Hiltzik: Regulators act to annihilate the crypto scam

The sun may be setting on the cryptocurrency craze. If you’re an investor or even just a curiosity-seeker on the fringes of this financial segment, you might want to prepare for its demise.

In just the last few weeks, market and banking regulators in the U.S. have tightened the screws on crypto-related firms. Legislative initiatives in Congress aimed at liberalizing rules for crypto promoters appear to be running out of steam.

The entire crypto market, from the pioneering cryptocurrency bitcoin to fad crypto such as Dogecoin and obscure proprietary tokens such as Stellar and Cardano, have been in an extended decline.

The capitalization of the crypto market, which peaked at more than $3 trillion in late 2021, is now estimated at $800 billion, implying enormous losses for late-stage investors. (Some cryptocurrencies have rallied lately, but the benchmark bitcoin is still down by more than 60% from its peak in November 2021.)

To critics of crypto, these developments reflect the influence of gravity on a marketplace characterized by “frequent instances of operational failures, market manipulation, frauds, thefts and scams,” as the U.S. Treasury put it in a consumer advisory issued last September.

“There’s no there there, and we have plenty of history to prove it,” Lee Reiners, a crypto expert at Duke and former regulatory official at the Federal Reserve Bank of New York, told the Senate Banking Committee at a hearing Tuesday.

Unlike stocks and bonds, which give owners a claim on the issuers’ profits, or precious metals, which generally have intrinsic industrial or commercial value, cryptocurrencies represent no ownership of anything tangible and no claim on economic productivity.

Given that the first bitcoin transaction occurred in 2009, Reiners observed that despite “a 14-year track record to look back on,” no one has identified what crypto is good for, except as something people can buy solely on the expectation that they can sell it to someone else at a higher price in the future — which is often described as the “greater fool” theory.

U.S. banking regulators have hardly been blind to this reality. In a joint statement issued Jan. 3, the Federal Reserve, Federal Deposit Insurance Corp. and Office of the Comptroller of the Currency offered a one-stop list of the biggest problems with crypto, many of which paralleled the concerns raised by the Treasury.

They mentioned “the risk of fraud and scams,” “inaccurate or misleading representations and disclosures,” “unfair, deceptive, or abusive” practices and the risks of “cyber-attacks, outages, lost or trapped assets, and illicit finance.”

The implicit goal of the joint statement was to warn regulated banks and their customers that they probably should steer clear of crypto at any price.

The immediate trigger for the change of heart in Washington was plainly the November implosion of FTX, a crypto firm whose founder, Sam Bankman-Fried, had been a prominent advocate for looser regulations on crypto firms. Bankman-Fried is free on bail while awaiting trial on criminal charges.

Yet FTX’s bankruptcy was only one of a string of crypto firm failures during 2022, and the precursor of further bankruptcies. Perhaps more important, many of the operational shortcomings allegedly found in FTX’s operations are common in the field, including inadequate record keeping and security arrangements, and commingling of customers’ and firms’ assets.

Consumer interest in crypto was probably destined to wane even without the FTX collapse. Last year’s Super Bowl telecast brimmed with high-priced commercials from crypto firms featuring celebrities such as Matt Damon and Larry David. Supernovas like 2022-vintage crypto are always destined to fade to some extent; this year’s Super Bowl was crypto-free.

In recent weeks and months, however, U.S. regulators have taken strong steps to inoculate the larger banking and financial system against contamination by crypto firm failures.

In January, the Fed rejected an application by Custodia Bank for membership in the Federal Reserve System. Custodia, which is chartered by Wyoming, aimed to issue its own crypto token. “The firm’s novel business model and proposed focus on crypto-assets presented significant safety and soundness risks,” the Fed said.

Last week, New York State banking regulators ordered Paxos Trust to cease issuing crypto tokens with a brand connected to France-based Binance, the world’s largest crypto exchange, because of “several unresolved issues” related to the two firms’ relationship. The Securities and Exchange Commission has also informed Paxos that it may face an SEC lawsuit for selling unregistered securities — the crypto tokens.

Also last week, the SEC forced crypto exchange Kraken to cease marketing a so-called staking-as-a-service program in which it advertised financial returns as high as 21% to investors who transferred their crypto assets to Kraken. The firm paid $30 million to settle with the SEC, without admitting the agency’s charge that it was marketing an illegal security.

Shills for crypto, including those on Capitol Hill, have typically advanced two main arguments. One is that crypto represents “financial innovation” that we stifle at our peril. The other is that it’s a path to give segments of society that have traditionally been excluded from the financial system, such as “unbanked” minorities, access to the financial services others enjoy.

Both are balderdash. Let’s take them in order.

At Tuesday’s hearing, committee ranking member Tim Scott (R-S.C.), declared that the reason the U.S. has “the strongest and most enviable capital markets in the world” is because “the sun never sets on American innovation.”

Scott was seconded by J.D. Vance (R-Ohio), a venture capitalist in his outside life, who asked “how people would have described the internet in the 1970s and 1980s. … If we had taken an overbearing approach then, we might have destroyed a lot of the upside that has come over the last three decades.” He asked how to regulate crypto now “in a way that protects the upsides of the technology right now.”

The flaws in this argument should be instantly apparent. One is that the virtues of any given innovation don’t validate any other claimed innovations. (Indeed, some “innovations” have qualities that society could well have done without, such as the technological innovations that gave us thermonuclear weapons.)

Another is that to talk about the “upsides” of crypto is to assume facts not in evidence, since no one has made a convincing case for crypto as a useful innovation — except as a tool for criminal activity.

At the hearing, committee member Elizabeth Warren (D-Mass.) mentioned “international drug traffickers who raked in over a billion dollars through crypto … North Korean hackers, who stole $1.7 billion and funneled that money into their nuclear program … and ransomware attackers who took in almost $500 million.”

She concluded, “The crypto market took in $20 billion last year in illicit transactions. And that’s only the part we know about.”

As for the purported inclusiveness of crypto, that’s an illusion. The most often-cited statistic comes from a survey by Charles Schwab & Co. of 2,057 adult Americans, which concluded that 25% of Black investors owned cryptocurrencies in 2022, compared with only 15% of white investors. (Yesha Yadav of Vanderbilt Law School, a witness at the Senate hearing, mistakenly asserted that those figures applied to all Black or white Americans, not merely investors.)

One might ask whether Schwab’s figures are plausible at all, but it’s important to note that the median income of its Black respondents was $99,000 and of white respondents $106,000.

These are not the unbanked Americans whose financial ambitions supposedly are liberated by crypto. “What unbanked populations really need are simple, safe, and inexpensive ways to save their money, as well as convenience,” Tonantzin Carmona of the Brookings Institution reported in October.

Unfortunately, crypto transactions tend to be just the opposite — “slow, costly and inefficient,” Carmona observed — and bristling with “many hidden fees.”

A 2019 FDIC survey Carmona cited reported that 29% of respondents without a bank account blamed their situation on not having enough money to meet the minimum balance requirements. Taking a flier on wildly volatile cryptocurrencies is hardly the most reliable way to fill the gap.

One should expect the crypto industry to fight regulation with the vigor that millions of dollars in lobbying expenditures can buy — $9 million spent on influencing Congress in 2021, the latest year for which figures have been compiled.

Yet the lobbyists’ narrative is bogus. “Big crypto” blames the serial blow-ups of crypto firms on the failure by the SEC and Commodity Futures Trading Commission to provide the sector with “regulatory clarity.”

Scott parroted this point in his opening statement Tuesday. “The regulators have permitted activity in this space without providing clear rules of the road,” he said. “Had the SEC provided anything besides hostility to the crypto industry, we may have been able to save investors from losing billions of dollars on FTX” and other such disasters.

The truth is that the agencies couldn’t be clearer about where Big Crypto is breaking the rules.

Since 2013, the SEC has brought 127 enforcement actions in the crypto space in one form or another without losing even once in court. “There are time-tested rules,” SEC Chairman Gary Gensler told Bloomberg Television on Monday. But “this is largely a noncompliant field.”

What the crypto firms want is a “giant loophole written into the law,” Warren said at the hearing. She’s right. The recent enforcement actions signal that the regulators are less inclined than ever to help them find it.

Without a loophole giving these firms an exemption from the rules with which every other financial intermediary has to comply, crypto is likely to wither and die. That will be consumers’ best protection against losing their shirts in crypto scams.