The cryptocurrency space is a promising asset class for individuals and investors, but the lack of proper and defined regulation slows down its innovation. Crypto is now becoming increasingly mainstream. From the entrance of major traditional financial institutions like banks, investment funds, and insurance firms, to the multitrillion-dollar market capitalization, crypto is mainly unignorable.
In that context, it is also mainly getting on the radar of the regulators throughout the world, specifically in China and the United States. How can this sector balance investor protection and stability on the one hand with the promotion and support of innovation on the other?
There are up to three paths to regulating cryptocurrency. The first is to not regulate the crypto space excessively. However, with the massive growth and increasing overlap with the traditional financial markets, it is unlikely that most regulators will find this path tenable.
Another option is to regulate the sector from on high, without deep engagement or even consultation from the good-faith firms in the crypto sector. That way might be perilous and might eventually sacrifice the powerful financial innovation that exists in the blockchain world, which could be harnessed for good.
The third is that regulation which comprises a continuing partnership with the sector itself. Many believe that it is the only truly viable option. Most in the crypto space already see this type of proactive, innovation-oriented regulation as something that will majorly advance the sector.
Bitcoin Regulation In Historical Definition
Bitcoin’s (BTC) inception happened over a decade ago coming up as a peaceful protest against the extensive monetary policy of the great financial crisis that happened in 2008. What began as a niche sector for cyberpunks, libertarians, and people who wanted to buy illegal stuff more conveniently and anonymously has changed into a concentration of mind power, with up to 46 million Americans reportedly owning Bitcoin.
The sheer scale of cryptocurrency as an asset class, with a market cap that peaked above $2 trillion puts the budding market on the radar of all regulators and lawmakers worldwide. To expect crypto to thrive in the unsupervised manner of its early years is just unrealistic. The mainstream asset classes can barely go unnoticed, and the influx of new investors needs protecting.
As an entrepreneur, the main concern about regulation does not arise from the desire to run amok. If history is taken into context, many times regulation on innovative ideas and businesses is imposed by the lawmakers who are, understandably, not into the intricate details of sector-native processes and have little or no practical experience.
There is a gap that exists between innovators and regulators. This gap has opened up decades ago with the huge expansion of internet-based firms, and has resulted from time and again in unnecessarily complex and cumbersome rules that do little to serve their alleged purpose.
The main alternative is of no real benefit to the advanced jurisdictions since most nimble firms will seek offshore tax havens that have minimal regulatory restrictions and lax rules, which eventually hits the state coffers, mostly in the post-pandemic remote-work-adjusted societies. The reality is that legislation lags behind innovation, which happens at a considerable pace.
That matter becomes more complicated whenever someone considers the decentralized finance (DeFi) sector. These solutions, normally referred to as ‘noncustodial’ or ‘unhosted’ which means that there is no centralized third-party platform or intermediary, but the intermediary is the software itself; current challenges in the matters of putting them into existing rules, mainly in the financial intermediation and securities laws.
CeFi – A Bridge Between Regulation And DeFi
The prevailing hypothesis is that the most productive law will arise from the regulators working with good-faith actors in the crypto sector who want to actively engage with them. What does the engagement look like? On one side, it is taking proactive steps to work within the existing regulatory infrastructure to determine where gaps exist, and where friction remains.
Taking the example of decentralized finance above, while it presents some new regulatory issues, there are other ways to ease the burden originally. Centralized finance (CeFi) firms can be the best interim solution, acting as a bridge between the traditional financial industry and the regulatory network that encapsulates them on one hand and the decentralized space on the other.
These firms mainly understand the industry from both the needs of their users and the infrastructure point of view. Until a viable conclusion is reached that the current regulatory network does not apply for the blockchain firms or the industry gets specific legislation, CeFi firms have been on a license acquisition crusade, culminating in a considerable number of licenses from regulators around the world.
For now, more pending authorizations are still in the pipeline. It means that they are perfectly placed to enable DeFi projects to eventually piggyback on the infrastructure since they are just starting to consider allocating the funds to legal expenses and lobbyism.
Furthermore, they can rely on established Know Your Customer (KYC)/Anti-Money Laundering (AML) processes prescribed by the Financial Action Task Force (FATF), and fiat on- and off-ramps to widen their offerings and bring it to their users in a way that is compliant with the incumbent rules.
Main Regulator Concerns And How The Sector Can Help
In case one part of being an engaged partner to the regulators is seeking to work within the existing frameworks initially, another part is having a good perspective on the key areas of legitimate worry for regulators, so that they can work with the sector instead of against it to develop functional solutions.
Cryptocurrency is quite volatile. Despite being in a downside trend currently, volatility is here to stay for the long term. Being a disciple of Benoit Mandelbrot and a good student of capital markets, one trader said:
Volatility seems to cluster which some volatility begetting other volatility. That condition is what attracts many people to the nascent space, with a promise of multiple X on their initial capital. This volatility works both ways. Bitcoin can gain 1500% in 12 months, or lose 30% within hours.
These rapid and severe corrections happen in every bull cycle. But, it just happens that the corrections normally precede bigger legs up, as the March 2021 crash showed. The most recent correction happened in May 2021, although it was not as severe. It was critical since it showed the remarkable resilience of the decentralized finance sector.
There was a lot of liquidations, yet the protocols stood their ground, for the most part, and performed as designed even as BTC lost 35% and Ether (ETH) close to 40%, the futures traded in major backwardation, and implied that volatility in the options market exceeded 250%.
Previously, the traders in equities futures have strong memories of the S&P 500 flash crash of May 6, 2010, where indexes lost 10% within minutes, only to retrace these losses a short period after. It was not orderly since the most advanced, complex, regulated, and monitored markets experienced chaos.
It took nearly five months for the CFTC and Securities and Exchange Commission to gain a preliminary understanding of what happened. It is worth noting that despite the May correction, Bitcoin has gained 27.26% in 2021 and soared by 284.58% over the past 12 months.
In the meantime, the S&P 500 has added 11.95% year to date and 34.63% in the last year. Gold is currently flat for the year and has gained around 11% in the last 12 months. In general, most of the volatility worries around Bitcoin have to do with one’s time scale, and also, the investment strategies the investor is using.
Within the general framework of volatility, there is one aspect that is worth close review: leverage. Being the best-performing asset of the last decade, BTC is unique in many ways, and investing needs a defined mindset and the right time horizon. Day trading any asset, more so cryptos, is a one-way ticket to obliterating the trading account.
100x, 135x and 500x leverage means that you will get liquidated when the underlying asset moves less than 1%, which might happen within seconds in the crypto world. Here’s a major thread on volatility and increasing cascades of liquidations. But although objective and informative, it comes from some investors that reap huge profits from excessive leverage.
Bitcoin together with the other crypto assets is a major addition to any well-diversified portfolio and needs to be acquired and held for long periods during which, history has shown, BTC has outperformed every other asset, except maybe the US dollar against the Zimbabwe dollar.
Is it advisable to risk all your money in crypto since it has gained explosively in the past 12 months? Maybe not. And not with any type of leverage, as even 2x leverage can get you liquidated in a type of correction that happened in March 2021, which made the intraday prices dip by over 50%.
Some companies have little tolerance for leverage and have advised the extensive customer base to be cautious since January 2021. Leverage in the crypto sector would be a reasonable place for the regulators to review when analyzing who is focused mainly on investor protection.
The key purpose of protecting investors in the budding sectors is a difficult balancing act, as it at times borders on the stifling of innovation in these fields. However, the reverse is true as well: ‘Innovation’ can never be used as an excuse for detrimental behavior since 100x leverage is not innovation. Forex had it pre-Satoshi, but it never contributes to the betterment of society.
Firms have to work with their respective national bodies to guarantee that the ideal type of investor protection law is implemented. That approach is quite constructive compared to insisting that today’s regulatory infrastructure is obsolete and does not capture the cutting edge of fintech and cryptocurrency.
Cryptocurrency And Money Laundering
In the case of money laundering, most crypto sector participants have the same notion: on one side, investors and market participants are happy to play by the rules. On the flip side, cryptocurrency has been unfairly maligned when the majorly preferred currency of money laundering has been and remains the US dollar.
Any currency that is widely accepted is prone to money laundering. The fact remains that the incumbent financial system and the US dollar are now the preferred means for illegal purposes. It is not just a medium of exchange itself. Do the rewards associated with helping the finance of illegal activities outweigh the repercussions?
Just search for major banks and money laundering and you will see how big the problem is. There are many civil and criminal complaints and some end with ‘no admission of guilt’ settlements. Provided that a slap on the wrist and several percentage points of the gains from abetting illegal activities remain the punishment, there is little to no hope that money laundering will suffer considerable blows.
There is no data to support that BTC plays a major role in the transnational money laundering space. Cryptocurrency is also far from being as anonymous as people may think. The fact that a system can be misused never means that the system should get outlawed; otherwise, we would have already parted ways with cash, banking, fiat currencies, the internet, and all manifestation of human ingenuity.
Yet, there are concerns, and we are ensuring that in the history books, there will be no more than temporary FUD, which is fear, uncertainty, and doubt.
There is another important aspect of money laundering fears. Many tools are used including complex algorithms of CypherTrace, Chainalysis, and Coinfirm, that help in tracing the origins of cryptos and show an extensive flow of funds. It enables participants to get defined conclusions on the status of specific cryptocurrency deposits and apply the needed risk-based AML approach of the FATF.
There exist obfuscation tools coupled with cross-chain methods that make tracking more challenging, but nothing more than what exists in the current banking sector, offshore jurisdictions, cross-border transfer, and much more.
For someone with a huge chunk of their net worth derived from cryptos, let us say: Acquiring fiat currencies from the sale of cryptocurrency into the banking system is a difficult task, which makes it the furthest thing from a ‘money launderer’s dream.’ The top-tier banks need extensive proof of funds from early Bitcoin investors, like the cryptographically signed messages of the earliest wallets.
Thus, nobody knows how a darknet drug dealer would transfer crypto wealth into the US dollar or euro in any significant amounts. The best hope is to stay within the crypto and pay for goods and services with cryptocurrency. That sounds similar to the method that the drug criminals have been using since before the Pablo Escobar days.
Why Protect Cryptocurrency? It Is The Only Existing Free Market
In the crypto space, regulators and authorities have something unique. The market is the only free market, where there is no central bank to engage in interventionist policies, to control the interest rates and money supply.
Furthermore, there is no lender of last resort, which has created moral hazards in the traditional market encouraging aggressive long positions. There is no Plunge Protection Team, no Fed put, and no bailouts.
The crypto market operates in a manner that market forces of demand and supply and deleveraging and leveraging have to play out without any arbiter. While that might be dramatic sometimes, it increases the antifragility of the market and makes it easy to adapt to new circumstances.
While being painful for the novice investors who join the party late and mostly with lots of leverage, none of these corrections that happen in the crypto sector cost any government taxpayer money. It means that crypto can never be a systemic risk and no firm within it can ever be ‘too big to fail’ which is a net positive for the advancement of innovation.
As opposed to traditional finance, in cryptocurrency, it is those that develop good products and services that eventually survive. In case crypto has been trading in a bubble in the past years and may very well be, equities have been in a bubbly state for most of the last ten years.
“The S&P 500 is arguably the second most expensive it has ever been in absolute terms, which doesn’t bode well for long-term returns.”
The bubble that exists in the crypto world needs to be considered to be a byproduct of the aggressive monetary policy by the world’s central banks and the fears that arise from 1970s type inflation. All that was explained clearly by Paul Tudor Jones, the person who put “hedge” in the term “hedge funds.”
What Next For Regulation?
Undoubtedly, the next Amazon, Google, Facebook, or Apple will arise from the cryptocurrency space. But for the cryptocurrency market to sustain and exceed its current market cap of $2 trillion, it has to continue its path to maturity.
That is the reason why innovators and licensed institutions welcome a constructive dialogue with all the notable stakeholders of the regulatory space and process that will perfectly translate into clear rules around the way business needs to be structured.
That happens for the benefit of all involved, including businesses, regulators, and retail clients. They need to have clear guidance and regulatory certainty. When that is achieved, it leads to innovation, sustainability, consumer protection, security of funds, defined AML procedures, and increased revenue for the countries that decide to embrace the nascent market, reiterating the United States’ embracing of the internet in the early 2000s.