Cleaning up crypto: How much enforcement is too much?
Many blockchain companies now believe that regulation is inevitable, but there’s a growing debate over where to draw the line between protecting users and strangling the lifeblood out of the industry — or forcing it outside the United States.
“Whether we like it or not, regulation is coming,” Sheila Warren of the Crypto Council for Innovation tells me during an interview in the lead up to the recent Collision conference in Toronto, Canada.
The CEO of the industry lobby group for blockchain technology explains that rather than trying to stop the inevitable, many companies are now focused on lobbying for rules that work for them instead.
Why the change? With every week seeming to bring new stories of loopholes, hacks and algo stablecoin failures — from the popular Netflix QuadrigaCX documentary to the dizzying world of crypto transaction mixers and the steps law enforcement used to track two Americans accused of selling fraudulent NFTs — increased regulation is starting to look like a better idea. And not just for businesses but also for legislators worried about being reelected. People seem to love hearing about crypto scams and lost money… as long as it’s not their own.
Even if regulation is inevitable, the question of how and what to regulate is still controversial. Specifically, what type of regulations and enforcement will actually help keep the industry fair and safe for participants without killing the unique and revolutionary aspects of blockchain, or turning it into another version of traditional finance?
Does regulation mean clarifying the 38 different considerations for the four factors that define a U.S. security? How about defining who owns what rights in NFTs? Or maybe it simply means following Wyoming’s example and regulating DAOs?
Walking the line
A week later at Collision itself — a 35,000-person tech who’s-who in Ontario — I plop myself down on a chair in the dark area in front of the “crypto stage” for a discussion with Ripple CEO Brad Garlinghouse about how to regulate cryptocurrencies.
Ironically, staring me in the face are a hundred or so branded seat covers sporting an eye-popping white-on-black Crypto.com logo, despite the fact that Crypto.com isn’t registered to operate as a crypto asset trading platform in Ontario.
According to the Investment Industry Regulatory Organization of Canada (IIROC) Staff Notice on crypto ads, Crypto.com’s seat branding is legal. It avoids statements that could be seen as unfair, misleading or inadequately informative of consumer risk. Most conference attendees — a global audience of tech entrepreneurs and CEOs — already knew what “Crypto.com” meant. Matt Damon could have the week off.
The advertising is an example of how regulators have their work cut out for them in finding the delicate balance between deterring bad actors while promoting innovation. For example, the Ontario Securities Commission (OSC) is mandated to protect consumers while encouraging novel businesses and competitive capital markets.
As part of the OSC’s mandate, it previously published a report on the suspicious death of QuadrigaCX CEO Gerald Cotten and how what used to be Canada’s largest crypto exchange lost its clients’ millions. It also kicked the world’s biggest crypto exchange by volume, Binance, out of the province for operating without permission.
This year’s plans include continuing to enforce securities law and engaging with crypto firms to get them to register to do business in the province, says OSC senior affairs specialist JP Vecsi. “Another priority will be identifying and addressing misleading information in crypto asset trading platform advertising, marketing and social media,” he adds.
The freedom to make terrible investment decisions
At the other end of the scale, there are plenty of crypto libertarians who aren’t convinced much regulation is necessary at all. The Satoshi Island group is attempting to establish a libertarian “blockchain-based democracy” on an island in the South Pacific (with the cooperation of nearby Vanuatu). It’s minting NFTs for citizenship, though the process has slowed thanks to the crypto downturn.
Lizaveta Akhvledziani, CEO of Chexy — a rewards card program for renters — leans liberatarian with a few ground rules. She believes people should be able to invest in whatever they want, no matter the risk.
All that investors need, she says, are Anti-Money Laundering rules and education. When she bought TerraUSD (UST), the algorithmic stablecoin linked to LUNA that would crash in May 2022, she understood it was risky.
“If you really go in there thinking it’s risk-free, but you’re going to be making 20% a year, you’re an idiot,” she says.
“What happened was a shitty situation — a lot of people lost a lot of money… But if it’s just market dynamics, you can’t just regulate that because that goes against the whole decentralized economy crypto stance.”
SEC v. Ripple, the ongoing saga
One pro-regulation argument is that compliance may be easier, market trust greater, and business smoother and more profitable after governments finally issue clear guidelines.
“Even though there are a lot of libertarian roots in crypto, my experience is most actors in crypto want to play by the rules. But we have to know what the rules are,” Brad Garlinghouse of Ripple tells the conference.
“It’s incredibly frustrating to be a citizen of a country that is behind almost every other country in providing clarity around crypto. Canada has approved a Bitcoin ETF. The U.S. has not. I think there are so many examples where the U.S. has been out of step with other G7 economies.”
Ripple is currently fighting the U.S. Securities Exchange Commission over the latter’s claim that the company’s sales of XRP were investment contracts sold as securities without a prospectus. The case would set an important precedent for other companies, and Garlinghouse said he’s fighting for both his company and the entire industry.
“The SEC is a hammer, and when you’re a hammer, everything looks like a nail,” said Garlinghouse. “The current chair of the SEC has said he thinks probably everything except Bitcoin is a security. That could be very negative for the U.S. crypto industry. It’s the reason a lot of people are moving outside of the U.S. to build and invest in various crypto projects… If the country you’re based in is making it hard to be successful, you go other places.”
According to Garlinghouse, the tides have already shifted on the west coast of the United States. “I think the big change that’s happened is Silicon Valley had an advantage around tech talent. That’s just not true today,” he says.
Putting its money where its mouth is, Ripple is opening an office in Toronto. Coinbase is expanding in Europe, despite laying off 18% of its U.S. workforce in June. And Binance is also planning to return to Ontario by 2024 by registering with the IIROC, the national regulatory organization, thereby skipping the province’s registration process.
American bills on the table
The U.S. is moving toward regulations, just slowly. Ripple head of public policy Sue Friedman says both the proposed bipartisan Digital Commodity Exchange Act and Lummis–Gillibrand Responsible Financial Innovation Act are good starting points, but the U.S. is falling behind other countries, including the United Kingdom and Singapore.
Warren of the Crypto Council for Innovation agrees. “No one’s waiting for the U.S. to act,” she says. For now, her focus is on states such as Delaware, as well as Europe, India, Australia, Dubai, Singapore and the Bahamas, all of which are embracing more innovative regulations that create certainty for businesses. The Bahamas’ recent white paper on the future of digital assets in the country reiterated the country’s goal of improving the “attractiveness of The Bahamas as a well-regulated jurisdiction where well-run digital asset businesses, of any size, can operate, grow, and prosper.”
That means encouraging citizens to use the island’s central bank digital currency to operate their businesses and even pay their taxes. The U.K. more recently published a bill allowing the Treasury to regulate digital settlement assets, including payments, service providers and insolvency.
However, Warren warns that clearer regulations won’t always be beneficial to blockchain businesses. Singapore’s tone went from wooing blockchain firms and touting itself as a crypto hub to a much stricter regulatory regime.
“As the Monetary Authority of Singapore gets closer to unveiling what it wants to do for central bank digital currencies, we’re seeing less openness in some ways to crypto.”
With the Lummis–Gillibrand bill on hold until next year, the timeline for U.S. regulations is still unknown. What’s clear to her, though, is that crypto isn’t suddenly going off the radar.
“Our view is we’re actually ready for regulation in many cases. No one wants to see rugs pulled,” she says.
“Nobody wants to see scam artists thriving unless they’re the scam artist. It brings the whole industry down and gives us a bad name.”
Regulators should be helping people identify the scams and potential rug pulls, she says.
“To some extent, the industry can help and is willing to help with that. On the other hand, there has to be some guidance on how to do that. Everyone shouting on Twitter is not helpful. No one can distinguish who’s credible. For everyone saying ‘Terra LUNA is risky,’ you’ve got someone getting a tattoo of a dog,” she said, referring to the howling wolf LUNA tattoo that Galaxy Digital CEO Mike Novogratz got just months before the stablecoin’s collapse.
Like the Crypto Council for Innovation, the Canadian Web3 Council is also advocating for responsible blockchain regulation, but the wait will likely be long in Canada, too. Last April, the Canadian federal government announced a financial sector legislative review that will take five years to complete.
According to a Department of Finance official, the focus will be on the digitization of money and maintaining financial sector stability and security, starting with digital currencies, including regulating cryptocurrencies and stablecoins and establishing a CBDC.
Since the department plans to consult with stakeholders and Canadians, the Web3 Council will likely have a lot to say. The government will also be listening to its international counterparts and aligning its regulations with international standards and best practices, whatever those turn out to be.
Canada at least has some clearer guidelines and legal precedents than the U.S., but the wait for clear regulations isn’t ideal in either country since the worst regulations might be no regulations at all.
According to assistant professor Ryan Clements of the University of Calgary Faculty of Law, regulations create certainty for investors and increase crypto trading volume, prices and the total number of users. Lack of regulation does the opposite, pushing out both hesitant amateur investors and professional traders. It means fewer people lose their savings and fewer Netflix specials about scams, but also less VC and government financing for innovation.
Not everyone agrees with this view, with other scholars questioning whether strong regulations actually do hurt innovation and investment (but not trading itself). A recent study showed that while announcing new regulations and enforcement actions significantly impacted the prices of ETH and BTC in recent years — like when China banned ICOs in 2017 — neither negative nor positive announcements had a significant effect on the trading volume of those cryptocurrencies, either in the countries making the announcements or globally.
While these announcements don’t actually scare off traders, the study shows they do push companies out. It’s relatively easy for a trader to switch exchanges versus a company moving a brick-and-mortar business, like when Kraken left New York in 2015 and Deribit left the Netherlands for Panama in 2020.
Meanwhile, pushing innovative companies out could be as limiting for a country’s economy as not letting them in. Garlinghouse said 95% of Ripple’s customers are non-U.S. customers, which means a lot of potential revenue could end up in the U.S. economy if the company is allowed to operate there within a clear framework.
Binance.US doesn’t expect the class-action lawsuits against it to succeed
Like Ripple, Binance.US is also facing legal action that could potentially have been avoided with clearer regulations. After the Terra blockchain ecosystem collapsed, a number of class-action lawsuits in several states alleged that the company misled investors about the investment risk involved.
“The beautiful and horrible part about America is you can sue anyone for anything,” Brian Shroder of Binance.US told the Collision audience.
“On our platform, we actually never listed LUNA.” He added that the company’s due diligence process before listing a coin or token project takes days of research involving questionnaires, internal and external counsel, a listings committee made up of a cross-functional team of legal compliance and business, and a unanimous vote. All that to say, he’s not worried.
But if the government had regulated the due diligence process and the criteria in the first place, the lawsuits likely could have been avoided, or at least Binance.US could justify its process by saying it had followed the rules.
One way companies are dealing with risk and the wait for regulations is by hiring former regulators from the SEC and the Canadian Department of Justice. Those employees are helpful when conducting the 38-consideration SEC framework analysis for the four-factor Howey analysis used to determine whether potential token offerings are securities in the U.S., which SEC Commissioner Hester Peirce compared to a Jackson Pollock painting.
Ripple’s Friedman would also like clarification on those factors. “The goal for all of us is to be able to take a test, have multiple people apply the factors, and reach a similar conclusion,” she says.
Back at Collision, Shroder said the extensive Lummis–Gillibrand bill will not likely be passed as is, but he could see the parts about stablecoins being pulled out and passed separately because of recent media attention, the need to protect consumers, and politicians’ desire to be reelected.
“Anytime consumers are harmed or impacted, Congress tends to speed up or pay attention,” he said.
“This is an echo of the 1930s banking. This is the same process that led to regulations like the [Federal Deposit Insurance Corporation].”
“Will we have an FDIC for crypto?” Shroder mused. “Probably not, but who knows what kinds of regulations we can see put in place to make the industry safer” — and, of course, more profitable.