problems for other sectors and large numbers of people. Let us review these issues and why they increase the odds of regulation in the immediate future.
The most recent and obvious reason that regulation is more probable now than at any time in the past is the collapse of FTX. The details of this will be well known to the reader, and we will not extend this article by explaining it here. However, some of the broader implications must be considered at this time.
The scale of the failure and its side effects is substantial. Vast fortunes have been wiped out, and the general health of several ecosystems, including Solana, has been viewed as weaker in the past few weeks as the market shifts. BlockFi, which had been bailed out by FTX earlier this year, has ceased operations. The FTX contagion has spread to lenders, funds, and asset managers such as Genesis, Galois Capital, Sequoia Capital, Wintermute, Multicoin Capital, Amber Group, Paradigm, and Nexo, among others.
The FTX collapse raises questions in the American legal field over which federal agency will regulate them. While this issue is likely to be resolved fairly quickly, the general question of how crypto service providers will be regulated will have to be more generally resolved and will likely be addressed in the light of these events.
The trouble facing stablecoins earlier this year, especially the Terra incident, was another issue of concern this year. It became clear that many coins were not backed by enough assets to warrant their pegging to fiat currencies nor that their algorithmic controls were sufficient to maintain their desired price levels. This came on the heels of the crash of many coins in May, an event that wiped out huge sums of money and caused a general souring towards crypto to ripple through broader American society. These issues led to the collapse of Luna, UST, 3AC, and its related parties, such as Voyager Digital. The contagion also extended to the massive liquidation of Celsius, Babel Finance, BlockFi, etc, and the fire sale of miners’ BTC inventory.
Because of the scale of these issues and how stablecoins are the connection between crypto and the rest of the economy, these two crises were perhaps the first crypto crashes to impact the larger economy in a meaningful way. These alone would have been enough to make new regulations likely, as any industry that can damage the economy in general is going to be of interest to regulators, however, the nature of the crashes amounts to a PR nightmare.
Several new regulations are already on the table, ready for passage, or otherwise very near implementation. Let us review a few here.
Existing regulations and proposed bills
As reported in Forbes, many stablecoin regulations were floated in the months following the stablecoin crisis. For example, in California, the state senate passed a bill prohibiting California entities from trading in stablecoins that aren’t licensed either by a bank and fully backed by secure reserves or by the California Department of Financial Protection and Innovation. The bill, which has not yet been signed into law, would severely limit crypto exchanges in the largest state in the US. At the federal level, the Treasury Department has also called for stablecoin regulation, and a bill has been read before the US Senate Finance Committee- though it has yet to be voted on.
In the US Senate, there is also support for the Digital Commodities Consumer Protection Act, DCCPA, which has been interpreted as damaging to DeFi. However, this bill was closely tied to FTX and SBF, and it may well be delayed as a result of recent events. However, those senators supporting it have expressed their continued support for the bill. Also in the United States, the federal Commodity Futures Trading Commission is considering the use of its existing authority to address cases of fraud involving digital assets, including digital currencies.
In Europe, the crypto-assets bill MiCA, which would set reserve requirements for stablecoins and require authorization for wallet providers and exchanges, will be voted on in February 2023. It has already passed some bureaucratic hurdles. The situation is similar in Britain, where legal reforms to enable the regulation of crypto have already occurred.
In Singapore, which already employed a regulatory scheme for crypto companies, a parliamentary inquiry into why FTX was not included on a list of risky investments has led to calls for more regulation.
The idea that any of these proposals are now less likely to pass or to be strongly enforced in light of recent events is ludicrous. If anything else, we might expect even more regulation than was previously likely.
The Morgan Report
The sentiment that regulation is imminent is shared by JP Morgan, which recently issued a report suggesting that regulation and consumer protection will be a major concern going forward. This is expected to increase auditing requirements, new security requirements, and other developments which may make DEX and DeFi less effective, as regulatory pressures may drive companies to unbundle various services. They suggest that an institutional DeFi may be the path forward.
It is highly probable that new regulations on crypto and other blockchain technologies are about to be issued. As in other industries, this will increase the cost of doing business in many cases and may slow the industry. In the lead-up to implementation and the full establishment of the letter of the law, it is also probable that a chilling effect will impact the industry.
What form these regulations will end up taking is still unknown. As we mentioned, examples currently exist that could be the foundation of future regulations. As we can see in some of the proposed laws in the United States, and existing laws in the state of New York, it is possible that some of these new regulations will make doing business impossible for certain companies or make certain territories unattractive to enterprises which don’t wish to bother with the regulation. In the worst case, many large states may be essentially locked out of the crypto market or abandoned by companies as new regulations pass.
However, there is also the possibility that regulation could benefit the industry after the issues caused by the implementation of the new standards have been worked out. The confidence of the general public in crypto, blockchain, DeFi, and other related concepts has been shattered this year, and a sense of reassurance by the government that things like the FTX collapse are made less likely by regulation could be a tool for restoring that confidence.
Likewise, the various practices that caused this year’s slew of problems, including unbacked stablecoins and what appears to be outright fraud at FTX, would become less likely under a system of robust regulation. Over the long term, the protections against these issues could benefit themselves in terms of a healthier ecosystem.
While regulations may increase the cost of doing business for many crypto companies and might even make some operations unable to engage with customers in some markets, the possible benefits that regulations might provide must also be considered.
Examples of what benefits could manifest are easy to find in other sectors of the economy, banking in particular. The number of global banking crises went to nearly zero during the years of the Bretton Woods system- suggesting that certain regulatory systems can prevent major crises at the cost of increased oversight. Focusing on the United States, banking regulations implemented in the 1930s provided protections for consumers and helped to prevent general crises up until the Savings and Loan Crisis in the 1980s.
As was the case in the United States in the 1930s, when banking regulation restored public confidence in banks, regulations could help restore public confidence in crypto and DeFi. Regulations that help prevent fraud, Ponzi schemes, or pump-and-dump operations would also help to rehabilitate crypto in the eyes of many people who have concerns for consumer protections.
There are risks, however, to certain sectors. As we see in New York, sometimes regulations mean that certain businesses simply cannot operate. This is a potential problem, as we don’t know what regulations will come to pass in the next year, and they may well limit what kinds of crypto companies are allowed to operate at all in certain jurisdictions.
A possible framework for the regulation of web 3.0 that could be generally positive was put forward by Miles Jennings and Brian Quintenz in an article published by a16zcrypto. They suggest that, if done properly, regulation could be used for such goals as “protecting investors and consumers, fostering innovation, promoting capital formation and the efficiency of capital markets, encouraging (or, unfortunately, discouraging) competition, protecting national interests, and so forth.” They warn, however, that this will require careful implementation and an approach tailored to the nature of web 3.0.
In the aforementioned report by JP Morgan, they expect that DEX and DeFi may become less competitive in the face of new regulations. If they are correct, centralized exchanges will remain a significant part of the cryptocurrency landscape in the foreseeable future, particularly for institutional investors.
However, it is still too soon to judge exactly what the effects of the proposed legislation will be given the shifting political attitudes toward crypto and its institutions. For example, while DCCPA may threaten DeFi’s unique features of composability and permissionlessness. the FTX collapse may prompt rewrites that change several aspects of the bill. In any case, centralized regulations will cause some disruption to the industry and will certainly clash with the ethos of decentralization so prevalent in crypto.
Given recent events, increased regulation of crypto is all but certain. What that regulation will look like is still undetermined, but existing regulations and proposals can give us an idea.
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