Then They Fight You: Scenarios for Coming Crypto Regulation

U.S. regulators are clearly ready to impose rules on the crypto market. If crypto advocates are serious about all this, it’s time to quit messing around.

AccessTimeIconAug 31, 2022 at 3:46 p.m. UTC
Updated May 11, 2023 at 6:12 p.m. UTC
AccessTimeIconAug 31, 2022 at 3:46 p.m. UTCUpdated May 11, 2023 at 6:12 p.m. UTCLayer 2
AccessTimeIconAug 31, 2022 at 3:46 p.m. UTCUpdated May 11, 2023 at 6:12 p.m. UTCLayer 2

I can’t count how many times over the years I’ve seen someone on Crypto Twitter trot out the old saw that starts with “First they ignore you, then they laugh at you …” Well, be careful what you wish for, because over the past year, we’ve clearly reached the “then they fight you” portion of the quote often misattributed to Mahatma Gandhi.

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For more than a decade, regulators including the U.S. Securities and Exchange Commission have been imposing only minimal restraints and targeting egregious frauds for prosecution, but otherwise leaving crypto largely to its own devices. But when Gary Gensler was appointed to head the SEC under the Biden administration, he signaled early and often his intention to take a more rigorous approach.

That attitude has manifested in a variety of ways, even beyond Gensler’s formal domain. In May, the SEC doubled the number of staffers in its enforcement division who were focused on crypto. Sanctions against the Tornado Cash privacy software by the Office of Foreign Assets Control have triggered the most acute worry in the industry, and will face legal challenges. And last week saw filings from Grayscale Investments acknowledging, in response to an SEC inquiry, that the stellar, zcash and horizen crypto tokens “may currently be” securities. (Grayscale and CoinDesk are both owned by Digital Currency Group.)

Some of this increased scrutiny may be simply a consequence of crypto’s growing influence and stakes, rather than entirely due to Gensler. According to law blog Legal Intelligencer, cryptocurrency enforcement actions by the SEC have shot up to 79 for the three years from 2018 to 2021 from just 18 between 2013 and 2017.

But it also does no good to deny the obvious: Gensler came in ready to regulate, and he got a convenient mandate courtesy of the immense amount of truly damaging fraud and foolhardy experimentation in crypto. That was always present, but the increased exposure of the general public to crypto speculation during the 2020-2022 bull market made the situation far more dangerous than it had been.

Possible outcomes

There are two, maybe three, possible outcomes here. The most likely, unfortunately, is that Gensler’s SEC places mounting legal pressure on both token issuers and exchanges, primarily using even more enforcement actions to treat tokens as securities in a relatively uniform way. That would almost certainly strangle many good crypto projects along with the bad.

The preferable alternative would be a real attempt to structure rules that wouldn’t hamper the potential of this new technology, along the lines of the formal time-limited safe harbor proposed by SEC Commissioner Hester Peirce.

That proposal included data-reporting requirements for token projects (good) but didn’t place any prior restraints on entities that wanted to try something new (also good). Personally, I would love to see additional safe-harbor permissions for tokens with very low value, the sort that might be deployed for small-scale DAOs (decentralized autonomous organizations) or other truly community-driven projects.

But let’s be realistic: Regulation that leaves substantial room for experimentation isn’t particularly likely to come to fruition. In part, that’s because Congress remains a bit of an ineffectual mess, ill-equipped to craft complex and rational new rules.

But more fundamentally, the SEC and other regulators just aren’t set up to grapple with the truly mind-bending complexities of blockchain’s crossover between technology and finance. That disconnect may be inevitable, because regulation implies a normative vision of the way things “should” be.

Embracing risk and chaos and figuring it out as we go is probably the only real way to find out the long-term potential of these innovations.

Growth and hucksterism

But that possibility has basically closed over the past two years, thanks to a combination of real growth and shameless hucksterism. Figures like Alex Mashinsky and Do Kwon conveniently disregarded the experimental nature of the products they were promoting to the general public, and real engineers and designers tinkering at the truly bleeding edge are poised to pay a completely undeserved penalty.

As these tighter constraints close in, it will be increasingly important to remember what’s actually being targeted by stricter regulation. Ultimately, the problem is not cryptocurrency or blockchain itself, which are merely technologies. The problem is that they have been overhyped and exploited to further a much larger system in which promotion of high-risk investments yield big rewards, even if those investments are more likely to get vaporized.

The same dynamic is in play in the “regulated” venture capital industry. We recently saw the absurdity of another $350 million being handed to low-rent P.T. Barnum Adam Neumann, who became a billionaire in the course of destroying $11 billion of other people’s money at WeWork. Is Neumann a smarter, better or more trustworthy person than Do Kwon? That seems like a stretch.

Of course, there is a potential upside as the crackdown ramps up: It could return cryptocurrency to its roots. The fat days of loose oversight removed incentives to build truly robust systems that could operate beyond government reach in favor of fragile systems with superficial features that could be shilled to retail traders and investors. Features like censorship resistance and true decentralization are about to get a lot more important, and in the long run, that could be the best outcome of all.

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David Z. Morris

David Z. Morris was CoinDesk's Chief Insights Columnist. He holds Bitcoin, Ethereum, and small amounts of other crypto assets.