Fight to control $2 trillion crypto market heating up

It's not that governments like China are banning cryptocurrencies because they necessarily expect the technology to fail. It's that they want to be in charge of an experiment with potentially trillions of dollars in play.

With its latest move, China joins a small list of nations that are crypto prohibitionists. And it is a swing in the opposite direction of El Salvador, which adopted Bitcoin as legal tender this year and was lauded by Libertarians as well as Bitcoin believers. In the US, where crypto trading is allowed but regulators are taking a close look, some see an opportunity in China's deepening crackdown.

Understanding the many dimensions of this multi-pronged battle to control the market will be key for the millions of investors hoping to cash in on the crypto craze. The fight is set to reverberate through the global financial system, where every day brings news of products such as Bitcoin exchange-traded funds, bizarrely named digital tokens and NFT assets. The ultra-rich are also involved, and mainstream financial institutions are embracing digital currencies.

More broadly, the fight will also influence socio-cultural discussions over everything from climate change to inequality, and trade to fiat currencies. How the world's two biggest economies — the US and China — fare in their effort at oversight over the market will likely have the most far-reaching impact. 

"Crypto has become too big to ignore," said Matt Hougan, chief investment officer at Bitwise Asset Management. "Five years ago, at least in regulators' minds, it was people wearing hoodies playing Dungeons & Dragons and trading among themselves. Today it's a $2 trillion industry and every major Wall Street bank is helping investors gain exposure to it, and now they have to deal with it."

Crypto Rules

China rattled financial markets this week by announcing that all crypto-related transactions will be considered illegal, echoing less definitive exclusions dating back to 2013 that cracked down on initial coin offerings, crypto exchanges and cryptocurrency mining — in which it had become the world's leader.

Instead, the Chinese government aims to unleash its own cryptocurrency. It's one of 81 nations that are exploring their own digital currencies, a list that started with early adopters like Venezuela and Estonia but now includes larger nations, including the US China's 1.4 billion population will likely give it an edge when it begins rolling out the digital yuan on a global scale at the winter Olympics in Beijing in 2022 — a prospect that has some US politicians wanting to ban American athletes from using the e-coin while there.

"For China, I think it's pretty clear they want to promote the digital yuan, and that they are simply taking care of the competition," said Nicolas Christin, an associate professor at Carnegie Mellon University.

China said that 10 regulatory agencies, including the central bank, would work together to track down crypto-related activity. The ban even says that overseas exchanges are barred from providing services to mainland investors. The country's moves over the past few years already had the effect of squeezing local trading volumes, said Randall Kroszner, deputy dean at the University of Chicago Booth School of Business and former governor of the Federal Reserve System. "Even with a VPN, it can be very difficult to connect and can be slowed down," he said.

Governments crack down on crypto for two reasons, Bitwise's Hougan says. They want to curb crypto mining — the energy-intensive computing process involved in creating the digital currency and verifying transactions. And second, perhaps more critically, they want to be able to monitor currency transactions and negate any challenge to their homegrown digital currencies.

Gary Gensler's Approach

In the US, the government's regulatory strategy has been different. The approach is aimed at trying to avoid problems, according to Christin at Carnegie Mellon University. For example, financial markets have historically held up high barriers of entry for certain types of transactions, but no such stringent controls are in place for cryptocurrency trades. That leaves the door open for inexperienced investors to take highly leveraged positions that could lead to potentially catastrophic financial losses.

"Now of course there is a line of thought that people should be able to do whatever they want — after all, it's their money," Christin said. "But the question is whether a lot of retail-level folks engaging in these markets are actually equipped to judge the risks rationally, as opposed to engaging in gambling-like behavior."

US Securities and Exchange Commission Chair Gary Gensler, who has termed crypto as the "Wild West," is signaling a robust oversight regime over the industry. Coinbase Global Inc.'s planned Lend program, which would have let users earn 4% by lending their tokens, was a flash point in growing tensions between the regulator and the industry. BlockFi CEO Zac Prince recently said the SEC and other regulators needed to give his industry clarity on what's allowed.

Gensler has in fact been interested in the crypto world for years and once taught a class at MIT's Sloan School of Management called "Blockchain and Money." He's even signaled a pathway for the SEC to approve an ETF tracking Bitcoin futures.

Caution from regulators is understandable. Scammers have ripped off billions of dollars in crypto pump-and-dump schemes, using myriad tactics to draw in unsuspecting investors.

"The government is worried about consumer protections," said James Seyffart, an analyst for Bloomberg Intelligence. "The US government generally doesn't ban new technology, they usually embrace innovation. There is going to be new regulation but they just need to give guidance for people."

Former US Treasury Secretary Lawrence Summers says that rather than resist regulation, the crypto industry should embrace it for its own good. Given the large financial sums involved in crypto, it's unrealistic for the industry to expect to operate in secrecy without government oversight, Summers said in an interview on Bloomberg TV.

The crypto industry should shed the idea that it'll function as a "libertarian paradise" where government rules can't be imposed, Summers said.

Disclaimer: This article first appeared on Bloomberg and is published under a special syndication arrangement.