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How Crypto Regulations Affect Investor Confidence & Market Growth

How Crypto Regulations Affect Investor Confidence & Market Growth

Crypto enthusiasts may not be too keen on regulations, but they could help improve investor confidence. But going too far could negatively impact the pace of innovation.

Carl Sagan once said, “You have to know the past to understand the present.”

Crypto enthusiasts may be upset by regulators looking to wield authority over cryptocurrencies and other tokens. But a cursory look into the history of these regulators reveals striking parallels between today’s crypto meltdowns and crises following other unregulated speculative assets. So, the push for more regulations shouldn’t come as a surprise.

On the other hand, cryptocurrencies don’t fit neatly into existing rules, so regulators will need to adapt or risk stifling innovation. New regulations must balance protecting investors with promoting a vibrant crypto ecosystem while accommodating new approaches to old problems like lending or market making.

A Brief History

Stock market regulations resulted from rampant speculation in the 1920s, leading to the crash and Great Depression. Before the crash, companies didn’t have to disclose any financial or meaningful information, brokers promised large profits without any substantive basis, and bank runs were commonplace due to a lack of federal insurance.

The Securities Act of 1933 and the Securities Exchange Act of 1934 focus on disclosure, giving investors access to information about the securities they buy and the companies issuing them. The laws require companies to disclose information and ensure the efficacy of these disclosures by introducing extensive liability fraud.

In the aftermath of the crash, the pendulum swung heavily in the other direction with the creation of the Securities and Exchange Commission (SEC) and new regulations to protect the public. These rules helped create massive financial institutions by limiting competition and increasing costs, resulting in potentially higher systemic risks.

Parallels to Crypto

The stock market’s history parallels today’s lightly-regulated crypto market. According to Satis Group LLC, 80% of initial coin offerings (ICOs) are scams, while only 8% ever trade on an exchange. At the same time, numerous crypto exchanges have failed over the past few years, resulting in billions of dollars in losses.

Examples of these parallels include:

  • Initial coin offerings (ICOs) provided little information for investors and promised unrealistic returns. And predictably, many of these tokens imploded, resulting in losses for investors.
  • Unregulated exchanges commingled customer funds with internal trading operations. If trading losses occur, the exchanges can no longer meet customer redemptions, resulting in losses.
  • Stablecoins sought to provide a stable source of value underpinning exchanges, lending, and other activities. But many of these products failed to disclose the reserves backing the coins, leading to potential systemic risks.

And there is no shortage of specific examples:

  • BlockFi, Celsius, Genesis, and other firms imploded and declared bankruptcy, resulting in billions of dollars in losses.

Not surprisingly, the SEC is keen on applying rules and regulations to these markets to prevent these problems. The agency wants to regulate most crypto tokens as securities while ensuring that exchanges have separate exchange, broker-dealer, and clearing functions to mitigate the conflicts arising from commingling these services.

Improving Investor Confidence

Regulations could help improve investor confidence by ensuring exchanges safeguard their deposits and tokens disclose the risks associated with their business.

Improving Investor Confidence
Crypto regulations vary worldwide, but in the U.S., they remain a grey area. Source: ComplyAdvantage

After all, stock investors never have to worry that a stockbroker is mishandling their funds by trading on their own behalf or simply pocketing it. Meanwhile, they have easy access to a treasure trove of information about most stocks in their SEC filings. And when a news release comes out, they know they can usually trust the contents to be accurate.

The same sentiments could help build confidence in the crypto market. With regulations in place, investors wouldn’t have to worry that their crypto exchange was on the brink of implosion or that the “team” behind a new ICO offering is actually a criminal syndicate looking to take as much money as possible before leaving investors dry.

Beyond the SEC, banking regulators could ensure stablecoins have sufficient reserves to prevent a “run on the bank.” Doing so could prevent potential systemic risks from the failure of a widely used stablecoin. Putting other lending-related protections in place could help protect borrowers and lenders from other scams and losses.

Potential Impact on Growth

There’s little doubt that the lack of regulation has turbocharged the pace of innovation. New techniques, like DeFi lending or market making, may have resulted in high-profile implosions, but the new approaches could democratize access to capital and streamline trading. At the same time, intense competition has kept costs low and innovations rolling.

Regulations will likely slow the pace of innovation. For example, even the most basic registration requirements could immediately deter many smaller projects because of the cost and complexity. And ongoing reporting requirements introduce costs for both crypto entrepreneurs and regulatory agencies responsible for monitoring the industry.

Moreover, regulators that apply existing rules built for conventional financial assets and services could stifle innovation altogether by making some novel approaches illegal. For example, lending rules may enforce Know Your Customer (KYC) requirements, which many DeFi lending protocols don’t collect in the interest of privacy and efficiency.

Striking the Right Balance

The key is striking the right balance between protecting investors and encouraging innovation. If regulators make these requirements too high, it might deter new companies from entering the market and inhibit innovation. And registration requirements may lead to greater scrutiny of overall ideas and concepts rather than solely risks to investors.

On the other hand, a failure to regulate the crypto markets could mean these technologies never reach the mainstream. Institutional investors will only put the same levels of capital involved in stocks and bonds into crypto assets with proper disclosures and protections. And consumers burned by an ICO scam will be less likely to return.

Ultimately, both sides may have to make some sacrifices. The SEC and other regulatory bodies must provide clear rules that align with the crypto markets. And crypto projects must find a way to improve disclosures, prevent conflicts of interest, and protect investors and consumers from the well-known problems impacting today’s market.

What’s Next?

The battle to apply securities regulations to the crypto markets continues to evolve, while some crypto companies take a unique approach to address the underlying issues.

In July, the SEC experienced a significant setback in its bid to apply securities laws to crypto tokens when a judge ruled in the SEC v. Ripple case that XRP is not necessarily a security. As a result, the agency will likely have to develop a framework for applying securities laws to crypto assets rather than making it a case-by-case decision.

On the other side, some crypto firms are hoping to comply with stricter requirements. FINRA recently approved Prometheum Ember Capital LLC and OTC Markets Group the right to provide trading for crypto securities legally. These platforms could provide an early indication of compliance and whether it’s viable for other entities.

Other crypto projects are attempting to meet the spirit of these rules while maintaining their approach to a problem. For instance, some stablecoins are working on proof-of-reserves algorithms to demonstrate real asset backing without any centralization requirements. As a result, they could reassure investors without the need for an auditor.

If you trade crypto assets, ZenLedger can help you comply with constantly-evolving IRS rules and regulations. You can aggregate transactions across your wallets and exchanges, compute your capital gain or loss, and generate the tax forms you must file yearly.

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The above is for general info purposes only and should not be interpreted as professional advice. Please seek independent legal, financial, tax, or other advice specific to your particular situation.

Justin Kuepper