Cryptocurrency Regulation – Iceberg Dead Ahead?

Financial markets and any asset with a public market valuation operate on a rate of change principal. This simply means that the asset value grows or decays under a sentiment condition driven by, “Are things getting better or worse?” In this vein, if fundamentals for a stock, bond, or commodity are getting “less bad” this can result in a solid reason to buy or get long the investment.
Conversely, when a stock is priced for perfection with everything having gone right, the next chapter of the story is likely to be a disappointment because investors have piled in and are “expecting good outcomes.” If these positive expectations are not satisfied this will lead to a down leg for prices.
Mathematically, the rate of change is calculated as the second derivative or the year-over-year increase or decrease in growth, revenues, or sentiment.

Regulatory scrutiny for digital assets can only get tighter

With that outline, the rate of change setup for regulation in digital assets or cryptocurrency markets can only get worse.
Up-to-this point, crypto markets have been largely unregulated as regulators technically have only loosely defined the asset class to begin with.
While the Commodity Futures Trading Commission (CFTC) has categorized Bitcoin and other major cryptocurrencies as commodities, statutes on trading regulations, market quality parameters, and investor protections have largely been undeveloped.
Because digital asset markets have been such a successful investment for early adopters, this “hands-off” approach from a regulatory standpoint has been welcomed.
However, history says that when eventual losses by retail investors manifest, regulators will come hard and fast to “protect the little guy.”

Central Bank heads are saber-rattling, which mean something is in the works

The drumbeat is getting louder for governance and two of the most important regulatory heads have “called out” digital assets in recent addresses. Christine LaGarde, the head of the European Central Bank, stated at the turn of 2021:
“Bitcoin is a highly speculative asset, which has conducted some funny business and some interesting and totally reprehensible money laundering activity” – January 13th, 2021.
In addition, Janet Yellen, the former head of the Federal Reserve and now the incumbent Treasury Secretary, announced on February 23, 2021, that:
“I don’t think Bitcoin is widely used as a transaction mechanism. To the extent it is used, I fear it often for illicit finance. It’s an extremely inefficient way of conducting transactions, and the amount of energy that’s consumed in processing those transactions is staggering.”
While these references may seem unsubstantiated and short on detail, these anecdotes mean that governmental body involvement is in the works and a more formal program is coming.

Why are digital markets a target for lawmakers?

Regulatory action will hurt digital prices in the short run before a requisite rebound. Digital assets may be a target for new regulations for three reasons.

Mania

There is a bit of mania in digital assets, and speculation mainly by retail investors is rampant. Regulators hate to see retail investors participate in marketplaces that they haven’t “weighed in on” and thus there is an element of CYA (cover your behind) from a regulatory standpoint. While markets have largely been a boon for early retail crypto adopters (early crypto investors have been rewarded handsomely with high returns), the digital asset markets are a big drawdown away from retail euphoria turning into regret.
I firmly believe that any future account of market manipulation, a widespread technology glitch, or a good ‘old-fashioned sharp drop in prices (with retail investors holding the bag) will draw substantial regulatory investigation and an eventual overhaul.
Also, crypto and (mainly) Bitcoin have been directly traced to unsavory activities as outlined by regulatory heads above. For every bonafide Bitcoin enthusiast is a counter character who is laundering money via BTC to faraway places. The original Silk Road, which was an online narcotics marketplace, only accepted payment in BTC and the asset is also directly linked to terrorist financing and online gaming. This obviously, creates both regulatory and law enforcement risks for the sector.

Anti-ESG

Bitcoin is probably the biggest anti-ESG asset in the world right now. Environmental, Social, & Governance (ESG) investing has been a category that is now mainstream and highly supported. Simply defined, ESG is a higher standard for companies and other organizations to prove that their operations are calibrated to minimize their impact on the environment and to greatly optimize societal benefits.
Public companies now focus on scaling down their carbon footprint by maintaining more efficient vehicle and truck fleets in logistics for example. Large organizations will tout that their employee bases are more diversified by race and gender. Energy sources and usage is now outlined in annual reports with CEOs and CFOs discussing how they are consuming less energy and when they do that it is from more efficient sources. As a result, there are now ESG exchange-traded funds (ETFs) and mutual funds that only invest in companies in the top quartile of new mainstream ESG standards.
This is where there is concern about Bitcoin and other digital assets. BTC mining is the computing infrastructure needed to participate in the cryptographic creation of new BTC units. With Bitcoin having crested over $60,000 per token over the past year and with the digital asset still well over $30,000 at the current day, BTC mining is profitable. As a result, BTC farms (or warehouses of computers to participate in mining) have popped up all over the globe. The energy consumption that these operations consume is staggering.
For example, the global mining initiative around the Bitcoin network is in aggregate greater than the entire energy consumption of Norway and also 10 times the consumption of the Google internet browsing network. With ESG now an institutionally relevant category, I think this only increases the forthcoming attention on digital assets from a regulatory standpoint.
BTC Energy

Decentralization

Regulators are scared of decentralized virtual currency and the loss of their grip on the global medium of exchange. While the 1970’s repeal of the Bretton Woods Agreement and the debunking of the Gold Standard (that every U.S. dollar would be fixed to a requisite supply of Gold) has fostered an unnecessary printing of U.S. dollars resulting in U.S. dollar depreciation and secular inflation, the monetary system has largely been in order.
Governments back their sovereign currency and manage them by increasing or decreasing interest rates (thus making their currency more or less valuable) and also reigning in supply each year via taxation. With the advent of financial technology and cryptocurrencies, the global governments now have competition from largely unregulated markets — and they hate it. While the U.S. Federal Reserve and other important Central Banks will likely fight back and issue “stable coins” or digital dollars to compete with nascent crypto markets, I think it is a very safe bet that they will also respond with market-curbing regulation that starts to put a governor on recent unfettered growth in digital assets.

Are Musk and Saylor drawing undue attention to digital markets?

On top of the landscape outlined above, the iconoclastic leaders of both MicroStrategy and Tesla are also drawing unnecessary attention to crypto, which will only embolden regulators. I am not opining on the very sophisticated and important technologies that both Elon Musk and Michael Saylor have created, but because they have become so powerful, with cult-like followings, regulators now see risk in how much influence they have.
On top of taking substantial positions in Bitcoin with their corporate cash (which has a very unfavorable accounting treatment for investors), a Musk tweet on Dogecoin or a Saylor corporate update can have a disproportionate influence on the prices of different cryptos.
As it stands, Bitcoin is accounted for at history cost from a Financial and Accounting Standards (FASB) treatment. This means that Bitcoin gains are not written up on TSLA and MSTR balance sheets quarterly. However, historical assets have to be written down according to FASB, so unfortunately public investors in Tesla and MicroStrategy will have asymmetric earnings results because BTC assets can only be written down from their original entry points.

What is likely to happen?

Limitations around ICOs or initial coin offerings

Not dissimilar from “Blue Sky” laws in stock issuance, both the SEC and the CFTC will outline information quality parameters, investor suitability requirements, and new legal recourse for new issuance of tokens including Ripple, Dogecoin, and others.

Digital wallet and cryptocurrency custody guidelines

The Treasury Department’s Financial Crimes Enforcement Network (FinCEN) has completed a 60-day comment period on reporting rules for digital wallet and custody guidelines. Custodians like Coinbase and other crypto storage technologies would have to follow recommended rulesets to prevent money laundering and other controversial uses of crypto as discussed above.

New exchange regulation

Crypto exchanges again including Coinbase, Bitmex, Gemini, and BlockFi, to name a few, are likely to have to agree to incremental market quality stats, investor protections, and reporting requirements so regulators can understand and assess suitability requirements for the large retail investor base in crypto. Many of the stock and commodity exchanges including ICE and CME have had these guidelines in place for decades.

Regulators have good intentions

Regulators are coming for digital asset markets as they have grown in popularity and are in direct competition with government-created fiat money. This will pose a speed bump for all major crypto assets, but if well thought out and appropriately administered, will make digital asset marketplaces safer for all participants involved.

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