Why the crypto crash is fueling calls for regulation

Cryptocurrencies have thrived by positioning themselves as alternatives to the traditional financial system. But the ongoing crypto crash — which has seen markets plunge, investors madly selling assets and even a bank run — is reigniting calls to regulate the freewheeling industry.

In other words: The crypto crackdown is coming. And what emerges could look much more like the traditional banks, stock markets and investments that the industry has long disparaged.

The prices of market-leading cryptocurrencies such as Bitcoin and Ethereum have plummeted in recent weeks. Meanwhile, liquidity problems prompted crypto lender Celsius Network to freeze transfers and withdrawals earlier this month, citing “extreme market conditions.” And cryptocurrency exchange Coinbase said last week that it plans to lay off approximately 1,100 employees, or 18 percent of its workforce.

An end to crypto shadow banking?

Much of the recent concern around crypto centers on the idea that the industry is a hive of “shadow banking” — banking activities undertaken by under- or unregulated entities, rather than an insured and tightly regulated financial institution.

The bottom line is that companies operating in this way forego safeguards like federal deposit insurance, which can protect investors and ensure a baseline level of liquidity even when markets are stressed.

Those safeguards have the added benefit of building confidence in the overall financial system: reassuring the public that the value of money is stable and their funds will be available when they need to withdraw them. But confidence in crypto has so far rested largely on sheer enthusiasm, rather than the knowledge that the system has built-in protections.

“One of the foundational mythologies of crypto is that you’re going to have this private money and finance that is unregulated and yet still secure, because of the technological workaround,” Mehrsa Baradaran, a professor at the University of California, Irvine, School of Law and author of “The Color of Money” and “How the Other Half Banks.”

Yet Celsius’ decision to freeze withdrawals was a response to a classic bank run, as people rushed to pull their funds — and because Celsius is a crypto lender, there was no federal deposit insurance. The company’s collapse may be a harbinger of things to come.

“FTX bailed them out because they’ve got the money, like J.P. Morgan,” said Baradaran. “But as we saw from 1907, then what happens with the Great Depression, around 15 years later, is that there’s just isn’t enough money to bail out the firms this time.”

Writing on the wall

It’s not clear whether the Senate bill will make it into law, and if so, how much it will have changed by then.

But Baradaran is skeptical that legislation with real teeth will arrive quickly, because — to put it mildly — partisan gridlock means that Congress has become bad at passing anything in recent years. That doesn’t rule out action by the SEC, CFTC or other federal agencies on various aspects of crypto, but it does raise questions about when, or if, the U.S. will see a unified framework for crypto.

“I think getting any sort of regulation on this is kind of a mess,” said Baradaran. “You look at who is interested in this and who does it benefit. It benefits everybody generally to have some sort of regulatory system, but the regulated industries are going to oppose it. Those things have a harder time getting passed, which is why they tend to go toward the Federal Reserve or the Treasury or the [Federal Deposit Insurance Corp.] or the [Office of the Comptroller of the Currency]. All of those agencies already have the authority to do it.”

Lars Seier Christensen, chairman of the Switzerland-based Concordium Foundation, which oversees a major blockchain project, said he’s concerned that there will be further catastrophic decentralized finance events in the next 12 months. DeFi is the crypto industry term for peer-to-peer financial transactions made using blockchain technology.

“The worst conceivable scenarios could have systemic risks ingrained,” said Christensen, who is also a founder of Denmark-based Saxo Bank, which offers online trading and investments. “Even without systemic risks, the involuntary liquidation of crypto assets placed as collateral can have a big impact on prices, as the demand side is generally quite weak.”

Some crypto companies also see the writing on the wall.

“Regulation is coming — there’s no stopping that,” Mark Basa, director of Hokk Finance, a decentralized finance product builder. “Regulators want to ensure that the [backers of a cryptocurrency are] not promoting the asset as a speculative one, but also want to ensure that the investor is not dumping their life savings with zero chance of getting it all back.”