BlockFi faces regulatory heat, a sign of possible crypto lending regulations?

The crypto lending giant BlockFi is facing regulatory scrutiny from a handful of states in America ahead of a proposed public listing.

BlockFi’s eventful 2021 has continued in the second half of the year as state regulators in the United States began to crack down on the company’s crypto interest-bearing accounts. The move likely marks another operational headache for the non-bank lender in a year of substantial fundraises and public listing plans interspaced by controversy and technical blunders.

State regulators going after crypto interest-bearing accounts may also stand as a bellwether of possible federal regulations targeted at the cryptocurrency loan market. Indeed, such a scenario might be possible given the current focus on digital currency regulations in America.

From curtailing centralized crypto lenders, the focus of attention could move to their decentralized counterparts, especially amid the context of rhetoric like “financial 9/11” being ascribed to decentralized finance (DeFi) by members of Congress. Indeed, MakerDAO founder Rune Christensen recently warned that a U.S. crackdown on the sector would be an “own goal” 10 times more severe than China’s reported muzzling of private-sector tech giants.

Cease and desist

BlockFi has been served cease and desist notices by three states in the U.S. in July alone. Regulators in New Jersey, Alabama and Texas have accused the company of offering unlicensed securities.

This seemingly coordinated regulatory scrutiny reportedly hinges on BlockFi’s crypto savings and loans product wherein users can deposit their cryptocurrencies into interest-bearing accounts, dubbed BlockFi Interest Accounts (BIAs), and use the same as collateral to obtain loans. Regulators in these states say the product constitutes an offering of unlicensed securities.

It all started earlier in July with the New Jersey Bureau of Securities issuing a cease and desist order to BlockFi, ordering a moratorium on new account openings by the company. Initially scheduled to go into effect on July 22, the order was delayed by a week and has now been pushed forward another month amid ongoing talks between BlockFi and the New Jersey regulator.

In a statement published on the company’s website, BlockFi CEO Zac Prince assured customers that the firm was continuing its dialog with regulators. Prince pointed to the decision by the New Jersey Bureau of Securities to postpone its action against BlockFi as lending credence to the company’s efforts in navigating the current regulatory hurdles.

Alabama soon followed suit with a show-cause order, alleging that BlockFi was funding its crypto lending activities via the sale of unlicensed securities. The company has 28 days from the date of the notice to provide cause why it should not be served with a cease and desist order as was the case in New Jersey.

As previously reported by Cointelegraph, Texas has also joined the regulatory campaign against BlockFi. The Texas Securities Board plans to hold a hearing in October to decide whether to ban BlockFi from offering crypto lending services in the state.

As is the case in New Jersey and Alabama, regulators in Texas say the fact that BlockFi operates as a crypto business does not preclude it from securities law. In another statement on its website, BlockFi has come out to disagree with the notion that BIAs are securities.

According to Prince: “Ultimately, we see this as an opportunity for BlockFi to help define the regulatory environment for our ecosystem.” Back in June, the BlockFi CEO argued that regulatory interest was a net positive for the crypto ecosystem.

Crypto lending market on the radar?

BlockFi’s current regulatory problems also bring up the larger issue of crypto lenders seemingly coming under greater scrutiny from regulators. Judging by the exact wording contained in the notices served by New Jersey and Alabama, regulators in these states appear to have classified BIAs as a product rather than an account.

Despite being a non-bank entity, there is an argument to be made that BlockFi offers what is akin to the usual savings account provided by banks — albeit in BlockFi’s case, for Bitcoin (BTC), Ether (ETH) and stablecoins. By commingling user deposits, the company is able to offer loans to retail and institutional clients alike.

Depositors are incentivized with annual returns as high as 8.5% for dollar-pegged stablecoins and about 4% for BTC deposits, which is several orders of magnitude higher than the 0.03% on average for U.S. savings accounts. Apart from high-interest yields, depositors also have access to loan facilities against their crypto deposits.

By treating BIAs as a product, it is possible for regulators, like those in New Jersey and Alabama, to state that BlockFi’s interest-bearing crypto lending accounts qualify as securities. Meanwhile, such a designation is usually not given to certificate of deposit (CD) accounts, despite the latter behaving in much the same way as a security under the definitions set forth under the Securities Act of 1933.

However, it is important to note that these actions are based on unique state laws and might not have anything to do with federal mandates. America’s jurisdictional diversity, which often leads to a patchwork of regulations along state lines, is a common compliance hurdle for crypto businesses and the broader fintech industry in general.

Thus, with the absence of federal mandates that may offer some form of preemption, BlockFi and crypto lenders might soon be dealing with more onerous state laws. In a conversation with Cointelegraph, Dean Steinbeck, president and general counsel at blockchain development company Horizen Labs, stated that regulatory action against companies like BlockFi is inevitable, adding:

“Unfortunately, I think it’s only a matter of time before federal regulators go after centralized ‘crypto banks’ that offer their users fixed interest on crypto deposits. Regulators may elect to target these investments as unregistered securities offerings or as unlawful banking activity depending on the particular agency that decides to pursue these claims.”

Commenting on the possible route for such regulatory actions, Steinbeck stated that since interest-bearing instruments are “already well-regulated products,” there might not be a need for specialized legal policies concerning their crypto counterparts. “Regulators simply need to clarify what regulatory regime governs these types of crypto deposits and loans,” added Steinbeck.

Thus far, the U.S. Securities and Exchange Commission has limited its oversight involvement in the crypto lending space to probes and indictments against a handful of companies operating in the market. However, with the increased focus on America’s cryptocurrency industry by some members of Congress, an SEC ruling on whether or not crypto loan “products” are securities might be a possibility in the future.

BlockFi’s eventful 2021

Crypto lending took off in 2019 and, before the DeFi summer of 2020, was arguably one of the fastest-growing markets in the entire crypto sector. BlockFi reportedly manages over $14.7 billion in assets from its crypto interest-bearing accounts and has reached a valuation of about $3 billion, following a $350 million Series D funding round back in March.

In June, the company announced plans for another round of investments by leading backers and private investors that could see its valuation approach $5 billion. Earlier in the year, as Bitcoin and the crypto market rocketed to new price highs, BlockFi customers were seemingly earning record interest payments on their crypto and stablecoin deposits.

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However, it has not been smooth sailing for the company in 2021, with a couple of incidents that could arguably be described as public relations nightmares. Before the company’s $350 million funding round in March, about 500 of its customers were reportedly victims of racist and vulgar email attacks. In May, the company mistakenly sent outsized payments to winners of a promotional campaign, with some people allegedly receiving hundreds of Bitcoin.

BlockFi’s regulatory heat in the second half of 2021 has also coincided with a period of low activity for the company in terms of the flow of funds to and from miners and exchanges. Data from the on-chain analytics platform CryptoQuant’s inter-entity flows shows minimal activity between BlockFi and miners and crypto exchanges in the last month, with the company’s reserves also at their lowest level since the first quarter of 2020.

Having raised hundreds of millions of dollars in several fundraising rounds, BlockFi is reportedly eyeing a public listing to join the ranks of publicly traded multibillion-dollar crypto firms. It is not clear how the current regulatory problems might factor into the company’s bid to go public.