Why Crypto Is About to Face A Massive Inflection Point
When it comes to Blockchain technology, people often talk about the exponential user growth rates and the sheer number of big businesses adopting it to further their business goals. But what most commentators are missing is an enormous (and we believe very likely) inflexion point that is about to happen in this new industry……
“Once a new technology rolls over you, if you’re not part of the steamroller, you’re part of the road” — Stewart Brand
As with any emerging technology, there are numerous ‘inflexion points’ at which it can travel in one direction, producing remarkable impacts on the world; or it can go in another direction, going out of existence with a whimper.
For the last 5 years, one of the major talking points surrounding blockchain technology and the digital assets market, in general, is if and when it can fit into the current financial regulatory structure. This is important, as numerous studies show this lack of regulation is what is holding institutions back from having a significantly higher allocation to the asset class. This uncertainty together with vastly differing country-specific approaches to the industry makes it somewhat difficult to most effectively break down where we are, and where we are headed.
So far, in order to not take any regulatory risk, most institutions have sought to gain exposure to the blockchain space through of one three (indirect) routes:
- You can purchase shares of companies that are using blockchain technology,
- You can purchase shares in companies that are putting Bitcoin on their balance sheets,
- You can purchase shares in companies that enable the buying and selling of Cryptocurrencies,
Obviously, depending on how you approach gaining exposure, you will be subject to different tax and disclosure requirements according to your local financial/regulatory jurisdiction.
You will notice that I have not mentioned having direct exposure to blockchain projects in the above list of options. It is direct exposure that is badly affected by lack of regulation. In this piece, I am going to focus on what more regulation will mean to the buying and selling of cryptocurrencies directly. We’re going to look at how imminent regulation will positively impact the valuation of cryptocurrencies, and what we can expect from the coming months and years.
First off, we must understand why regulation exists. Let’s look at the UK’s Financial Conduct Authority:
“Financial markets need to be honest, fair and effective so consumers get a fair deal. Our role is to ensure markets work well for individuals, businesses and the economy as a whole.
We do this by:
regulating the conduct of around 51,000 businesses
prudentially supervising 49,000 firms
setting specific standards for around 18,000 firms
We were established on 1 April 2013, taking over responsibility for the conduct and relevant prudential regulation from the Financial Services Authority (FSA).“
This makes sense. Ensuring a level playing field, and maintaining market integrity is pivotal for the ongoing success of the free market economy. Over time, the FCA has become much more focused on its secondary mandate, retail protection. The evolution of the FCA has seen it become extremely protective of the ‘everyday working person’, expanding its mandate to ensure that normal people are protected from bad actors in the financial sector.
Within this context, they are guided by two primary principles: Understanding Risks & Healthy Competition.
It is the ‘Understanding Risks’ part that I am particularly interested in.
“We protect people by helping them understand some of the most common risks they might come across when using financial services…”
Since 2017, the FCA has continued to step up its campaign to implement stricter market conditions on all organisations that have ‘consumer’ focused marketing efforts. At present, the restrictions on financial promotions are so severe that without a fully seasoned compliance team on hand, it becomes almost impossible to launch sustainable business marketing to retail clients.
So, let’s look at the approach of the Securities and Exchange Commission, over the Atlantic.
“At the Securities and Exchange Commission (SEC), we work together to make a positive impact on America’s economy, our capital markets, and people’s lives.
For more than 85 years since our founding at the height of the Great Depression, we have stayed true to our mission of protecting investors, maintaining fair, orderly, and efficient markets, and facilitating capital formation. Our mission requires tireless commitment and unique expertise from our staff of dedicated professionals who care deeply about protecting Main Street investors and others who rely on our markets to secure their financial futures.”
In a nutshell, they have a three-part mission:
- Protect Investors,
- Maintain fair, orderly, and efficient markets,
- Facilitate capital formation.
Now that we understand what they both do, let’s look at how they have regarded Cryptocurrency up to now.
Now, let’s look at the U.S:
You can see from both timelines that the respective jurisdictions have approached the legislation of digital assets, blockchain technology, and more specifically cryptocurrencies with a level of caution.
A common characteristic of most regulators is that they tend to move slowly and struggle to change direction… The classic ‘Oil Tanker’ analogy.
This analogy is more than apt when it comes to the regulatory approach they have taken to Digital Assets. To me, it seems that they are moving slowly, then all at once! In the UK timeline, you can see a clear focus on the inclusion of Digital Assets within the available tax structure within the initial period. HMRC led the way for several years, working with HM Treasury to ensure that the Government ‘gets its cut’ of the profits that are being generated from this nascent industry. Then, as the FCA becomes ‘literate’, it releases broad rules and guidelines all at once. So just because we do not see announcements every day, we cannot conclude that progress isn’t being made on establishing a regulatory framework for this space…I believe it is likely that we will see initiative again ‘all at once’.
The most obvious reason for the perceived lack of speed is quite simply that none of the regulators or legislators had recruited the expertise needed to guide policy and develop suitable bespoke legislation to cover this new technology.
As you progress through the timeline, you see a shift in tone, as the FCA begins to deploy more effective resources for gathering information and developing an opinion on the approach that broad regulations should take.
It is, at this point, important to note the considerable difference in stance here between the regulator (FCA) and the tax collector (HMRC). You can see how differently the two bodies approach the same question, and how that can often lead to the broadly confusing and often contradictory tone coming from governments around the world.
Switching to the U.S timeline, we see a very different timeline. It isn’t until 2016 that we see any significant acknowledgement of Digital Assets from the SEC, and even in 2016 it is merely a fact-finding mission.
As you flow through the timeline, one thing sticks out… The general theme from the U.S regulatory and tax bodies is: Pay your taxes.
The stark contrast between the SEC and the FCA is that, whilst they carry similar mandates, the FCA seems to be much more fierce on its expectations and requirements of consumer-facing organisations, whereas the SEC is less so. As a result, I believe that is why we see the SEC move much more slowly in the consumer protection aspects, perhaps because they want to let the space develop and see how it fits within the broader financial ecosystem already in operation first. But collecting taxes is obviously a no-brainer while this is happening!
There has been much debate this year centred on how the U.S regulators will view the entire sector, as well as whether they will acknowledge and build bespoke frameworks for sub-sectors (DeFi, Blockchain, DEX’s, CEX’s). With more significant regulation pending…. It leads me to my $10 trillion question:
How will the SEC act toward Digital Assets moving forwards?
Honest answer… no one knows.
However, what we can safely say is that more substantial regulation, whatever the severity, will unleash enormous ‘fresh capital’ into the sector. Some commentators calculate that it is this one factor — a clear regulatory framework — that will in itself lead the sector to a $10,000,000,000,000 valuation. Bear in mind, after the harsh crypto winter we have experienced, the whole sector is now valued at just £1trillion….As far as inflexion points go, it doesn’t get much more meaningful!
Even today, many blockchain ‘maximalists’ fear and loathe regulation of any type, citing the core principles of blockchain to be ‘trustless, private & immutable’. However, as more sophisticated investors as well as more level-headed, proven business leaders have become involved in the space, they are seeing the logic and value of regulation and not only welcome it but lobby for it.
“A trillion dollars will come into this market overnight” — Kevin O’Leary.
In this interview, Kevin discusses his optimism for the Digital Assets space.
As one of the key crypto sceptics in 2017, his conversion to advocate has drawn a lot of attention in the space. He, along with other thought-leaders like Mark Cuban espouse much more mature views on the next phase of development needed to unlock much more significant inflows.
They conjecture that as regulation enables adherence to the compliance requirements for bigger institutions, we will see a wall of capital flow into the space as those players become comfortable in providing clients with marginal exposure.
For these large institutions, marginal exposure represents a 2% allocation target, but this translates to trillions of dollars of fresh capital injected over the next coming months and years.
The irony is that it is the blockchain maximalists who will also profit from this hated newly regulated world: it is their projects and the scope for innovations within their beloved industry that will be the primary beneficiary.
A Changing of the Guard
One of the issues that Digital Assets has faced over recent years is the unpalatable Marketing and Public Relations standards we see repeatedly from projects which explode to many billions in MCAP, run by overly confident and brazen young CEOs.
More recently, we witnessed the Luna debacle, which saw over $60billion disappear from investors. That however is just the most recent in a long line of incredibly naive and frankly unfit leaders in the space. We have reached the point in this technology’s life cycle where the ‘big boys’ have entered the room, with the likes of Citadel and Bridgewater. These funds have significantly larger access to capital than most crypto projects, and we have seen a lot of evidence that those hedge funds are actively attacking weaker projects like Luna and others. As hard as this destruction is to watch, it is, if you think about it, part and parcel of the maturing of the industry into something far more robust and investible.
As we move into this next phase, we will see the biggest players on the planet pour in, and deploy increasingly sophisticated strategies, much like we saw in the early 2000s as the hedge fund world exploded into view. This will represent a shift from the immature state of play we’re currently experiencing, towards a much more sophisticated, murky, and quite frankly normal environment. This environment will much more closely resemble the equities market we see today. And all of this will be directly enabled by regulation.
Do we think further regulation of the crypto space is likely over the next 2–3 years? We do. All signs point towards this more mature and investible phase of the industry. Taking this logic further, if it is likely that we see regulation coming imminently, digital assets are even more attractive from an investment standpoint than when viewed solely through their growing adoption.
Summary
The need for fresh capital and the need for regulation are reliant on each other:
The fresh capital will not enter the space without effective regulation, effective regulation will not happen without those wishing to deploy fresh capital driving through that change.
We have seen how regulators in both the UK and the US are building increasingly sophisticated policies towards the entire space, demonstrating a step-change in their understanding in recent months. As this continues, it becomes highly likely that we will see a move towards a regulatory solution, in whatever form.
Now that we understand the mandate and the tone in which both regulators approach the markets, we can make a marginally more informed forecast on when regulation is likely to arrive, and in what form.
In August 2021, we saw Gary Gensler write to Elizabeth Warren in relation to crypto, referencing more deeply the nuanced sub-sectors within (DeFi, DEXs, lending), and it demonstrated a clear move towards bringing the entire sector under the ‘Securities’ umbrella.
I don’t see why this trend will not continue. I believe that almost all cryptocurrencies will be subject to ‘catch-all’ regulation, which will seek to bring them under the same requirements and restrictions as equities markets. It seems very unlikely that valuations will not be positively impacted.
P,
Co-Founder of Dragonfly Asset Management
DISCLAIMER: This content is for EDUCATIONAL AND ENTERTAINMENT PURPOSES ONLY and nothing contained in this blog should be construed as investment advice. Any reference to an investment’s past or potential performance is not, and should not be construed as, a recommendation or as a guarantee of any specific outcome or profit.
