Is the crypto crash a failure of regulation?

The crypto industry has been on a white-knuckle rollercoaster over the last few years. Establishing a market presence back in 2013, the price of Bitcoin rose from just over $10,000 in 2017 to over $61,000 in October 2021. However, the market is now experiencing a bust. Was a failure to regulation to blame?

Values of cryptocurrency are currently plummeting across the board. The high-risk, high-reward nature of cryptocurrency led many to not foresee the potential huge crash that was potentially lying in its wake. Why was more not done on the regulatory front to prevent this boom-and-bust scenario?

“In the past, crypto assets have thrived presenting themselves as an alternative to traditional financing. However, with concerns over rising interest rates and markets plunging, the crypto space is struggling,” said Bodo Windmöller, who is SVP at Regnology.

Windmöller gave the example of how Bitcoin – the biggest cryptocurrency by a mile – has already dropped 52% over the course of this year, with other crypto assets also suffering from this huge downturn.

However, he does not believe the crash of crypto is down to regulation deficiencies. “The whole market has gone down due to war, inflation/recession fears and rising interest rates and crypto has taken a larger hit, due to probably higher speculative behaviour and possibly inflated pricing.  To get a better understanding of this nuanced area, we need to look at the aims of regulation in general as well as in relation to crypto assets.

“Regulation itself has many different goals, most of which are highly relevant when we look at the crypto space. Regulation exists because we need to protect investors from dubious actors. It looks to reduce the likelihood of market manipulation and to protect investors from shady offers. Regulation sets minimal requirements for solvency and liquidity for all the actors in the markets and it is there to ensure transparency, especially on the supply side of the markets. And yes, we can say that in the area of crypto assets, we are not there in all those areas. We need to improve the regulation of crypto assets.”

Many regulators in the financial services industry have called for greater regulation of cryptocurrencies, with Federal Reserve Vice Chair Lael Brainard recently claiming the industry ‘needs strong regulation before it becomes so pervasive it poses financial stability risks’. In the opinion of Windmöller, however, while regulation in the lead-up to the crash would have helped and ‘shone a better light on the real value of crypto assets’, it wouldn’t have stopped it entirely, mainly due to the evolving nature of crypto assets.

One of the key and pressing concerns around crypto assets and regulation is shadow banking – an umbrella term for banking activities undertaken by unregulated actors – the Regnology SVP claims.

The traditional safeguards that surround regulated banking activities and actors can have the additional benefit of reassuring the market and public that their crypto assets are safe. Windmöller believes, however, that the problem runs deeper than regulation, “When you’re looking at these established banks and providers of other broker services, they have applied similar rules to crypto assets as they have done to other assets. It is really about these unregulated venues catering to ill-informed parties. That’s not something that the industry could easily have prevented.”

While some industry participants may not see the crypto bust as a failure of a lack of regulation, there will undoubtedly be broad agreement that its collapse will strengthen regulators’ desire to get their teeth into crypto’s deficiencies.

Peter Sherwood – an associate for Zeidler Group – remarked, “Recent events in the crypto market will strengthen regulators’ determination to rein in the industry, and measures are already being taken. In the UK, the FCA is expanding protections on crypto assets which include strengthening financial promotion rules for high risk investments, including crypto assets.

“In the EU, the Council presidency and the European Parliament have reached a provisional agreement on the markets in crypto-assets (MiCA) proposal. MiCA will primarily protect investors and seek to increase financial stability. While it may not prevent a future boom-and-bust scenario it is expected to add a degree of stability to what is considered a “wild west” market.”

On the topic of MiCA, Sherwood cited the current downturn in the cryptoasset market has been related to issues surrounding stablecoins – and MiCA, he believes, can protect consumers by requesting stablecoins issuers have a sufficiently liquid reserve.

He added, “Every stablecoin holder will be offered a claim at any time and free of charge by the issuer, and the rules governing the operation of the reserve will also provide for an adequate minimum liquidity. This will certainly bring a degree of stability to the market. HM Treasury also wants a regime in place for dealing with a stablecoin collapse, which will also act as a buttress to a boom-and-bust scenario. These measures would lead to a degree of stability although preventing a boom-and-bust scenario in the future could be out of reach of at the present time.”

Sherwood underlined that while there is distinct lack of regulation in the crypto market, due to large volatility and price fluctuations of the asset class, the current downturn itself is not likely due to a failure of regulation.

A similar opinion is shared by Michael Channing – a business development manager at RegTech firm eflow Global. He remarked, “While it’s true that there is currently little to no regulation around the crypto market, I don’t believe this fact has directly led to the recent crypto crash.

“The unfortunate truth is that we’re facing a recession which is impacting all corners of the financial markets. Just look at the stock market – it’s heavily regulated, but is still seeing huge losses, even more than ‘stablecoins’ like Bitcoin and Ethereum in some cases. To take an example, at the time of writing, Netflix stocks are down 68.8% year to date; the price of Ethereum has fallen by roughly the same (-67.76%), whereas Bitcoin is only down 56.44% YTD. If regulatory failure was playing a significant role, these price slumps would only be seen in the crypto markets, but as it is, these negative movements are being seen across the entirety of financial markets.”

Market challenges

With the varying questions surrounding the cryptocurrency industry, there can be a range of different voices sniping on the challenges the industry faces and how they can best deal with them. While cryptocurrency has become more ingrained within mainstream markets, the recent crash may have signified that crypto is being subjected to the same forces that are moving the economy and affecting traditional asset classes.

Eventus director of regulatory affairs, digital assets Mike Castiglione said, “The lessons we’re gathering from what’s happening in the crypto space are similar to the lessons of traditional asset classes. These involve issues of proper risk management and scenario analysis of what happens under different market conditions. This is something traditional finance and legacy organisations have been doing for centuries.”

In the opinion of Castiglione, this current period of examination of how the crypto industry is handling risks is equally undercutting two extreme views of regulation.

He continued, “One extreme view of crypto regulation was the view that the market only needed strong enforcement. The problem with that view is that enforcement, although helpful, often takes years to happen. Enforcement is a blunt instrument, and the players in the system don’t necessarily see how it applies to varying scenarios. Enforcement is a lagging indicator, and it’s hard to shape clear incentives from there.

“The other extreme view that is being undercut is that we don’t need regulations. This view claims that governments might act hastily without a proper understanding of this technology and the industry can somewhat govern itself. That is showing itself to not be true across the board and, in fact, many leading crypto firms are calling for more government involvement. So, the middle ground, the consensus view where most people are right now, is that yes, we need enforcement, but enforcement needs to come along with a clear channel to let responsible people have confidence that they are free to compete and that they and their competitors are governed by the same rules.”

The Eventus director also mentioned that another key lesson coming out of this collapse is that there are a good number of businesses that will emerge stronger and in a better position. He said these firms ‘were probably the companies that were proactive in establishing monitoring and surveillance systems that could scale with markets and operate across asset classes’.

He concluded, “Our argument is that the technology exists to increase transparency in these markets. This compliance technology is needed in the boom cycle and certainly needed in the bust cycle.”

How to prevent a future crash

With this crash in mind, how can the industry address – and subsequently prevent – similar issues?

Windmöller believes to prevent similar scenarios in future, a culture shift may be required. He commented, “We need to look at the attractiveness of these crypto assets. A lot of investors actually liked that they were lightly regulated, if at all. One of the positives (for investors of) Bitcoin was that it wasn’t highly regulated.”

Another cause for concern for Windmöller is the disparate types of crypro assets, “Most states are opposed to non-fungible tokens (NFTs). There must be a greater understanding of crypto assets like NFTs – regulators are starting to better understand what kind of different animals are hiding under the name of crypto. It’s going to be very important to inform the public about what these different assets mean. How do we view NFTs as an asset against something more stable such as currencies? Getting that transparency in the market is the way to go.”

Cryptocurrencies and cryptoassets are still to many, new and novel – with a vast percentage of the older population not fully knowledgeable about the sector at all. This also is relevant for crypto’s risk. Windmöller remarked, “It’s challenging to create a regulatory framework to mitigate risk if we don’t yet have a full definition of that risk. Regulators are preparing for this as much as possible, but they also have other areas to consider.”

Future regulations

While the crypto crash will undoubtedly affect the industry, there is little to no doubt that the genie is out of the bottle when it comes to the use of the asset – and the use of cryptocurrency is likely to return to high levels once the storm has passed. With this considered, new regulations are already beginning to fall into place to govern the usage of cryptocurrencies – however, the landscape is evolving quickly.

Windmöller commented, “Keeping up with regulations of uncharted digital assets is not easy and the regulation changes from country to country. EU regulators have already warned that crypto assets are not suited for most retail consumers as an investment or as a means of payment, calling them “highly risky and speculative.

“In June 2022, EU leaders and lawmakers outlined new regulations that will “put order in the Wild West of crypto assets.” While in the United States, regulation varies state by state. In May 2022, Treasury Secretary Janet Yellen urged comprehensive action on stablecoins after the collapse of Terra.”

Windmöller remains hopeful on the future of regulation, claiming, “It is part of the regulator’s job to see what’s happening in the unregulated space, what is evolving there and what needs to be regulated. That discussion has been ongoing, but it is also a political discussion. And we have seen that with Markets in Crypto Assets Regulation (MiCA) coming into place and EBA taking action, but it can be a long process.”

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