A Sea Change is Happening in the Cryptocurrency World

There is the story about a visitor to New York who admired the yachts of the bankers and brokers. Na?vely, he asked where all the customers' yachts were. Of course, there were none[1].

It is now Year 2 of the Pandemic. Take a look at the shiny new 120-meter superyacht, WhaleCoin in bright lettering across the stern, towering over the boats in the marina. Your friendly neighborhood banker or money manager standing on the boardwalk is probably feeling both serious envy and frustration. It is sad, but true: Wall Street has essentially been a bystander during the cryptocurrency boom, when a host of startups, fintechs, and the occasional shady character have made fortunes. And it’s not that the big names of finance are catching up with the upstarts. The large investment banks offer a very limited range of crypto products to their clients. The storied NYSE and NASDAQ do virtually nothing with crypto; Coinbase is the #1 on this block. Only one big American asset manager offers a crypto funds for investment; the biggest player in this space is the little-known Grayscale[2]. And so on.

How did this strange state of affairs come about? Two words: Regulatory. Void. But first, the story of crypto in four parts:

The Gospel of the Nerd

In the beginning, there was the infant crypto (“bitcoin”) and they were esoteric, based on cryptographic proof, and someone only geeks could love.

?Insignificant niche. Why would Wall Street care?

?The Gospel of the Lowlife

As bitcoin reached the toddler stage, their anonymity and peer-to-peer nature attracted a following of drug dealers, peddlers of illegal weapons, ransomware specialists and similar.

No surprise, then, that the pinstriped brigade viewed bitcoin with outright skepticism: "It's worse than tulip bulbs. It won't end well. Someone is going to get killed."[3]

The Gospel of the Evangelist

And the evangelists of bitcoin went forth and preached everywhere, and the people were astonished at the teaching. The price of bitcoin rose, and the multitudes marveled, saying it was never so seen[4].

Over the last year, establishment finance has swallowed their distaste and cautiously dipped their toes into the cryptocurrency world. But dipped, only, because the scars of the last regulatory crackdown have not entirely healed[5]. Regulators have offered very limited public guidance about how they will regulate crypto-related products and services. Guidance behind closed doors has likely been negative. Unsurprisingly, major players on Wall Street have limited themselves to cautious experimentation. The most widespread crypto-related offering from the large players lie in custody services. Most private banks now enable clients to invest in crypto funds. Investment banks enable trading in listed crypto derivatives, and some have designed structured notes that offer exposure to crypto and crypto proxies[6]. The overall offering, particularly for institutional clients, lags considerably behind the crypto-related products available to individual investors.[7]

The Gospel of the Regulator

The Assyrian came down like the wolf on the fold.

?Or did they?

The next chapter of the story of cryptocurrency is being written by the regulators, who have thus far played a game of traffic lights. Permission to launch regulated products (“green”) has not gone beyond listed futures; regulatory action has been mostly “red” - oriented towards enforcement and stopping egregious behavior. Recent remarks from the SEC Chairman referred to the crypto sphere as “rife with fraud, scams and abuse” and as “the Wild West”[8]. And there is some justification for this: identity and wallet theft, large scale hacking of exchanges and trading venues, dubious token and coin offerings, amongst others. Between 2013-2020, the SEC launched approximately 75 enforcement actions in the crypto domain, collecting fines estimated at $1.8 billion[9] and forcing several bad actors to shut down.

The very fact that cryptocurrency markets have not only survived these shocks but thrived—suggests strong fundamentals. The crypto phenomenon is too large and well established to be shut down; hence it will be regulated. Once the BIS, CFPB, FDIC, Federal Reserve, FinCEN, FINRA, IRS, OCC, SEC[10] and their colleagues have at it, we can expect a forest’s worth of new rules and regulations governing cryptocurrency, as well as new enabling legislation from Congress. Additionally,

• These regulations will set aside the founding principles of Bitcoin and thereby cryptocurrency—peer-to-peer, no third party needed, zero-trust, anonymity.. particularly anonymity.
• The regulators exercise control through the broker-dealers, banks, exchanges, and other regulated entities; they rarely directly regulate individual and institutional investors. Hence, the primacy of the regulated intermediary will be emphasized. Existing, unregulated incumbents in the crypto space will be encouraged to become regulated players.
• Wall Street firms will launch a large number of products and services across the spectrum of buy-side, sell-side, and custody.
• Some crypto-related businesses built during the years of regulatory inaction will now be actively audited by regulators. Decentralized Finance (DeFi) initiatives that seek to do away with regulated intermediaries will get special regulatory treatment.
• Anonymity in the crypto space will be discouraged and probably outlawed[11]. Transfers and payments of cryptocurrencies will be brought under the KYC/AML regime that banks currently follow. Crypto holdings will be required to be disclosed, irrespective of domicile. Self-custody, which enables anonymity, will be curtailed.
• And finally: cryptocurrency is the most visible use case built on the enabling blockchain technology, but by no means the only one. As the regulatory regime for cryptocurrency is created, there will be a considerable expansion in non-crypto use cases within financial markets—such as trading, tokenization, and trade settlement. In parallel, Central Bank Digital Currencies, which more effectively fulfill the need for a low-cost mode of payments and transfers, are being piloted by several countries[12]. Once launched, they will shift transaction demand away from cryptocurrencies and so-called stablecoins. Such applications of blockchain technology should, in time, lead to markets that dwarf that of cryptocurrency

To summarize: broad-ranging regulatory action on cryptocurrency is coming, possibly in conjunction with new legislation. This could well depress cryptocurrency prices in the near term, and thereby demand for them[13]. But if done properly, the new laws and rules should provide a solid basis for the institutionalization of financial products based on crypto-currency and digital assets powered by blockchain, as well as unleash waves of further innovation within financial markets.

Notes

[1] With full acknowledgement to Fred Schwed’s 1940 classic “Where are the Customer’s Yachts? or A Good Hard Look at Wall Street”

[2] The ProShares Bitcoin ETF launched on October 19, 2021. It will invest in bitcoin futures, not bitcoin

[3] Link to remarks by Jamie Dimon of JP Morgan Chase, September 12, 2017. His view does not seem to have changed much

[4] The high prices of bitcoin for the years 2016 and 2021 (year to date) were approximately $960 and $65,000 respectively

[5] The consulting firm BCG estimated that aggregate fines paid by banks following the 2008 crisis were $321 billion by the end of 2016. No surprise, then, that banks are cautious

[6] The common theme to these offerings is that they do not require banks to hold crypto assets on their balance sheets

[7] Note that banks are also pursuing several blockchain-based initiatives that have nothing to do with cryptocurrencies

[8] From a speech by Gary Gensler, Chairman of the SEC, on August 3, 2021

[9] Source: Cornerstone Research

[10] Non-comprehensive list of key regulatory bodies impacting the US financial system

[11] The Colonial Pipeline ransomware incident suggests that the anonymity principle is already breached. More detail is available in this excellent blog here and here

[12] Cambodia’s Bakong and China’s e-Yuan stand out in this regard; both are well ahead of the US

[13] Like most speculative commodities, demand for cryptocurrency seems to move in the same direction as price. Consumption goods usually do not follow this paradigm i.e., demand moves inversely to price.