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| 9 minutes read

The Crypto crash and the regulatory response

Cryptoassets continue to fall in value and the industry is in trouble. Andrew Pimlott summarizes what is happening and how regulators around the world are responding.

Cryptoassets continue to fall in value and the industry is in trouble

The big question now being asked about the cryptoassets meltdown is this: Is it the end of crypto as we know it, or only a short-term correction? The global cryptoassets market has slumped in value from $3 trillion last November to $900bn today. Bitcoin, the main cryptocurrency, has plummeted from an all-time high of over $68,000 in November 2021 to $19,406 in early July 2022. The stablecoin terraUSD and its sister token luna fell in value to almost zero in May, wiping out $40bn in market valuation and having negative knock-on effects in the rest of the crypto market.

Cryptosceptics like Bank of England Governor Andrew Baily say these events have proved them right. Testifying in Parliament in June, the day after crypto lending platform Celsius suspended transfers and withdrawals, he reiterated his oft-quoted view that “Crypto assets have no intrinsic value” and “This morning we have seen another blow-up in a crypto exchange.”

The headline on CoinDesk was “Bank of England chief takes victory lap as crypto crumbles.” He is not alone in his distrust. Regulators around the world are speeding up their plans to introduce stricter regulation on the crypto marketplace.

Even cryptoasset exchanges, lenders, custodians, and other service providers recognize the seriousness of the problem and the need to introduce greater stability and legitimacy, primarily through tougher regulation. At the same time, most of them remain optimistic about the future. “Some cryptocurrencies may drop in prices, and some projects may fail, but the industry will stay,” said Changpeng Zhao, the founder and CEO of Binance, the world’s largest cryptocurrency exchange, during June’s DIFC Fintech Week event in Dubai.

He is probably right because the market is so large and established, with enough investors happy to take their chances, that it is hard to imagine it being wiped out. The most likely scenario is that it will continue to grow with more volatility than traditional financial markets, but in a more controlled way as governments and national regulators get a grip.

Crypto firms are facing liquidity and regulatory trouble

Before looking at the regulatory reaction, here is a summary of some of the dramatic incidents that have occurred since May. Terra is a blockchain protocol and payment platform for stablecoins pegged to fiat currencies, created by Terraform Labs of South Korea. Terra’s best-known stablecoin is terraUSD and its associated luna reserve asset cryptocurrency. When investors began to lose confidence in terraUSD, they sold their holdings, and its peg to the dollar failed in May; within a week, it and luna had lost almost all their $40bn market value, and the Terra blockchain was temporarily halted.

Research firm CryptoCompare called it “the largest destruction of wealth in this amount of time in a single project in crypto’s history”. South Korea’s Financial and Securities Crimes Joint Investigation Team is now investigating the crisis. 

As the value of coins plummets and the reputations of coin issuers are trashed, crypto exchanges, crypto lenders, and other service providers are suffering. Crypto exchanges are being criticized for the standards they apply when deciding to list a coin, which critics have said are too lax. Competition between exchanges has led to a rise in the number of coins being traded without enough checks being made to ensure they are worthy of a listing.

The Hong Kong crypto exchange CoinFLEX froze client funds in June, prohibiting withdrawals. Coinbase, the biggest cryptocurrency exchange platform in the US, announced in June that it was laying off 18% of its workforce.

New Jersey crypto lender Celsius – whose customers deposit digital assets in return for a percentage of income, or obtain loans by placing their digital assets as security – has suspended all withdrawals and transfers. In its “Memo to the Celsius community” in June it blamed “extreme market conditions” for its actions while attempting “to stabilize liquidity and operations.”

The Singapore crypto hedge fund Three Arrows Capital is going into liquidation after being issued a notice of default by Canadian crypto bank Voyager Digital for failing to repay a huge loan, and Voyager’s shares have crashed.

The regulatory response has been uniform and swift

The reaction of governments and financial regulators around the world has been swift. The G7 finance ministers and central bank governors –meeting in Petersberg, Germany, in May, where they were joined by the World Bank, International Monetary Fund, Organisation for Economic Cooperation and Development, and Financial Stability Board (FSB) – issued a statement on the need to speed up global regulatory initiatives on crypto.

It read: “In light of the recent turmoil in the cryptoasset market, the G7 urges the Financial Stability Board, in close coordination with international standard-setters, to advance the swift development and implementation of consistent and comprehensive regulation of cryptoasset issuers and service providers, with a view to holding cryptoassets, including stablecoins, to the same standards as the rest of the financial system.”

The FSB, the international body that monitors the global financial system, in February established a workstream to examine supervisory and regulatory issues raised by “unbacked” crypto-assets like bitcoin. It complements existing FSB work on issues raised by stablecoins and decentralized finance (DeFi) and other platforms on which crypto-assets trade.

The Basel Committee on Banking Supervision in June published a second consultation document in June on how banks should treat their cryptoasset exposures, with submissions invited by the end of September. The committee noted that “recent developments have further highlighted the importance of having a global minimum prudential framework to mitigate risks from cryptoassets.”

The committee’s chairman, Pablo Hernandez de Cos, who is also the Governor of the Bank of Spain, in an earlier speech, referred to a famous quip three years ago describing cryptoassets as "everything you don't understand about money combined with everything you don't understand about computers". He said that banks’ understanding of cryptoassets had deepened since then, but even so, “the jury is still out when it comes to ascertaining how best to harness their oft-cited promises and benefits, while mitigating their risks and safeguarding financial stability.” He said the rapid growth in these assets poses risks to individual banks and overall financial stability, which “calls for a forward-looking approach” to the regulation and supervision of them.

Sarah Pritchard, Executive Director, Markets, at the UK’s Financial Conduct Authority, focused on the opportunities associated with cryptoassets in a speech she gave at the CityUK annual conference at the end of June. But she added that the authority is working with the government and others “to explore what regulatory standards could be put in place to manage risks to consumers, while boosting market integrity and competition in supporting the digitalizatio of financial services and markets.”

Also last month, FCA Chief Executive Nikhil Rathi, speaking at the Dutch Authority for the Financial Markets (AFM) warned of the dangers of relying on artificial intelligence in the crypto market. “The belief that allowing algorithms to control the supply and demand of crypto could avoid the volatility of markets controlled by fickle humans was challenged recently with the Terra Luna episode,” he said. “The stable-coin ended up being anything but, and was subject to dramatic volatility as seen with other cryptocurrencies.”

And Charles Randall, Chairman of the FCA, in May told a legal audience at Queen Mary University in London about the authority’s project “to bring speculative crypto into regulation.” “With celebrities as varied as Kim Kardashian and Larry David willing to take money to promote speculative crypto, how do we curb people’s enthusiasm to do something that may seriously harm their financial lives?” he asked. “A challenge like crypto demands a well-functioning partnership between Government, Parliament and regulators.”

In the US, Treasury Secretary Janet told the Senate Committee on Banking, Housing and Urban Affairs in May that although digital assets “may present opportunities to promote innovation and increase efficiencies” they may also pose risks to the financial system, and increased and coordinated regulatory attention is necessary”.

The US Securities and Exchange Commission (SEC) is looking into whether Terraform Labs – the Singapore-registered firm that created the terraUSD stablecoin and luna token – violated US laws on how it marketed them, according to a Bloomberg report.

The SEC’s enforcement division in May renamed its Cyber Unit the Crypto-Assets and Cyber Unit and nearly doubled it in size. “As more investors access the crypto markets, it is increasingly important to dedicate more resources to protecting them," said SEC Chairman Gary Gensler. Since its creation in 2017, the unit has brought more than 80 enforcement actions related to fraudulent and unregistered cryptoasset offerings and platforms.”

Two years ago, the European Union presented a proposal for a Regulation on Markets in Crypto Assets (MiCA) which is expected to come into force at the end of next year. It will give the European Securities and Markets Authority (ESMA) and the European Banking Authority (EBA) supervisory powers over companies providing crypto asset services such as trading, lending and custody.

Verena Ross, ESMA’s Chair, wrote in June that although linkages between crypto-assets and core financial markets are still limited, “the quick developments and cross-border nature of crypto-asset markets raise the potential for increased risk to ESMA’s objectives of financial stability, orderly markets and investor protection.” She added: “The recent issues with rapid falls in the value of some cryptocurrencies have only exacerbated the risks and the need for rapidly moving ahead with a robust EU-wide legislative regime. The fall of Terra, which saw its value wiped out in just a few days, should not be taken lightly. More and more European investors are turning to this market to invest their lifetime savings and we need to ensure an appropriate regulatory framework and effective supervision. Therefore, we believe that the European Commission’s Digital Finance Package, which includes a Regulation on Markets in Crypto-Assets (MiCA), is a welcome step forward."

The industry response 

Many crypto service providers are actually looking forward to a more regulated market. They believe it will create greater stability, increase its legitimacy and ultimately attract more investors.

One of these is Dina Sam’an, Managing Director of CoinMENA, a fully regulated, Sharia-compliant cryptoassets exchange in Bahrain. “Recent events have not changed my opinion on the long-term value proposition of crypto, but it has highlighted the need for more regulation in the sector,” she says. In an article entitled “Crypto crash highlights the need for regulation,” posted on her LinkedIn page, she describes the terraUSD/luna collapse as “the largest collapse in crypto history.” For the crypto sector, it is “a watershed moment equivalent to the collapse of Lehman Brothers during the 2007-08 financial crisis”.

“Like Lehman Brothers, terraUSD was stable in name only. As an algorithmically pegged token, its so-called stability depended on an unstable token. That’s why regulation is so important. Whether to combat mis-labeled stablecoins or unlicensed exchanges, we need appropriate frameworks and enforcement mechanisms to protect investors and support sustainable growth within crypto and DeFi.”

The future of crypto

To return to the question posed at the beginning of this article, do recent events signify the end of crypto as we know it, or only a short-term correction? It is only natural that people like Changpeng Zhao, the CEO of Binance, believe it is just a temporary setback. But when government ministers, like Britain’s John Glen, Economic Secretary to the Secretary, continue to back crypto – at least certain forms of it – you have to believe it is here to stay.

In April, Glen set out the government’s approach to cryptoassets and distributed ledger technology, which he described as “an opportunity” that would have “profound effects across multiple domains.” He said he wanted the UK to be “a global hub, the very best place in the world to start and scale crypto-companies” and that the Royal Mint will be issuing a non-fungible token (NFT) this summer.

That belief in crypto does not seem to have waned despite the current turmoil. Glenn reiterated the government’s positive outlook to a City of London audience in June: “We will harness the opportunities of innovative technologies in financial services, including supporting the safe adoption of a certain classification of cryptocurrencies, stablecoins, where used as a means of payment.”

There could not be a stronger official endorsement than that. Whether that attitude will prevail a year from now remains to be seen.

© Copyright 2022. The views expressed herein are those of the author(s) and not necessarily the views of Ankura Consulting Group, LLC., its management, its subsidiaries, its affiliates, or its other professionals. Ankura is not a law firm and cannot provide legal advice.

Tags

cryptocurrency & blockchain, data & technology, financial services, forensics & investigations, memo

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