‘We’ve grown too fast’: Crypto faces reckoning as market falters

That could be said for the entire digital asset market, which has evaporated more than two-thirds of its value since peaking at $3 trillion last fall. As the Federal Reserve ramps up its campaign to curb inflation, investors are dumping risky assets in anticipation of rising interest rates. Startups that have skyrocketed in the two stimulus-driven pandemic years have started to plummet.

The market’s plunge is likely to dampen expectations of a two-year lobbying campaign that has made digital assets one of the most visible industries on Capitol Hill. Crypto’s shrinking footprint could weaken a bid by top exchanges and developers to push for new laws and light-hearted regulations they claim will help blockchain-based businesses thrive. And it could damage industry confidence in Washington — especially amid mounting scandals at popular lending platforms that have seen customer accounts frozen or deleted.

“When everything goes up, there’s a lot hidden,” said Caroline Pham, Commodity Futures Trading Commissioner, in an interview. “From a regulator’s perspective, it really just underscores that we just have to do something.”

According to a report by monitoring group Public Citizen, top exchanges and industry groups pumped $9 million into lobbying in Washington in 2021, more than tripling their spending from the previous year. That drive accelerated into early 2022, bolstered by tens of millions of campaign donations from power brokers like FTX founder Sam Bankman-Fried.

But the battle to shape legislation and influence regulators’ decisions to tighten oversight of the industry has only just begun, and Caitlin Long, the founder and CEO of a Wyoming-based crypto bank, said some digital asset companies are herself responsible for the growing heat of the regulators . The representations companies make to Washington policymakers often amount to “regulatory theatre,” she said.

“They know they’re in a regulatory gray area,” said Long, who is suing the Fed for opening a master account that would put her bank under the direct supervision of the central bank. For some crypto companies, “the strategy is to get as big as possible as quickly as possible; become too big to have to comply with regulations.”

This strategy might be too big to work. Market regulators and law enforcement agencies have already targeted areas such as insider trading, disclosure errors and investor protection issues. And regulators, including senior officials from the Securities and Exchange Commission and the CFTC, have signaled further investigations are likely.

“I hope we use the turmoil of the last few weeks to take a look at where we stand from a regulatory perspective,” said Robert Baldwin, a former Treasury Department official and head of policy for the Association for Digital Asset Markets. While the industry has built credibility with policymakers, he said, “recent events are forcing people to take a step and think about what’s going on. It’s probably also forcing companies to be a bit more cautious.”

With Congress’s attention divided by crises from Ukraine to inflation, the urgency to pass new crypto laws is likely to diminish as investors shy away from risky digital assets. Despite headline-grabbing celebrity endorsements of crypto companies, a recent Fed survey found that only 12 percent of American adults had owned or used digital currencies in the past year.

The demise of digital asset markets, coinciding with losses in more traditional financial markets, is accelerating as hedge funds, crypto-based lending platforms, and stablecoin issuers scramble for liquidity to bail out their projects.

The latest explosion began last weekend after Celsius Network — a bank-like crypto lender that had pledged annual returns of up to 18 percent on customer deposits — announced it was offering withdrawals and crypto-to-crypto trading services to about 2 million customers “due to extreme market conditions.” The company, which has not responded to multiple requests for comment, is reportedly considering a restructuring.

Celsius’ woes mirrored those of TerraForm Labs — the startup behind an algorithmic stablecoin that collapsed last month — which had also attracted billions of dollars from retail traders and institutional investors by linking its token to a high-yield decentralized lending program.

The market downturn is starting to bring down major crypto investment firms as well. Three Arrows Capital, a Dubai-based hedge fund, is reeling after posting hundreds of millions in losses from its investments in TerraForm tokens and other flagging digital assets.

Both companies have had disputes with securities regulators. Celsius has been ordered by four state agencies to stop offering unregistered securities in the form of interest accounts amid fears the company might default on its obligations to depositors.

“Policymakers care less about common stockholders and preferred stockholders; They care about those depositors first and foremost,” said Mike Boroughs, co-founder and head of portfolio management at blockchain investment firm Fortis Digital.

While some decentralized finance (DeFi) lenders — or more centralized firms offering access to DeFi-like returns — may offer cheaper alternatives to tightly regulated banks, a lack of institutional underwriting standards introduces even more risk to crypto markets.

“If you’re offering a higher yield by taking out worse credit, that only leads to a 2008 subprime crisis in another industry,” Boroughs said.

Crypto advocates have resisted these types of comparisons, arguing that autonomous or community-managed systems that mimic the functions of traditional lenders and exchanges could become safer and cheaper alternatives. And to date, no existing platform has evolved to the point where it could pose systemic risk to the economy.

Lawmakers and crypto advocates say market volatility could offer certain companies an opportunity to flag their practices as a potential model for future legislation or regulation. Sense. Cynthia Lummis (R-Wyo.) and Kirsten Gilbrand (DN.Y.) say their recent crypto bill — hailed as a milestone by the industry — was marked by some of the issues that emerged after the TerraUSD collapse.

“We’re kind of in this ugly duckling phase,” said Linda Jeng, a former Fed official who leads regulatory and policy efforts at the crypto industry-backed standards organization, the Centre. Jeng said she looks forward to working with regulators to develop “reasonable, proportionate, rational rules and regulations.”

Still, the arrival of more scandals could pose obstacles for the industry as it attempts to make these arguments in Washington — particularly with new venture capital-backed platforms offering similar services rolling off the conveyor belt.

“If you want to launch a successful platform in this space, the current framework is just extremely unclear how you would go about it,” said Tomicah Tillemann, the global chief policy officer of Haun Ventures, a recently provided venture firm providing startup funding for a new DeFi lending platform. “We and others have been asking the SEC for clarity for a very long time and they have totally failed.”

SEC Chairman Gary Gensler says the rules for crypto lending are clear.

BlockFi, another platform that recently survived layoffs, paid $100 million to settle claims that its revenue-generating accounts were unregistered securities. Coinbase scrapped plans for a product that would have allowed customers to earn interest on their digital assets after a very public row with the regulator last year. The agency was reportedly investigating Celsius — as well as several other crypto lending platforms — in the months before freezing its customers’ assets.

An SEC spokesman declined to comment on whether an investigation is pending.

“Lending platforms work a bit like banks,” Gensler said at an event on Tuesday, adding that trading platforms and exchanges that offer sky-high yields have largely failed to disclose enough information about their products to investors.

“If it seems too good to be true, it might be too good to be true,” he said.

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