BlockFi SEC settlement spells broader crypto regulation

Clear crypto rules, fair markets and innovation. Pick two.

Some hailed BlockFi’s settlement with the SEC as a groundbreaking move to start regulating the crypto sector through enforcement. But there’s a strong undercurrent of dissent, beginning at the commission itself.

There are huge stakes. There was nearly $60 billion in crypto locked in DeFi credit contracts as of September, according to a recent IMF study. There’s also a large amount of lending using crypto as collateral, catering both to hedge funds placing big, leveraged bets on digital assets and to wealthy individuals who would rather HODL than liquidate and pay taxes on their appreciated coins.

The crypto world needs to pay attention. It’s not just lenders that should be concerned, because rules or precedents set in the BlockFi case could easily be broadened.

• BlockFi was an easy target for the SEC, because it’s a third party holding customers’ crypto assets and using them to generate yield, part of which it shares with those customers as “interest.” But crypto lending can also be conducted on a peer-to-peer basis through smart contracts. If the same regulations are applied to centralized lenders and decentralized exchanges, the consequences could be far-reaching.
• Costs are a concern, too. An ostensible way crypto lending offers better yields is cutting out administrative overhead. According to Banking Exchange, the global financial services industry spent $180 billion in compliance costs in 2020. Crypto may find it hard to sustain its rates if it bears similar costs.

Regulation of some sort is coming. It’s just a question of what it looks like.

• Policymakers and regulators are getting serious about imposing KYC and AML rules on crypto, and the industry is developing some clever and efficient ways to comply using blockchain technology.
• Inflexible, traditional rules could well drive crypto customers attracted to crypto lending’s high yields back into the Wild West of unregulated peer-to-peer exchanges.
• The flip side is that crypto being seen as unsafe — as hackers run wild on poorly secured, decentralized systems — could sour consumers on cryptocurrency altogether.

Gary Gensler’s “regulation through enforcement” approach is drawing more critics every day. Some are questioning whether BlockFi should have settled, rather than fight as Ripple is doing.

• Inside the SEC, Commissioner Hester Peirce has emerged as a key voice for a different approach to regulation. She disagreed with the BlockFi ruling, asking her colleagues whether “the approach we are taking with crypto lending [is] the best way to protect crypto lending customers.”
• As Protocol Fintech has noted, much of crypto lending is happening outside the kind of entities the SEC has regulated in the past. Traditional finance — TradFi — happens on networks operated by a bank, exchange or money transmitter. Chase, the NYSE and PayPal all have their various regulators.
• Crypto transactions are often global. International money flows are relatively small and heavily regulated. How do numerous national regulators in their geographic stovepipes oversee a global, peer-to-peer marketplace that runs 24/7 on automated systems?

There are already examples of the harm of knee-jerk regulation. Remember initial coin offerings?

• Jill Grennan, an assistant professor at Duke University’s Fuqua School of Business, observed in a recent paper that most regulators either ignore or misunderstand the economic purposes of financial innovations, overweighting the risk of facilitating fraud and undervaluing the benefits of a new means of capital formation.
• Economists Chris Brummer and Yesha Yadav call the crypto situation a “trilemma.” In a 2019 paper, they wrote that when regulators try to “provide clear rules, maintain market integrity, and encourage financial innovation,” they usually end up providing two out of three at most.
• One example: The Bank Secrecy Act requires transaction reports and customer identification to fight money laundering. The crypto industry is struggling to figure out how to apply this to a marketplace where customers can preserve their own anonymity by using self-custodied wallets.

It would be smart for the SEC to show publicly that it’s taking its internal and external critics more seriously. Peirce argues that regulators should work harder to develop a “bespoke set of conditions that make sense in this context.” And she asked her agency to do a better job of accommodating innovation. There’s a way out of the trilemma: It’s called doing the work.

— Leah Zitter (email | twitter)

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