The Rules of the Game

Regulations are coming for blockchain and crypto. Here’s what they’ll look like and how to interpret them.

Blockchain and crypto had quite a year in 2022. A crash in liquidity during the first half of the year was quickly followed by the FTX collapse in the second—all of which generated negative press. While some of these problems were not without precedent, it was their speed that altered the general public’s perception of cryptocurrency and blockchain technology. Unlike previous issues, these will cause changes in the markets and institutions themselves.

However, the most important changes that are coming for the industry are the pending regulations that these crises have kicked off. It is evident that more regulations, likely stringent ones, are going to be issued in the coming months in a number of countries. Let’s take a look at why these regulations are coming, what their effects will be, and how to prepare for them.

As mentioned, last year was a rocky one for many crypto and blockchain projects. In addition to the problems faced by those in the industry, the adoption of many cryptocurrencies by members of the general public, along with increasing interaction between the crypto economy and the rest of the global financial system, meant that the problems facing crypto became problems for large numbers of people.

The collapse of FTX is a great example of this—and is proving to be a catalyst for regulation. After all, vast fortunes were wiped out. The general health of several ecosystems, including Solana, has been viewed as weaker. BlockFi, which had been bailed out by FTX earlier in 2022, has ceased operations. The FTX contagion has spread to lenders, funds, and asset managers such as Genesis, Galois Capital, Sequoia Capital, Wintermute, Multicoin Capital, Amber Group, Paradigm, and Nexo, among others.

But the FTX collapse raises questions over which federal agency will regulate the company. While this issue is likely to be resolved fairly quickly, the general question of how crypto service providers will be regulated is still to be resolved, and will likely be addressed in the light of these events.

Stablecoins have also emerged with challenges. It became clear that many coins were not backed by enough assets to warrant being pegged to fiat currencies, and algorithmic controls were insufficient to maintain their desired price levels. This came on the heels of the crash of many coins in May, an event that wiped out huge sums of money and caused a general souring towards crypto. These issues led to the collapse of Luna, UST, and 3AC and its related parties, such as Voyager Digital.

Because of the scale of these issues, and because stablecoins are the connection between crypto and the rest of the economy, these two crises were perhaps the first crypto crashes to impact the larger economy in a meaningful way. They alone would have been enough to make new regulations likely. Any industry that can damage the economy in general is going to be of interest to regulators, however the nature of these crashes has been the cause of nightmares.

A Chilling Effect

So, what regulations are already on the table or are very near implementation?

In California, the state senate passed a bill that would limit trading stablecoins to those who weren’t licensed by a bank or backed by secure reserves or by the state of California. The bill, which as of early February had not yet been signed into law, would severely limit
crypto exchanges.

At the federal level, the Treasury Department has also called for stablecoin regulation, and a bill has been read before the Senate Finance Committee, though by early February it had yet to be voted on.

There is also support in the Senate for the Digital Commodities Consumer Protection Act, DCCPA. However, this bill was closely tied to FTX and its chief executive, Sam Bankman-Fried, and it may well be delayed as a result of recent events. Still, the Senators who supported it then continue to do so.

The Federal Commodity Futures Trading Commission is also considering the use of its existing authority to address cases of fraud involving digital assets, including digital currencies.

In Europe, the crypto-assets bill MiCA, which would set reserve requirements for stablecoins and require authorization for wallet providers and exchanges, was set to be voted on this month. It has already passed some bureaucratic hurdles. In Singapore, which already employed a regulatory scheme for crypto companies, a parliamentary inquiry into why FTX was not included on a list of risky investments has led to calls for more regulation.

The idea that any of these proposals are now less likely to pass or to be strongly enforced, in light of recent events, is ludicrous. If anything, these bills are likely to become even more stringent as they pass through committee.

It is highly probable that additional regulations will be issued, as well. As in other industries, this will increase the cost of doing business and may slow the industry. In the lead-up to implementation and the full establishment of the letter of the law, it is also probable that a chilling effect will impact the industry.

Possible Benefits

What form these regulations will end up taking is uncertain. As we can see in some of these proposed laws, as well as existing laws in the state of New York, it is possible that some new regulations will make doing business impossible for certain companies, or make certain territories unattractive.

In the worst case, many large states may be essentially locked out of the crypto market or abandoned by companies as new regulations pass.

However, there is also the possibility that regulation could benefit the industry after the implementation of the new standards has been worked out. The confidence of the general public in crypto, blockchain, DeFi, and other related concepts has been shattered, and a sense of reassurance by the government that an FTX-like collapse will be less likely is critical for restoring that confidence.

Likewise, the various practices that caused the recent slew of problems, including unbacked stablecoins and what appears to be outright fraud at FTX, would become less likely under a system of robust regulation.

Over the long term, protections against these issues could benefit the crypto industry in terms of a healthier ecosystem. While regulations may increase the cost of doing business for many companies and might even make some operations unable to engage with customers in some markets, the possible benefits that regulations might provide must also be considered.

Examples of how regulation could be a positive development are easy to find in other sectors of the economy, banking in particular. The number of global banking crises went to nearly zero during the years of the Bretton Woods system, suggesting that certain regulatory systems can prevent major crises at the cost of increased oversight.

Here in the United States, banking regulations implemented in the 1930s provided protections for consumers and helped to prevent general calamities up until the Savings and Loan Crisis in the 1980s.

Too Soon to Judge

As was the case in the 1930s, when banking regulation restored public confidence in banks, regulations could help restore public confidence in crypto and DeFi. Regulations that help prevent fraud, Ponzi schemes, or pump-and-dump operations would also help to rehabilitate crypto in the eyes of many people who are concerned about consumer protections.

However, it is still too soon to judge exactly what the effects of the proposed legislation will be, given the shifting political attitudes toward crypto and its institutions. For example, while DCCPA may threaten DeFi’s unique features of composability and permissionless characteristics, the FTX collapse may prompt rewrites that change several aspects of the bill.

In any case, centralized regulations will cause some disruption to the industry and will certainly clash with the ethos of decentralization so prevalent in crypto.

Given recent events, increased regulation of crypto is all but certain. What that regulation will look like is still undetermined, but existing regulations and proposals can give us an idea.

—Felix Xu is a co-founder of ARPA Network and Bella Protocol.