US Crypto Regulation is Appalling
Crypto has problems:
Public permissionless blockchains are considerably slower, costlier, and less flexible than centralized databases and aren’t private and are extremely vulnerable to hacks. Transactions aren’t reversible, data deletion is impossible and the loss or theft of private keys is catastrophic.
Cryptocurrencies and blockchains have limited economic uses. Coins are too volatile to be units of account; too volatile to be stores of value (for most people). And fees are too high and unpredictable to be a medium of exchange for retail payments. Most ‘web3’ use-cases like tokenized real estate don’t withstand basic scrutiny. Crypto is often used for ideological or fundraising reasons, not because it’s technically necessary or useful.
Ponzis, pyramids, scams, pump and dumps, rug pulls, insider trading, wash trading and market manipulation are rampant. There are significant market structure issues (fiduciaries trading against clients, vertical integration of services, etc). Crypto equity tokens aren’t held to the same standards as securities.
These problems have important differences.
Whether blockchains can get faster, cheaper, safer, private and user-friendly is fundamentally a technology question. Engineers, entrepreneurs and VCs should be free to spend as much time and money on these things as long as they think it’s worth it and no one else gets hurt.
Whether cryptocurrencies can reduce their volatility or tokenized real estate (or any web3 idea) can work is largely an economics and business question. The private sector should be free to do unlimited R&D on these problems provided appropriate guardrails are in place.
The third set of problems is different, though. Scams, market manipulation, and regulatory arbitrage aren’t a private problem. They are a public problem that is intimately tied to governance and oversight. Ponzis, insider trading and conflicts of interest are direct outcomes or at least co-determined by inadequate government regulation and weak enforcement of existing rules.
So that’s what I’m talking about: US oversight of the crypto industry, which is appalling and has led to massive investor losses, economic waste and misallocation of scarce engineering talent —>
Last Monday, the Securities Exchange Commission (SEC) announced it fined Kim Kardashian $1.26M for promoting the worthless cryptocurrency EthereumMax (no relation to Ethereum) on her Instagram sixteen months ago, in June 2021, without disclosing she was paid $250k for the endorsement. Minutes later, SEC chair Gary Gensler posted a cringey PR video on social media and went on national television to talk about the news.
Celebrity crypto endorsements are a moral disaster as Ben Mckenzie and Jacob Silverman called them and influencers should certainly be prosecuted and fined for promoting scams. But this performative wrist slap highlights how hollow US crypto oversight is.
The SEC has failed to regulate the crypto industry for not one but two bubbles now, first the 2017 initial coin offering bubble and now the 2020-22 COVID-Musk-NFT bubble. It’s been five years and the SEC still hasn’t found ways to protect mom and pop investors from garden variety scams and fraud. It’s been five years and the SEC still hasn’t set disclosure and registration requirements for crypto projects with equity tokens or set standards for listing equity tokens on centralized exchanges.
As everyone knows, the vast majority of tokens listed on FTX, Binance and the likes are securities. They’re almost all (1) investments of money (2) in common enterprises (3) with the expectation of profit (4) from the effort of others that straightforwardly pass the Howey test. So why aren’t they held to the same standards as securities?
Even now, in 2022, you can write a whitepaper for a crypto venture, spin up a website, market it on twitter and discord and then IPO equity tokens to the general public before there is a product, a customer or a business. And if you’re smart, you might even get listed on centralized exchanges with millions of customers. Chances are, you’ll fly right under the government radar.
The SEC’s refusal to set clear rules for the industry and its insistence on regulating by enforcement ex post has led to all sorts of gray areas, bad outcomes and waste. And as Matt Levine often writes, its habit of targeting friendly US-based projects with enforcement actions while ignoring rogue offshore projects discourages companies from incorporating in the US and cooperating with regulators.
So yes, the SEC should obviously fine Kim Kardashian. But does the penalty compensate the scammed individuals for damages or excuse the broader regulatory failure? No.
Why is US crypto regulation so bad? There are lots of theories, but it’s not entirely clear, not to me at least.
Jeff Roberts from Fortune writes that SEC chair Gary Gensler “is gunning to be Treasury secretary after Janet Yellen leaves the post” and “is doubling down on theatrical enforcement actions in hopes of pleasing Sen. Elizabeth Warren, who has President Joe Biden’s ear on financial policy.” This story is plausible but doesn’t quite add up. If Gensler wanted a bigger role in Biden’s government, it would probably look better if he was actually tough and effective on crypto, rather than just pretending to be and failing.
A second explanation is that the SEC is being aggressively lobbied by the crypto industry and that democratic politicians have been bought off with crypto money – a story of regulatory and political capture. This one isn’t super compelling either, though. Sam Bankman Fried of FTX and Brian Armstrong of Coinbase sure do lobby and donate, but they can’t be happy right now.
A two trillion dollar wipeout with most coins cratering 80-90% from the highs and tens of billion in losses for American retail investors isn’t exactly good for their legacy, their businesses or the broader crypto industry. Maybe SBF and Armstrong are short-sighted and were happy to torch their reputations to make a few billion over two years, but I don’t know, I like to think that they’re smarter than that (?). I struggle to see how this ‘wild west’ status quo is working for them.
A third explanation is that the SEC is busy and that crypto is too low on their priority list. Honestly, this probably explains like 70% of the story. Equity and debt markets are orders of magnitude larger and more consequential to people’s lives, so it would make sense that they get all of the attention. A related hypothesis is that the SEC is underfunded or short-staffed. Maybe they could use a bigger budget for crypto enforcement. Or maybe their crypto lawyers are underpaid and are all getting poached by the industry.
A fourth explanation is that the SEC can only do so much without new legislation from congress; that they don’t have the statutory authority to lay out a regulatory framework for the industry and are afraid to push for one and then have it shot down in the courts. I’m not sure if this is plausible, I’m not a lawyer, but I suspect it’s broadly true. Congress hasn’t ever passed a major crypto bill and the ones in the pipeline are apparently stalled.
A fifth explanation is that crypto is inherently censorship resistant, so regulators have limited tools to enforce laws. This is a nice story but it’s BS. The vast majority of people come into contact with crypto through centralized exchanges that have deep links to the traditional financial system: the on and off ramps where people exchange regular money for tokens. It’s only a minority of people that have self-hosted wallets on-chain, so regulators do have significant leverage.
Look, at the end of the day, pyramids, ponzis and fraud aren’t new. Wash trading and insider trading aren’t new. Conflicts of interest and regulatory arbitrage issues aren’t new. All the SEC needs to do is level the playing field and enforce the laws that apply in the rest of finance to crypto. If they need more money they should ask for it. If they need new laws they should ask for them. But this ongoing oversight failure is just unacceptable.