Crypto Lending

The sheer amount of money invested in the crypto space is causing regulatory dialog to occur at a frenetic pace as regulators struggle to keep pace.

A number of states in the United States, including Kentucky, Texas, Alabama, Vermont, New Jersey and, most recently, New York have been cracking down on crypto lending. Depending on one’s perspective, these can amount to acts of collective desperation or a foretoken of things to come.

Asked about the clampdown on crypto lending firms like BlockFi and Celsius, Firat Cengiz, senior lecturer in law at the University of Liverpool, told Cointelegraph: “The crypto regulatory space is getting increasingly heated, and not only in the U.S. but also in the rest of the world.” She added that a new regulatory approach is emerging and, as such, “the crypto market will no longer be an example of a free market regulated purely by the ‘invisible hand of the market.’”

“DeFi and stablecoins — rather than exchange or store-of-value coins such as BTC or ETH — will be the key target of emerging regulations,” Cengiz continued. “For instance, the draft EU regulations will ban interest on stablecoins,” which some believe most challenge central finance and banking institutions.

But, Cengiz doesn’t necessarily see the New York State attorney general’s mid-October shutdown of two unnamed crypto lending platforms operating in the state because of “unlawful activities,” as part of this global trend. “New York State historically has tried to make a political point by targeting crypto,” she said. Meanwhile, others have noted that James is expected to run for governor of the state, so almost everything she does at this point has a political aspect.

Is crypto lending legit?

New York State isn’t alone in raising its eyebrows with regard to crypto lending, however. Alabama, Kentucky, New Jersey and Texas brought cease and desist orders against New Jersey-based crypto lenders BlockFi Inc. in July and Celsius in September. Both were alleged to have “unlawfully offered unregistered securities in the form of high interest-bearing accounts used to fund their lending operations and proprietary trading.”

Investors often don’t realize that the 8-9% interest they're earning on their crypto deposits — at a time when savings rates at traditional banks are well below 1% — comes packed with certain risks, i.e., their entire stake can be wiped out if the project is hacked or collapses, regulators have suggested.

“They do have a point,” Lee Reiners, executive director of the Global Financial Markets Center at Duke University School of Law, told Cointelegraph. “The marketing around many of these yield products makes it sound as though they are similar to savings accounts with guaranteed returns, when, in fact, they are not.” Nor do they come with FDIC insurance, like traditional bank saving accounts.

Others have asserted that the (sometimes) double-digit rates being paid for crypto deposits couldn't be sustained during a sharp crypto price downturn, and especially during a bear market. That is, they are mere “artifacts of an artificially inflated crypto market,” as Kevin Werbach told Roll Call.

“Of course, returns have to come from somewhere,” Reiners, a former supervisor at the Federal Reserve Bank of New York, further explained, adding:

“If you are lending crypto to a DeFi protocol or centralized firm, what are they doing with it to generate that 8% or 9% interest rate you’re getting? Well, they’re just using it to trade other coins, which is profitable when the market is going up. But, if crypto prices decline, those yields can’t be sustained.”

Regulators are struggling to keep pace

Anne Termine, a partner in the government enforcement and investigations practice at Bracewell LLP and former chief trial attorney at the Commodities Futures Trading Commission (CFTC), said that “there are no easy answers” on the crypto regulatory front, but the sheer amount of money invested in the crypto space now is causing the regulatory dialog to occur at a more frenetic pace, telling Cointelegraph:

“In any industry, innovation comes first and regulation comes after. What’s happening here is that the innovation is happening at such a speed that the regulators are struggling to keep up.”

With regard to the questions surrounding lending, some in the crypto community argue: “Just because we’re offering a product that’s better than what banks can offer doesn’t make us illegitimate… it doesn’t mean we’re an outright fraud,” she added. And not all crypto protocols should be tarred with the same brush. The big actors in the space are often fairly sophisticated companies that take consumer protection seriously, Termine added.

Asked if regulators have a point that 8-9% saving rates seem perhaps too good to be true, Cengiz answered. “Yes, of course, there are undeniable gaps of consumer protection in the crypto market.” It still isn’t clear, from a legal standpoint, to what extent lending to or borrowing from a decentralized finance (DeFi) protocol counts as a financial contract under current financial consumer protection rules, she said, adding:

“However, the response to this should not be bringing highly political individual cases, but taking legislative action to provide sufficiently clear regulatory guidance both to consumers and providers. I find it hard to categorize the types of individual actions that you mention as genuinely originating from consumer protection incentives.”

Reiners, for his part, has little patience with the position that state attorneys general like Letitia James are just trying to score political points or protecting legacy banks. “The crypto community always acts like they are victims whenever something like this happens when, in reality, regulators are simply doing their job and enforcing the law. And frankly, I don’t see how going after crypto companies scores any ‘political points.’ It’s not as if there is an anti-crypto lobby out there with votes to be had.”

“A dangerous game”

“There is nothing new under the sun,” Geoffrey Goodell, a research associate at University College London and deputy executive director of the UCL Centre for Blockchain Technologies, told Cointelegraph. “Businesses are seeking sources of capital and investors are seeking sources of yield. In this case, businesses are using the language of asset custodians to suggest safety that does not exist, while dodging traditional regulatory barriers to such activities.” He added that since investors are eager to earn high eyelids, the situation turns into a “dangerous game that we have seen many times before.”

“The problem with any cryptocurrency not backed by central banks is volatility and potentially losing the investment,” Laura Gonzalez, associate professor of finance at California State University at Long Beach, told Cointelegraph. She added that “There is a significant risk and return tradeoff,” and investors should tread carefully when they enter this space.

Others have suggested that by going after firms like Celsius, BlockFi and others, regulators are simply seizing the low-hanging fruit. It may be more difficult to clamp down on more decentralized lending projects where no individual or company is clearly in charge.

Cengiz acknowledges that decentralized platforms could present “significant problems and complications” for enforcement agencies including locating the jurisdiction responsible for the investigation, deciding on the applicable law and identifying individuals responsible:

“Successful enforcement against decentralized platforms will require a very strong international network between enforcement agencies, which we do not see in any other area of law.”

“Having said this, sometimes crypto platforms make themselves a target of law by blindly ignoring regulatory advice,” Cengiz added. One example: The United Kingdom Financial Conduct Authority (FCA) ordered Binance to cease all operations because Binance failed to ask for FCA authorization “under very clear regulatory guidance.”

A global regulatory dialog

“We are seeing a lot of movement across governments, not just at the federal level but at the worldwide level and certainly at the state level too,” said Termine. “The crypto community is asking: Can we please get coordinated on this.”

Is the same debate going on in other countries as well? Termine said “Absolutely,” all over the world and especially when it comes to the Bank of England (BOE). Its deputy governor, Jon Cunliffe, drew comparisons between the current cryptocurrency boom and the run-up in U.S. sub-prime mortgages in 2008 right before the financial collapse.

Indeed, crypto’s market value, which touched $2.5 trillion in mid-October, was roughly double the value of the subprime market in 2008 — $1.2 trillion — which shows that “you don’t have to account for a large proportion of the financial sector to trigger financial stability problems,” Cunliffe said.

Termine viewed the BOE deputy governor’s remarks as a good example of the growing “fervor” on the part of regulators globally to deal with cryptocurrencies. Cengiz told Cointelegraph:

“Regulators do not seem to understand the dynamics of the crypto market fully, and the actions that they take are likely to discourage at least some consumers from partaking in an emerging and potentially very efficient and innovative investment market.”

She added that the goal should be regulation that “protects citizens against usual hazards of the crypto market such as financial complexity, fraud, cyber attacks, etc. without compromising innovation.”

Reiners was asked if there were any circumstances under which he would support crypto lending, to which he stated: “If it facilitated real economic activity. But right now, all it does is facilitate more speculation in crypto. But from a legal standpoint, if these products are offered outside of banks, they need to be registered as securities.”

Related: Crypto breaks Wall Street’s ETF barrier: A watershed moment or stopgap?

In sum, the cryptocurrency and blockchain industry is “not something that can be ignored anymore” by regulators, said Termine, who worked nearly 20 years at the CFTC. “Ten years ago, it seemed that this was a fad,” the province of software engineers in an obscure corner of the world.

No one took the idea of an open decentralized financial network seriously. “But 10 years later, there’s more than $2 trillion of market value floating in this space, and regulators around the world have to sit up and say, ‘We can’t not look anymore.’”