The Breakdown - A "Crypto Frenzy"? Today's Congressional Hearing Puts Bitcoin and DeFi in the Hot Seat

Episode Date: July 1, 2021

An interview with a congressman followed by a congressional hearing on crypto signal policymakers are moving to the next phase of talks about regulating crypto. Troubling comments in Congressman Bill Foster’s interview with Axios Upcoming committee hearing titled ominously “America on ‘FIRE:’ Will the Crypto Frenzy Lead to Financial Independence and Early Retirement or Financial Ruin?” Foster has historically been a champion of the crypto market: He is a co-chairman of the Congressional Blockchain Caucus and was previously supportive of the future of crypto. However, in his recent Axios interview, his tone flipped, as he went as far as to suggest the need for a “cryptographic backdoor” to allow the court the ability to view or even reverse transactions. Is Foster’s new viewpoint indicative of a greater shift in policymakers’ attitude toward crypto regulation? Today’s House Committee on Financial Services hearing with a particularly colorful title is yet another signal for an upcoming regulatory push in crypto. The hearing’s agenda includes a discussion of bad actors on decentralized currency exchanges, or DEX, including a reference to Mark Cuban’s recent loss of money in a DeFi “rug pull.” With an expert witness lineup, including Jim Cramer of “Mad Money,” Alexis Goldstein of the Open Markets Institute and Peter Van Valkenburgh of CoinCenter, there is quite a mixed set of viewpoints on the current state and future of crypto. -- Earn up to 12% APY on Bitcoin, Ethereum, USD, EUR, GBP, Stablecoins & more. Get started at https://nexo.io/ -- Enjoying this content?   SUBSCRIBE to the Podcast Apple:  https://podcasts.apple.com/podcast/id1438693620?at=1000lSDb Spotify: https://open.spotify.com/show/538vuul1PuorUDwgkC8JWF?si=ddSvD-HST2e_E7wgxcjtfQ Google: https://podcasts.google.com/feed/aHR0cHM6Ly9ubHdjcnlwdG8ubGlic3luLmNvbS9yc3M=   Follow on Twitter: NLW: https://twitter.com/nlw Breakdown: https://twitter.com/BreakdownNLW   The Breakdown is produced and distributed by CoinDesk.com

The full hearing name is America on fire. Will the crypto frenzy lead to financial independence and early retirement or financial ruin? Good job, intern committee naming person. Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by nexus.io and produced and distributed by CoinDess. What's going on, guys? It is Wednesday, June 30th. And today we are talking about a congressional hearing that is putting Bitcoin, crypto, and

Defi in the hot seat. Now, there has been something of an alarming shift in tone around crypto among U.S. politicians. Yesterday, Congressman Bill Foster participated in an interview with Axios and gave insight into how much sentiment among U.S. longmakers was turning against crypto. Quote, I'm not there yet, but there's significant sentiment in Congress that if you're participating in anonymous crypto transaction that you are a de facto participant in a criminal conspiracy. For the sake of this episode and me actually getting all the way through it, let's get it out of the way that this is an absurd point of view.

It's like saying that if someone buys cigarettes or alcohol or condoms with cash, they're part of a criminal conspiracy. It's ridiculous, but unfortunately, I don't see much resonance for that argument. As we'll see, I believe that lawmakers right now are more likely to want to ban cash than to accept anonymous crypto transactions. Anyway, I wanted to get my two cents on the absurdity of this whole line of reasoning out of the way so that we can focus on the tonal shift. In the same interview, Foster argued that it's not just governments, but actually citizens, investors that want the ability to, quote, unmask crypto participants and reverse fraudulent transactions. Quote, I think for most people,

if they are going to have a big part of their net worth tied up in crypto assets, they're going to want to have that security blanket of a trusted third party. Crypto Twitter has been quick to point out that one of the fundamental purposes of cryptocurrencies is to remove the need for trusted third parties. In other words, a reasonable response from many crypto advocates might be that if an end user wants a security blanket of a trusted third party, then perhaps crypto is not for them. Now, one important note is that this conversation is also caught up in design considerations around a US digital dollar. Put differently, the conversation is not just about whether private or anonymous crypto transactions should be allowed, but how much privacy and anonymity

should be designed into a forthcoming US CBDC. Quote, there's a middle ground that we have to strive for, somewhere between the chaotic criminal ransomware environment that we're seeing in some crypto assets and a completely surveilled environment. And I think that middle ground is third-party anonymity, where 90% of the time the blockchain will determine who gets paid what,

but in those rare instances where something fraudulent, criminal, or mistaken has happened that you have to be able to unmask and potentially reverse those transactions. So there goes immutability. His ultimate recommendation was that the court should be able to have a, quote, very heavily guarded key, a cryptographic backdoor, in essence, that would allow it to reverse transactions on the blockchain. To be honest with you guys, even before we heard about the congressional hearing today, this was enough for me to focus on this topic. You have to put Foster's statements in context. He has historically been one of the champions of this entire technology space.

He's a co-chair of the Congressional Blockchain Caucus and even has dabbled with coding in the space. To see him talking about things that are completely contrary to the entire nature of the field, things like backdoors and the undoing of immutability, suggest to me a significant shift in the prevailing political winds around this industry. Now, to be fair, it may not be the best way to describe it as a shift. For most regulators, so far the crypto industry has been at best a tertiary concern. The only people who thought about it at all in government were those who either love, loved it or hated it. It seems possible that regulators are now finally digging in, and the specific

context for that digging in is ransomware attacks and crime. We've heard people like Janet Yellen and Elizabeth Warren repeat specious, non-facts about how much of crypto's use is for crime. And frankly, you don't have to view regulators as malicious to see how this could become an issue. Imagine you're a regulator from some small state who hasn't really thought about crypto. You're more concerned with the day-in, day out of your constituents, including whatever topics that matter most to them, which probably also isn't crypto. All of a sudden, there are these massive reports of key U.S. energy infrastructure being held hostage by nefarious actors demanding this crypto stuff. You want someone or something easy to blame in a way to solve the problem, right?

I mean, that's what your job is, ultimately. It's to solve problems. Just get rid of this stupid crypto stuff, one of your colleague says, and the problem will go away. And oh, by the way, it uses more energy than medium-sized countries, so that's completely at odds with your environmental values as well. Well, screw crypto then, right? It's not worth it. Of course, there are holes and problems with this reasoning at every level, but the point I want to make is that it doesn't take a cabal of anti-crypto-communists or something for serious negative sentiment to begin to prevail. So, as I said, that's where I was going to end this show. But then this morning, the House Committee on Financial Services announced a hearing today about the, and yes, these are their words, crypto frenzy.

The full hearing name is America on fire. Will the crypto frenzy lead to financial independence and early retirement or financial ruin? Good job, intern committee naming person. The hearing will be later today, so I'm obviously going to have to come back to you tomorrow to let you know if there was anything notable in the questioning. But for now, let's glean what we can about the positioning based on, one, the committee memorandum about the hearing, and two, the prepared testimony of invited witnesses. Let's talk first about the committee memorandum.

This is divided into a few sections. The first is background and the TLDR of it is that this set of things in which they include cryptocurrency, stablecoins, and CBDCs are real and big. They note mainstream financial players like State Street and BNY Mellon have set up new digital asset divisions and that globally 98% of hedge fund managers plan to start to invest in digital assets within five years. Part two is called individual and system risks related to cryptocurrency usage. They, of course, discuss volatility, but there are a couple more interesting lines.

The first has to do with retirement. Quote, the potential for significant losses could heighten investor protection concerns, especially if individual investors of limited financial means rely on cryptocurrencies for potential retirement income. I'm not sure what has gotten them to identify this as a concern. However, I do think it's interesting to discuss. I believe that one of the main trends shaping markets now is that individual retail investors are saying, I want in on mass.

and this is shaping everything from ETFs to crypto to meme stocks. These investors are often disaffected coming in. They view financial markets as a game slanted towards the rich getting richer and are just trying to carve out their little piece. I think denying them access to markets in the name of protecting them from themselves would be a catastrophically paternalistic response, whether it's in the name of investor protections or not. Another line that matters is this one.

In addition to risks to investors, some experts have raised concerns that leveraged crypto, cryptocurrency positions and cryptocurrency derivatives could present systemic risks to the global economy. This language is extremely politically charged, especially for an administration for whom many of their senior officials' most formative political moments were during the great financial crisis. That experience has left a sort of hyper-awareness and PTSD around the possibility of systemic risks. Now, at this point, it probably goes without saying, but I've seen absolutely no evidence of systemic risk, especially spilling over into the broader system.

In fact, crypto has consistently proven, over and over, that it is the only industry capable of dealing with true market volatility without any sort of backstopping, bailouts, guardrails, or market kill switches. I think one could argue convincingly that it is much more resilient than the brittle traditional system. As I tweeted the other day, they get bailouts, we get memes. And by the way, you would think that with a claim this serious, this notion of crypto becoming a systemic risk,

that it better be some pretty profound experts behind it, right? Nope, slide down to the footnotes and you discover that it is Jim Kramer, the host of mad money whose comments they're referencing and clearly taking seriously. No disrespect to Jim Kramer, but he's an entertainer, not someone who the U.S. Congress should be looking to as an expert on what is and isn't a systemic risk. And what's more? One would think that Kramer's classic Bear Stearns rant would disqualify him especially from this role. On March 11, 2008, in response to a question from a viewer who asked,

should I be worried about Bear Stearns in terms of liquidity and get my money out of there? Kramer said, no, no, no, Bear Stearns is fine. Do not take your money out. If there's one takeaway, Bear Stearns is not in trouble. I mean, if anything, they're more likely to be taken over. Don't move your money from Bear. That's just being silly. Don't be silly.

Five days later, Bear Stearns was no more. Still, the biggest part of this section is reserved for so-called scams. They discussed the SEC, not approving, coin ETFs because of market manipulation and fraud concerns, but they also go in on Dex's decentralized exchanges. Quote, the emergence of peer-to-peer or decentralized cryptocurrency exchanges, Dexes, which are not contemplated by current government regulation, has led to another avenue for cryptocurrency scams. Many Dexes generally allow any digital asset projects to be swapped on their platform. Bad actors can establish a new cryptocurrency, solicit investors to exchange

more established and valuable cryptocurrency for their new project, and then abandon the new project and leave with investors more established cryptocurrency. This increasingly common scam is known as a rugpole and has made headlines recently as celebrity investors were potentially victimized. They're referencing, of course, Mark Cuban, who days after writing a breathless open letter saying that the government needed to get on board with defy as the next great American growth engine, lost some money in a random defy exploit and spouted off about how defy should probably be regulated.

He literally said, please regulate this thing I just lost money on. And well, it seems like he might get his wish. Looking for the best way to unlock your crypto's liquidity? NexO.io is exactly what you need. Borrow against your digital assets at just 6.9% APR. Earn passive income with yields of up to 12%. And swap between more than 100 market pairs with the instant NexO exchange. Try the NexO wallet app to get the whole 360 degrees of crypto banking.

Get started at nexo.io. That's nexo.io to get start. today. The third section here is called investor protection and regulation of cryptocurrency exchanges, and the biggest thing to note is a long paragraph that effectively claims that all market price is manipulated. They erroneously argue that Bitfinex and Tether are under investigation, referencing a 2019 article and failing to mention that Tether has settled with the New York Attorney General. They argue that, quote, cryptocurrency exchanges also frequently face network congestions or trading halts, calling into question their readiness to serve a growing marketplace, which is rich, again,

me, given how many times recently trading has been shut down in traditional markets around the stocks that investors most want. The penultimate section of the memorandum is called enforcement activity against cryptocurrency market participants, and it basically just repeats that Gary Gensler from the SEC wants clear authority over crypto exchanges, which frankly wasn't what many heard in his previous testimony, but if this is what we'd get with the house in control, I'd take it. Finally, the last section is called regulatory activity and rulemaking on digital assets, And this really just repeats the recent actions of new regulators such as Michael Sue over at the Office of the Comptroller of the Currency who are reviewing rulemaking from the previous administration. Now, the last thing is an appendix of recent actions, and I think it's a really telling catalog of how they see the highlight events of this year, so let's rip through it.

January 1st, 2021, 1 Bitcoin equals 30,000 USD. January 2021, BlackRock adds Bitcoin futures as a potential investment for two of its funds. Elon Musk adds Bitcoin to his Twitter bio, preceding a 20% rise in the price of Bitcoin. February, Tesla purchases $1.5 billion for, quote, more flexibility to further diversify and maximize returns on our cash. Bank of New York Mellon announces plans for digital currencies to pass through the same financial network it uses for traditional holdings like U.S. Treasury bonds and equities. March 2021. Morgan Stanley launches three investment fund products with Bitcoin exposure for its high net worth clients. March 2021 again, Morgan Stanley,

New York Life, Mass Mutual, Soros Fund Management, and others announced participation in a 200 million dollar investment round in NIDIG, a firm leading Bitcoin-related strategic initiatives that span investment management, insurance, and banking. April 14th, 2021, Coinbase lists on Nasdaq reaches 100 billion market cap first day of trading. April 2021, Bitcoin hits peak of one Bitcoin equals around 65,000 USD. April 26, 2021, Tesla reverses course and sells its Bitcoin holding, citing environmental concerns, making proceeds of 272 million. May 2021, Bitcoin plummetes to one. Bitcoin equals 30,000 USD. May 6th, SEC Chairman Gary Gensler calls for greater investor protections in the cryptocurrency marketplace, including crypto exchanges. Chair Gensler warns FSC members that right now,

these cryptocurrency exchanges do not have a regulatory framework at the SEC or at our sister agency, the Commodity Futures Trading Commission. Right now, there's not a market regulator around these crypto exchanges, and thus there's really no protection around fraud or manipulation. May 11th, SEC issued staff statement calling Bitcoin a highly speculative investment warning investors in mutual funds that trade Bitcoin futures about their potential exposure to hidden risks. June 10th, SEC and CFTC issues investor bulletin urging investors to carefully consider the volatility of Bitcoin and the Bitcoin futures market, as well as the lack of regulation and potential for fraud or manipulation in the underlying Bitcoin market.

So I would say that the two things that stand out here are one, a clear focus on growing institutional participation, and two, a 100% increase followed by a 50% decline in the price of the Bitcoin asset inside of six months. Clearly, there is a ton to chew on in this prepared memorandum, but let's also look at some highlights of the expert witnesses invited. First, from Alexis Goldstein, the director of financial policy at the Open Markets Institute, she writes a long set of prepared comments, but let's just highlight two things. The first is that she, unlike Jim Kramer, outlines a rationale of how crypto could become a systemic risk. Basically, her argument is that if hedge funds get deep enough that they could have an

archigo-style implosion based on crypto volatility, that's how crypto risk could become a larger market risk. I think it's important to note, and she does here, that this is not necessarily, or at least not just, a crypto issue. It's an issue of the opacity of hedge funds, which is something that the traditional finance space has to reconcile with completely independently. Second, I think that this testimony, combined with the fact that the committee memorandum explicitly discusses Dex's shows just how much regulatory scrutiny is coming for defy. She has an entire section called particular risks in the decentralized finance defy space. One of the subsections of that catalogs quote,

recent hacks and exploits in defy. And p.S, here's Mark Cuban again back in this one with a direct quote. There should be regulation to define what a stable coin is and what collateralization is acceptable. Defy friends, choose your friends wisely. Next up is Sarah Hammer, managing director of the Stevens Center for Innovation and Finance at the Wharton School at UPenn.

Her big thing is just like, is both important and really tricky. It involves a huge number of bodies and the risk to innovation is serious, so please be conscientious. After Sarah, we have Christine T. Parker, a partner at Reed Smith, LLP, and I have to say her testimony is fire. Let me summarize a set of her key points. First, it's hard to determine how a particular digital asset that isn't Bitcoin or Ethereum is characterized from a regulatory perspective. What's more, there isn't a single agency with authority over digital assets. While crypto-haters might think this is good, it isn't. A lack of regulatory clarity harms retail investors. Many of those investors want access to digital asset derivatives. Unless

the U.S. gets its crap together to allow for that sort of thing in a safe, regulated way, they're just going to VPN it and go elsewhere. Quote, this is a losing proposition for U.S. crypto markets and market participants. The solution is not to continue to shadow ban these markets, but offer them in the U.S. under an appropriate regulatory regime. In her conclusion, she also nailed why this is going to require such a key mindset shift. Quote, while a number of recent fintech innovations depend on a partnership with a regulated banking institution,

Defi seeks to disrupt this model entirely by eliminating the regulated intermediary. However, our current regulatory regime centers around regulated intermediaries, not regulated activities. I expect it will be a significant challenge for regulators to understand the deployment of smart contracts in the blockchain

to enable financial transactions, such as trading and lending. Our second to last witness is Eva Sue, who is an analyst in financial economics at the Congressional Research Service. The CRS's role is to provide, quote, objective, nonpartisan research and analysis to Congress and to take no specific positions on any specific policy. Her testimony is exactly that. It is just really a massive primer on the state of the regulatory discussion so far. And by the way, this one is super helpful if you just want the 101 on what regulatory conversations have already transpired.

I will say the most interesting note in the whole thing is a section about tether and whether reserve disclosures should be mandated. This probably would find some allies within the crypto community. Or at least there would be a tension between the desire of many for reserve attestations, something Nick Carter, for example, has been talking about forever, and the desire for those sorts of things to be voluntary rather than mandated from on high. Lastly, there is Peter Van Valkenberg from Coin Center, doing God's Work, Fudd fighting over here.

There are a couple of key shifts in perception he tries to make. First, around the idea that crypto isn't regulated. That's wrong. It's regulated all over the place at the state and federal level. It's just fragmented. Second, crypto is for crime. Wrong again. In 2020, only 0.34% of all cryptocurrency transaction volume involved a criminal sender or recipient. And remember, those numbers came from chain alias, an organization that a huge number of government agencies spend multiple millions of dollars with every year. Peter's key line, we don't need new regulations. Quote, with the rise of central bank digital currencies from authoritarian nations happening in tandem with the rise of Bitcoin, we are at a decision point as an advanced technological open

society. Are we willing to accept some risks if it means we can eliminate the choke points to economic participation that further inequality and stifle innovation? Or would we prefer to strengthen those choke points and outlaw alternatives in the hopes that a powerful elite will smartly choose who should and should not have access to powerful tools and volatile markets. For every transaction we want blocked, there's a transaction that we should celebrate for being unstoppable. Yes, there are criminals making payments on the Bitcoin network because banks won't bank them. There are also pro-democracy activists in Belarus and anti-police violence protesters in Nigeria, taking donations on the Bitcoin network because local banks won't bank them.

For every decentralized app that's trying to scam investors, there's another that's testing out ways to disperse universal basic income, or remove the money. corporate control over social networking, or eliminate the hacking risk inherent in centralized identity solutions. It's a mic drop moment, or at least it should be. So as I said, there is a lot to unpack here. We'll have more information tomorrow about what questions we're actually asked, but for now, suffice it to say that it feels like we're entering the next all-important phase of U.S. regulatory discussion. Perhaps a fair amount hangs in the balance. For now, guys, I appreciate you listening. until tomorrow, be safe and take care of each other. Peace.