News last week that the Securities and Exchange Commission (SEC) of the US is suing the world’s two largest crypto exchanges, Coinbase and Binance, has led to much debate on the future of cryptocurrencies.
Could this be the final death knell for the asset class that has caused so much debate and inspired such fervent opinions, both for and against?
Among other things, the SEC is accusing the crypto exchanges of running unregulated security exchanges. The SEC complainant quotes the Binance chief compliance officer memorably writing to another executive, “We are operating as a fking unlicensed securities exchange in the USA bro.”
This accusation is fair, and even seemingly conclusive – but perhaps premature.
The point is not that crypto represents anything like what hardline devotees say it is: ostensibly the future of finance. Rather, it is a dangerous absurdity, an investment cult Ponzi scheme dressed up as an inflation hedge.
Cryptocurrencies are not securities, so can Coinbase and Binance be accused of being security exchanges? They should be allowed to die on their own, or if regulated, then regulated the way that gambling or Ponzi schemes are regulated.
Instead, by suing them, the SEC risks inadvertently endorsing them – and thereby creating even bigger risks for consumers.
Cryptocurrencies are, to borrow a term from Bloomberg’s Matt Levine, magic beans. Like any Ponzi scheme, their value is based on the greater fool theory. One can sometimes make money through the purchase of overvalued assets — items with a purchase price drastically exceeding the intrinsic value — if those assets can later be resold at an even higher price to an even greater fool. But this only works as long as there are enough new “greater fools” willing to pay higher and higher prices for the asset.
Eventually, investors can no longer deny that the price is out of touch with reality, at which point a selloff can cause the price to drop significantly until it is closer to its fair value, which in some cases could be zero. This is exactly the dynamic that led to the values of cryptos becoming completely detached from reality between 2020 and 2021.
Magic beans should not be the kind of thing that the SEC regulates and therefore, on this matter, the SEC should demur.
What counts as a security is defined in US law by the Howey Test, which says that an investment contract is anything that involves a) a person investing, b) in a common enterprise, c) with the expectation of profits, d) based on the efforts of others.
Unfortunately, this is vague to the point of tautology, and risks making anything which people think is an investment into an investment when it isn’t.
For example, a lot of people think sports betting is an investment, and it seems to pass the Howey Test. Self-evidently the SEC should not regulate sports betting, because it is not suited to regulating things like it, but moreover, it would send the dangerous message that gambling can potentially be safe.
Finance is all about trust.
The loss of trust from surging failures such as FTX is already bringing about crypto’s demise. The market capitalisation of the myriad “coins” is down by about 75% from its November 2021 peak.
As argued by Stephen Cecchetti of Brandeis International Business School, and Kim Schoenholtz at NYU’s Stern School of Business, put simply, the crypto system as it currently exists is unsustainable.
Absent clear and easily enforceable property rights, relying solely on private investors to monitor and discipline the behaviour of opaque intermediaries, has never been safe and effective. There is no prospect for a technological solution to these age-old problems.
It is ironic then that the SEC is making these accusations just as the crypto industry has been slipping towards obsolescence for months, even since before the collapse of FTX.
While the price of bitcoin is up 58% this year due to the liquidity pumped into the US financial system following the collapse of Silicon Valley Bank, it is still down 61% from its 2022 highs. But the rally looks thin, with very low volumes.
Despite the bounce in BTC prices this year, trading activity on Coinbase’s platform remains in the doldrums. The number of monthly transacting users stood at 8.4 million at the end of the first quarter, compared with 9.2 million a year ago. Trading volume slid by more than 50% over the period, while total transaction revenue was 63% lower.
Crypto is dying.
Rather than creating a new legal and regulatory framework that legitimises it, regulators should simply let it burn on its own. DM