Crypto fans: Hold on for dear life as rules pile up

With all the excitement around AI, one could be forgiven for forgetting another great tech innovation that promised to change the world: crypto.

The sector has stumbled into yet another rough patch after two of the biggest exchanges, Coinbase and Binance, were accused by the SEC of—among other things—failing to register as brokers. The brouhaha is casting a pall over the crypto markets and the decentralized finance sector as a whole.

But even as regulators take steps like these to tighten the screws on exchanges, some investors remain focused on the long-term prospects of crypto. Earlier this week, Andreessen Horowitz doubled down on its commitment to crypto by opening an office in London to focus on its Web3 investments.

This reflects a hope that tighter rules—while delivering short-term pain to the industry—will also provide a more stable regulatory platform upon which the technology will mature. The challenge for lawmakers will be striking a fair balance that provides security while encouraging innovation.

Unsurprisingly, venture capital’s appetite for crypto overall has been in decline in recent months. According to PitchBook’s Q1 2023 Crypto Report, VC investment in crypto startups during the first three months of the year fell by 11% to $2.6 billion, compared to the previous quarter, while the number of deals declined by 12.2% to 353. The first three months represented the lowest quarterly funding raising total since 2020.

While this does come alongside a broader decline in VC deal flow, there are also a few fundamental headwinds that are unique to the crypto sector.

One of the biggest hurdles has been uncertainty over the legal status of crypto assets. The SEC has been turning up the heat on the sector since another exchange, FTX, collapsed last year after losing billions in user funds. The debacle not only provoked tighter regulations but also eroded public trust and further adoption.

One crucial matter to resolve is whether cryptoassets should be considered a security, a commodity or something else entirely. That question has never been fully settled. But now, the SEC is taking the view that most cryptocurrencies are securities, meaning that even well-established crypto exchanges will now be expected to register with the SEC.

In March, Coinbase—which has some $130 billion in assets on its platform—received a formal letter from the SEC threatening enforcement on the basis that the trading of digital assets should have been registered as securities. Coinbase, a publicly traded company that was backed by Andreessen Horowitz, had to cut 20% of its workforce in January. In response to the SEC lawsuit, the company has vowed to defend itself.

In another lawsuit this month, the SEC accused Binance and its CEO, Changpeng Zhao, of fraud and market manipulation. Kraken, another large exchange, has also been under investigation by the SEC in connection with the sale of unregistered securities.

The implications of regulation

Greater regulation will be a double-edged sword for the crypto market. On one hand, it may threaten to stifle innovation, but on the other hand, it can help legitimize the industry and bring investors more stability. However, regulatory regimes could differ widely between jurisdictions.

It’s because of this inconsistency that a16z, which has been active in crypto since 2013, recently decided to set up shop in London. The firm went so far as to cite the need for a regulatory framework that seeks to stamp out crypto’s “casino culture” but also incentivizes startup innovation in Web3.

The UK, whose economy has been hit hard by Brexit, has gone to great lengths to attract investment by burnishing its tech credentials, particularly in areas such as Web3. The British government announced last year its plan to make the country a “global crypto asset technology hub.”

Britain’s estranged economic neighbors within the EU have gone even further to improve regulatory frameworks. In April, the EU parliament voted to pass the Markets in Crypto Act, or MiCA, which governs how crypto platforms and token issuers operate. When the measure becomes law in 2024, it will put the region’s crypto regulatory regime ahead of both the US and the UK.

An uncertain future

Even with some countries providing clearer—if not friendlier—regulatory guardrails, the crypto market will still be dogged by uncertainty. One key risk for investors is that a lack of international cooperation among regulators will lead to a fragmented market, which could ultimately erode market integrity and impede adoption.

There may also be a drift toward stricter rules. The US isn’t the only country to err on the side of caution when it comes to crypto regulation. China has even gone to the extent of outright banning the use of crypto in payments. What’s more, if the SEC gets its way, other countries may yet follow the US in introducing stricter rules—shrinking crypto’s Wild West frontier even more.

Even the UK, which will likely remain bullish on crypto under current Prime Minister Rishi Sunak, may change its tune if there is a change in government in 2024—which is likely. And that may not necessarily be a bad thing if better rules can help restore confidence and fuel adoption.

While the crypto space has been around for well over a decade, this latest controversy once again proves that it is a technology that is still very much in its infancy in many ways—at least from a regulatory perspective. The next few years, even months, could be crucial in deciding where the industry will go from here. For now, all crypto evangelists can do is what they have always done: Hold On for Dear Life.

Featured image by Drew Sanders/PitchBook News