Regulation Could Help Drag Crypto Out Of The Bear Market

The cryptocurrency industry is under pressure amid a strong bear market sentiment that has wreaked havoc on the value of most tokens. With the price of assets like Bitcoin, Ethereum, Avalanche, Solana, and others all way below their all-time highs, investors are getting nervous. 

Added to that are the challenges in the DeFi industry. The turmoil began in May with the collapse of the Terra blockchain and its stablecoin UST, which was until that time rapidly growing in popularity. Unlike other stablecoins such as USDT and USDC, which are backed by real-world assets, UST was an algorithmic stablecoin that relied on some clever number-crunching to maintain its 1:1 peg to the U.S. dollar.

Unfortunately, those algorithms failed to do their job when UST came under sustained selling pressure, and in the space of just two days its value dropped far below $1, completely wiping out the value of Terra’s native LUNA token as well. 

That was followed by yet more shocks involving a number of big names in the DeFi space. The most notable was Celsius, a crypto borrowing and lending platform that promised high interest for depositors. In June, Celsius suddenly announced it was temporarily suspending withdrawals until further notice, meaning investors could no longer access the cash they’d locked into its protocol. 

At the same time, prominent crypto firms including Three Arrows Capital and Voyager are said to be facing bankruptcy, while crypto lender BlockFi narrowly avoided the same fate thanks to a $680 million bail out by the cryptocurrency exchange FTX. 

Such developments have led to a new chorus of calls for greater regulation of the cryptocurrency industry. Regulators say there’s an urgent need to know who is running these crypto companies and understand how their operating policies and procedures work. 

During the bull market that began in early 2021, the clamor for regulation had all been drowned out. Warren Buffet has previously called this the “lemming effect”, or a crowd mentality – when the going is good, no one cares about regulation because they’re all too busy trying to cash in on the good times and make a quick buck. So no one cares about the risks and repercussions. However, when things go bad and the price of crypto assets start to fall, investors suddenly turn around and demand protection from their governments. 

Previous bear markets have led to similar calls for regulation with little result, but it seems that things could be different this time. In a recent blog post, the institutional cryptocurrency exchange AAX noted that some influential people and bodies appear to be paying serious attention to the crypto space in the wake of the Terra debacle, which wiped out millions of dollars in investors’ cash. 

For instance, the U.S. Treasury Secretary Janet Yellen has urged Congress to introduce a “comprehensive framework” to govern stablecoins. Also vocal is the Securities and Exchange Commission Chairman Gary Gensler, who warned investors that crypto platforms which promise high returns should be treated with caution. 

“Meanwhile, US politicians introduced major legislation in June 2022 that would create the first comprehensive federal framework for regulating digital currencies,” AAX stated. “And the European Union is reportedly working on its own proposal for crypto regulation.” 

Platforms such as Celsius advertise how crypto holders can earn big yields on tokens like Bitcoin, Ethereum, and other cryptocurrencies by depositing them on their platforms. For example, it claimed users could earn interest of up to 6.2% on their BTC deposits, and 5.35% on their ETH. The platform was able to do so during the bull market when the price of both tokens rapidly appreciated. However, when conditions changed and the value of those tokens nosedived, Celsius quickly found itself in trouble. 

According to AAX, Celsius was unprepared for the sudden market crash, and in a desperate bid to stop itself from being liquidated, it resorted to using customer’s funds to protect its own positions. That left it in a situation where it no longer had the funds available to return investor’s deposits. 

“That wouldn’t fly in a regulated traditional financial system,” AAX said, explaining why the calls for regulation are growing. 

It’s believed that regulators are paying attention, and will most likely be looking at how DeFi platforms like Celsius are able to pay such high rates of interest on customer’s deposits. They’ll be looking closely behind the scenes at how these protocols work, in terms of leverage and the controls on lending they provide. 

It’s likely that regulators will attempt to clamp down on anything they perceive as being too risky. An example of this happened recently when the SEC rejected Grayscale’s application to launch a Bitcoin spot ETF. Explaining its decision, the SEC said it was concerned that Greyscale had failed to answer questions surrounding concerns of market manipulation. 

Forbes senior contributor Rufas Kamau wrote later that the SEC Chairman Gensler has previously said he views Bitcoin as a “commodity”, which means that legally, multiple regulatory agencies must collaborate in order to put in place a proper structure to regulate such a product.

AAX said it believes crypto companies are anticipating more regulatory clarity in the near future, and that it will be welcome when it arrives. If the crypto industry, particularly the DeFi sector, can implement more safeguards such as federal deposit insurance, this will provide greater protection for investors and ensure enough liquidity remains even when markets are stressed. That will be a good thing, AAX said, as it will build confidence and stability in the overall DeFi system by reassuring investors that their funds will be available when they need to withdraw them. 

With all the alarm created by the current bull run, it seems inevitable that greater regulation will be on the way. That would likely help the industry to weed out the higher-risk platforms that don’t provide enough protection and safeguards for their users. If that happens, it could lead to a new wave of optimism and confidence in the crypto space.

“Perhaps a clearer regulatory playbook, together with a maturing Web3 economy, will be enough to kickstart the next bull run as even more companies and more consumers will then be all the more interested to join the crypto movement,” AAX said. “A more structured and clearer regulatory framework for cryptocurrencies will enable users to feel safer as they navigate within the digital assets industry.”

The only question is when the increased regulation will happen. For all of the talk, regulators have been notoriously slow to take action. An example of this is the scandal involving QuadrigaCX, a cryptocurrency exchange whose CEO allegedly gambled away his client’s funds and stole passwords to offline cold wallets. 

The QuadrigaCX scandal occurred way back in 2017, but it wasn’t until 2021 – four years later – that the first regulated cryptocurrency exchange emerged. Believers in regulation and what it can do for the crypto industry will be hoping for regulators to move much more quickly this time around.