Crypto Asset Meltdown May Have Far-Reaching Implications
Various regulators are working to clarify and expand their authorities over cryptocurrency assets, but with over $2 trillion in value wiped out since November 2021, market dynamics are driving changes faster than the regulators. A more mature regulatory framework would have protected at least some investors as exchanges and leverage proliferated in recent years, and the cryptocurrency market disruptions that we are seeing in June 2022 highlight the pressing need for further regulation.
Contagion within. Contagion without?
As demonstrated during the first two weeks of June 2022, the cryptocurrency markets are vulnerable to contagion. Extensive leverage, with coin deposits collateralizing and re-collateralizing multiple rounds of loans to fund speculative coin purchases, create the potential for cascading margin calls. The reported insolvency of Three Arrows Capital, a $3 billion Hong Kong-based hedge fund, and the Celsius Network, which was operating as a de facto cryptocurrency bank with more than $12 billion in customer deposits, have both created opportunities for downstream market disruptions. Some cryptocurrency exchanges have chosen jurisdictions that impose little or no regulatory oversight, and much of the ecosystem’s infrastructure is dependent on stablecoins that may have collateral deficiencies or liquidity mismatches. Like money market funds, stablecoins are vulnerable to collapse in the face of even modest losses; unlike money market funds, stablecoins lack regulations around transparency and collateral quality.
Furthermore, the lack of regulation in the crypto environment has enabled the return of many old frauds that had mostly been stamped out of regulated securities markets, including Ponzi schemes, price manipulation through wash trading, front running, and outright theft of assets.
The extent to which dislocations in the crypto markets could impact more traditional asset classes is a question both policy makers and investors are looking to understand. We have seen some tangible examples – most notably Canada’s pension fund investment in the Celsius Network. Potential avenues for further spill through could include heightened recession risks as cryptocurrency losses impact consumer spending, and potential losses on bank loans to crypto miners, collateralized by equipment that has suddenly become less valuable. Contagion risks are almost always obvious in hindsight, but can be difficult to identify in the moment.
Cryptocurrency clearly poses more contagion risks to traditional finance today than in prior years. If cryptocurrency advocates ever achieve their aims of mainstream adoption for commerce or investing, then contagion risks will rise exponentially. The current potential for cascading failures within the cryptocurrency ecosystem highlights the need for meaningful regulations of exchanges, leverage, and stablecoins.
Crypto asset meltdown may have far-reaching implications
The need for regulation has not gone unnoticed. On May 10, 2022, Treasury Secretary, Janet L. Yellen, testified before the U.S. Senate Committee on Banking, Housing, and Urban Affairs regarding the Financial Stability Oversight Council’s 2021 annual report. Yellen testified that digital assets “may pose risks to the financial system, and increased and coordinated regulatory attention is necessary.” She observed that President Biden previously signed an Executive Order calling for a comprehensive approach to digital asset policy. Yellen also stressed the importance of ensuring “that payment stablecoins and their arrangements are subject to a federal prudential framework on a consistent and comprehensive basis.”
President Biden’s Executive Order on March 9, 2022, made it clear that problems in the digital assets area are far-reaching. The Executive Order warned:
We must take strong steps to reduce the risks that digital assets could pose to consumers, investors, and business protections; financial stability and financial system integrity; combating and preventing crime and illicit finance; national security; the ability to exercise human rights; financial inclusion and equity; and climate change and pollution.
Questions remain as to who will regulate the cryptocurrency market. Certain members of the crypto industry hope that Congress will allocate some authority to the Commodity Futures Trading Commission (CFTC), not the Securities and Exchange Commission (SEC). In early June, a bipartisan bill was introduced in the Senate to allocate primary regulatory oversight responsibilities to the CFTC. SEC Commissioner Hester M. Peirce subsequently called for the SEC to take a more proactive role in crypto regulation during her remarks at the “Regulatory Transparency Project Conference on Regulating the New Crypto Ecosystem.” Recent and potential future dislocations in the space may influence legislative thinking on the appropriate regulatory framework. Ultimately, regulation will have a material impact on the future course of crypto assets.
We anticipate that regulatory trends will include:
- Making it more difficult for exchanges in less regulated jurisdictions to access investors and capital in more regulated jurisdictions;
- Limitations on leverage, including net capital requirements for cryptocurrency exchanges;
- Improved stablecoin transparency and collateral quality; and
- One or more financial regulators with a robust anti-fraud mandate, with commensurate powers, staffing, and funding.
The market capitalization of all cryptocurrencies is small relative to the size of more traditional debt and equity markets. However, the structures that have evolved in the cryptocurrency ecosystem in recent years, coupled with the introduction of significant leverage, creates the opportunity for significant dislocation in the crypto markets and potential spillover to other asset classes. Additional regulation is likely, but in the meantime Chief Compliance Officers can:
- Review client cryptocurrency exposures relative to their stated risk profiles.
- Review the firm’s disclosures regarding investment strategies, investment processes, risk management and asset class exposures.
- Review electronic communications and client files for context around any investments that could prompt client complaints or regulatory scrutiny.
- Work with portfolio management, trading, risk management and valuation professionals to ensure that the firm’s practices are robust against any potential dislocation spillover from the cryptocurrency markets into other asset classes.
How we help
ACA is a leader in assisting market participants investing in crypto assets. We represent some of the largest institutional digital asset advisers, many of which we have assisted with registration with the SEC. We also advise broker-dealers operating in the space. We help firms to build best practices and create compliance programs addressing conflicts of interest and implanting strong internal controls. In addition, we work closely with regulators and the industry to establish informed views.
Learn more about our solutions for digital asset managers here. If you would like to discuss any of the themes described within this article, please contact us here or reach out to your primary ACA consultant.