In the aftermath of the meltdown of crypto exchange FTX (FTT), it's almost certain that more regulation will be coming to the crypto industry in 2023. Almost everyone agrees that this new arena needs a comprehensive regulatory framework that clearly outlines the rules of the road for market participants and also protects against bad actors.
The only question, of course, is how aggressive U.S. regulators will be when it comes to reining in some of the excesses of the crypto industry. If regulators act too aggressively, it could ruin the crypto rebound.
Are cryptocurrencies actually securities?
The big question at the heart of nearly every crypto debate is what type of financial asset cryptocurrencies really are. This might sound like a simple question to answer, but it has confounded the industry for years. Are cryptocurrencies a completely new type of asset? Or are cryptos similar to existing assets, such as foreign currencies and securities?
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If cryptocurrencies are currencies, then they should be regulated by the Commodity Futures Trading Commission, which has regulatory oversight over the derivatives market, including foreign exchange derivatives such as futures, options, and swaps. However, if cryptocurrencies are securities, then they should be regulated by the Securities and Exchange Commission (SEC) under existing securities laws. The SEC has already opined that just about every cryptocurrency -- with the possible exception of Bitcoin (BTC -0.60%) -- should be regulated as a security.
As JPMorgan pointed out in a recent research report, the SEC has taken a lead role on this issue, and that means it's looking more and more like the cryptocurrencies-are-securities argument is going to win. Most notably, the SEC has suggested that even Ethereum (ETH 0.75%), the second-largest crypto by market cap, should be regulated as a security. That would have potentially profound implications for other coins and tokens, given the SEC's broad ability to take enforcement action against unregistered securities.
Impact on crypto innovation
In addition, new regulation could have a chilling impact on crypto innovation. Right now, regulators are reviewing different products and services offered by crypto market intermediaries. For example, the SEC has taken the position that crypto staking products -- a new form of passive income made possible by proof-of-stake blockchain technology -- are actually a form of securities offering. Recently, that led to the SEC crack down on cryptocurrency exchange Kraken, which was offering crypto staking services to its retail customer base.
And crypto staking might not be the only innovation put at risk. The $137 billion stablecoin market is under more regulatory scrutiny than ever. Stablecoins are the key to bridging the worlds of traditional finance and decentralized finance (DeFi), which is why regulators are concerned that they could provide a pathway for financial contagion to spread from the crypto market to the stock market and beyond.
In 2022, stablecoin venture Terra Luna (LUNA -2.99%) collapsed, and the prevailing sentiment now is that maybe some stablecoins are not as "stable" as originally thought. Recently, the SEC has suggested that it could launch an enforcement action against cryptocurrency exchange Binance (BNB 0.33%) and its stablecoin, Binance USD (BUSD).
What to do about regulatory risk?
For retail investors, investing in cryptocurrencies has always involved a certain amount of volatility and risk. Now, there is also a lot of regulatory risk. It is more important than ever to invest in cryptocurrencies that can minimize that risk. It's also important to pay attention to the goings-on in Washington, where lawmakers and regulators are trying to figure out the path forward for the crypto industry.
The worst-case scenario, of course, would be an outright ban on crypto. In a recent Wall Street Journal op-ed piece, Berkshire Hathaway (BRK.A -0.76%) (BRK.B -0.69%) Vice Chairman Charlie Munger argued for exactly this scenario, so a ban is not out of the question. The best-case scenario would be turning over crypto regulation to the CFTC, which has taken a much more crypto-friendly approach to regulatory oversight.
As for now, though, the most likely scenario seems to be that the SEC takes the lead on crypto regulation and that Washington lawmakers will follow the SEC's lead. This means the crypto ecosystem might start to look a lot more like the traditional financial system and that cryptocurrencies will be largely regulated as securities. If you're taking a long-term view of the crypto market, it's time to prepare accordingly.
