Early Investing

Crypto Regulations Are on the Horizon

Crypto Regulations Are on the Horizon
By Vin Narayanan
Date December 14, 2022

I had planned on writing about startups today. A major scientific breakthrough in fusion happened this week. The implications for humanity and startups are astounding. But then two massive crypto stories broke, so startups (and fusion) will have to wait.

Bahamian authorities arrested disgraced FTX co-founder Sam Bankman-Fried on Monday after the U.S. Attorney for the Southern District of New York shared a sealed indictment (that included eight counts of fraud) with the Bahamian government. And the SEC has also charged Bankman-Fried with defrauding investors. Bankman-Fried has been denied bail because a Bahamian judge said he was a flight risk. It’s expected that he will be extradited to the United State to face charges regarding FTX’s collapse.

The arrest came a day before Bankman-Fried was scheduled to testify before the House Financial Services Committee. But it wasn’t the most explosive crypto news story this week.

That honor goes to Binance. The world’s largest crypto exchange (by trading volume) is currently swimming in a sea of turmoil. The Department of Justice has been investigating Binance for quite some time, according to Reuters. Prosecutors are split on whether to file charges now or review more evidence. And that investigation isn’t even the news that’s worrying crypto investors the most!

Investors are on edge right now because of Binance’s finances and operations. In the wake of the FTX meltdown, Binance founder and CEO Changpeng “CZ” Zhao decided he needed to be more transparent about Binance’s reserves. He wanted to show that the amount of crypto people had moved onto Binance matched the amount of crypto being held by Binance. It was a nice thought. But the way Binance tried to demonstrate its proof of reserves was so terrible, investors became spooked.

Mazars, the accounting firm that conducted the analysis, declined to endorse the methods it used to say Binance had sufficient reserves. Mazars also indicated that Binance controlled the report’s scope and methodology, including what was and wasn’t included. As a result, it was entirely possible to view Binance’s reserves as inadequate. Or even if the reserves were adequate, the report felt sketchy.

And investors responded accordingly. Binance’s net outflow over the last seven days (as of Tuesday) was $3.66 billion. Additionally, Binance temporarily paused withdrawals for the USDC stable coin. Binance indicated the pause was for a token swap. But jittery investors are starting to wonder what exactly is going on.

In an effort to calm the waters, CZ sent a memo this week to Binance employees telling them that while the next few months would be “bumpy,” Binance was “built to last.” Bloomberg first reported the contents of the memo.

As the crypto markets sort themselves out over the next few months, I believe three trends will emerge.

  1. Governments are coming for crypto. Whether it’s through lawsuits, legislation or actual regulations that the public actually gets to comment on (what a novel concept!), governments are going to force rules and regulations on the crypto industry. That could be a good thing for investors if exchanges are forced to operate in a common sense manner. But regulators and policy taking a common sense approach to setting up guidelines doesn’t seem realistic — even if we ask nicely. So prepare for a mess. 
  2. One of the great ironies in the bitcoin/crypto space is that centralized exchanges have emerged as a primary pain point for what was supposed to be a largely decentralized ecosystem. I expect crypto and blockchain developers and investors to embrace decentralization more fully as we move forward.
  3. Remarkably, the crypto markets seem to be rebounding as I write this. Bitcoin is trading just under $18,000. And ethereum is trading above $1,300. The crypto markets have been extremely resilient over the years. That’s a remarkable feat considering just how young crypto is as an asset class. Don’t count crypto out. It’s proving to be a durable asset class.

This is just the beginning of a bad news cycle for crypto. But the selling pressure generated by the bad news is being offset by the buying pressure created by better than expected inflation news. That means we’re in for an interesting ride for the next few months.

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