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Opinion: Crypto can’t rely on the government to save it from itself

<i>Jakub Porzycki/NurPhoto/Getty Images</i><br/>Representation of Bitcoin cryptocurrency is seen in this illustration photo taken in Krakow
NurPhoto via Getty Images
Jakub Porzycki/NurPhoto/Getty Images
Representation of Bitcoin cryptocurrency is seen in this illustration photo taken in Krakow

Opinion by Emily Parker for CNN Business Perspectives

Cryptocurrency is having an existential crisis. Last month, crypto lender Celsius filed for bankruptcy protection. It has frozen withdrawals since June 12, and it’s unclear if or when customers will get their money back. But Celsius is just one domino to fall.

Crypto lender Voyager Digital also recently filed for bankruptcy protection. Ordinary investors who deposited their money into Voyager likely don’t know if or when they will see their funds again. Bitcoin, meanwhile, recently fell more than 70% off its all-time high from last year.

And back in May, TerraUSD (UST), a so-called stablecoin that was supposed to trade at $1, saw its price fall well below that, causing steep losses for those who held it or its sister coin Luna (Luna’s value was linked to UST).

The underlying problem is a combination of risky lending, poor risk management and opaque finances. So when crypto prices crashed, likely as a result of fears of rising inflation and the possibility of a recession, some crypto companies didn’t have the capital to cushion the blow. The result has been the disappearance of billions of dollars in value, often with ordinary investors paying the price.

Cryptocurrencies like Bitcoin are supposed to be independent of any government. But we have now reached the point where stronger government regulation of the crypto industry is both necessary and inevitable. At the same time, the industry can’t just wait for the government to act. Crypto companies must also try to better police themselves.

That starts with providing more transparency. While transparency is one of the core ideals of blockchain technology — all transactions on the Bitcoin blockchain are viewable for the world to see, for example — some crypto companies are strikingly opaque. In the case of Celsius, Vermont’s Department of Financial Regulation has said that “customers did not receive critical disclosures about its financial condition, investing activities, risk factors, and ability to repay its obligations to depositors and other creditors.” At the very least, companies need to put much clearer warning labels on their products outlining the risks of depositing or investing with them, as well as more information about how customers’ deposits are being used.

With stronger regulation, the Celsius situation might have played out differently. Its model was essentially to take user deposits and use them for risky and illiquid investments, and users enjoyed high interest rates in return. Celsius was essentially acting as a bank, without the regulatory protections or FDIC insurance.

“Prudential regulation, such as those applying to banks, would almost certainly have prevented many of the problems in our sector,” Caitlin Long, CEO of depository institution Custodia Bank, said in an interview. “Prudential capital requirements, investment restrictions, background checks on all executives, annual supervisory exams — all those things don’t apply to the crypto industry. They do apply to banks though.”

This kind of regulatory overhaul isn’t likely to come anytime soon, however. That’s why venture capitalists and ordinary investors alike should push companies for greater transparency and accountability, demanding audits and disclosures about lending practices and capital reserves. When crypto prices were sky-high, few took a hard look at these companies’ business practices.

The same was true with the stablecoin UST. When the market was strong, few publicly pointed out what are now obvious red flags, and those who did risked being shouted down by crypto enthusiasts on social media. Now, UST’s dramatic collapse may well hasten stablecoin regulation in the United States.

There are widespread concerns that some of the leading stablecoins are not nearly as stable as they claim to be. The fear is that if investors decided en masse to redeem their coins for the US dollars that supposedly back them, the stablecoin issuer would not have enough cash on hand to fulfill these orders. US lawmakers were reportedly closing in on a bipartisan deal to regulate stablecoins, but consideration for the bill has been delayed until after August. The bill, which is not yet public, would treat stablecoin issuers more like banks and subject them to federal supervision. It would also include strict requirements for the assets that back a stablecoin.

Another bill by Sens. Cynthia Lummis and Kirsten Gillibrand aims to bring more regulatory clarity overall by creating a standard for deciding which digital assets are commodities and which are securities. That would help clarify which assets are regulated by the Commodity Futures Trading Commission vs. the Securities and Exchange Commission.

A clearer and more consistent regulatory framework around what companies can and can’t do, as well as which federal agency regulates which digital assets, could bring greater protections for ordinary investors.

Hester Peirce, a commissioner at the SEC, has long argued for more regulatory clarity. “If we decided that crypto lending is an area that we can implicate the securities laws, we could have sat down a long time ago and hammered out some rules around that that made sense,” she said in an interview, speaking in her personal capacity.

Instead, what you often get is regulation by enforcement, where companies are punished after the fact. One of the problems with these one-off enforcement actions is that they don’t necessarily cover the whole crypto landscape.

“Not only is that not particularly fair, because sometimes enforcement actions come late, and sometimes it’s a question of ‘why did you go after this project instead of this project,’ but also because it allows people who are really doing bad things to get lost in the shuffle,” Peirce said.

These proposals are all steps in the right direction for starting a serious conversation about crypto regulation. But given other priorities in Washington, it’s unclear when new regulations would take effect or what they will look like in their final form.

Smart regulation is necessary, but it won’t be enough. Crypto innovation moves faster than any government’s attempt to rein it in. Political negotiations can also delay the passage of bills. Furthermore, with every new crisis, cryptocurrency loses more credibility. This could lead regulators to crack down harder than they would have otherwise, stifling innovation in a still-evolving field. An industry that prides itself on decentralization shouldn’t rely on the government to save it from itself.

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