A crackdown on the crypto sector by U.S. regulators that started last year has gathered pace. A series of probes have been announced, fines handed out and settlements reached with major players in the space. Among the crypto companies to suffer from the heavy hand of the SEC and other regulatory bodies over the past few weeks are Kraken and Nexo, which have both subsequently announced their withdrawals from the U.S. market.

Others, including Binance, the world’s biggest crypto exchange with around 55% of the global spot trading market in January, have found themselves under intense pressure from U.S. authorities.

The flurry of regulatory activity in the crypto space has been dubbed a “crypto carpet bombing” by Kristin Smith, the executive director of the Blockchain Association, a crypto industry trade group. He comments “every couple hours we hear of some new enforcement action”.

The ramp-up of regulatory pressure on the crypto sector in the USA is also not expected to fade away any time soon. The New York Times sees recent actions by regulators against crypto companies as most likely marking the beginning of a lengthy period of legal battles between the sector and U.S. authorities.

A series of high profile failures in the crypto sector last year included the lenders Voyager Digital and the Celsius Network and crescendoed with the November collapse of the FTX exchange, one of the world’s biggest. With retail investors losing billions of dollars as a result, regulators have responded and are attacking crypto companies and some tokes themselves with renewed vigour.

Some sector insiders, analysts and other stakeholders view the developments positively. They see a “shake out” and new regulatory environment positively and something that will ultimately strengthen the crypto sector by flushing out the companies and cryptocurrencies that offer little utility or value beyond the hype and consolidating it around a few with potential.

That could provide the foundation from which a new, sustainable crypto ecosystem that meets the standards required for integration into mainstream financial systems. The other potential outcomes are the crypto sector simply disengaging with the USA and moving offshore or it being pushed back to the margins of the financial sector, operating as a hard-to-police shadow economy.

Or, a period of wrangling between the most promising and willing to engage crypto players and regulators. That could see steps taken towards some kind of regulatory environment for cryptocurrencies and other exchange-traded digital assets that would allow for greater integration with mainstream financial markets.

The 2023 crypto crackdown – which regulators are hitting who for what?

The recent rise in regulatory activity targeting cryptocurrency assets and companies started with cases brought against those at the top of the collapsed exchange FTX. The Securities and Exchange Commission (S.E.C.), the Justice Department, and the Commodity Futures Trading Commission all opened cases against FTX CEO Sam Bankman-Fried, and two of his top executives, following its collapse in November.

The regulatory scrutiny of the broader crypto industry gained momentum in January when the S.E.C. slapped a $45 million fine on the crypto lending platform, Nexo, for unregistered securities, and filed similar charges against Genesis, one of Nexo’s competitors.

Earlier in February, the S.E.C. announced a settlement with Kraken, a leading crypto exchange, which led to the removal of one of its popular investment products from the U.S. market. The product is one called “staking” in the crypto space and has some similarities with interest earning cash accounts at mainstream retail banks.

The agency also issued a warning to Paxos, a company that issues stablecoins pegged to the U.S. dollar, of potential securities violations. That led to it withdrawing the Binance-branded stablecoin it issued in partnership with the exchange, now the world’s biggest.

Last week, the S.E.C. filed a lawsuit against Terraform Labs, the firm behind the digital coins Luna and TerraUSD, which collapsed last spring and triggered a broader meltdown in cryptocurrency prices. The agency also announced that former NBA star, Paul Pierce, had agreed to pay $1.4 million to settle charges of improperly promoting a cryptocurrency.

And it’s not only the S.E.C that is involved. Last week three of the major U.S. regulators sent a joint letter to banking organisations in the country, warning them to tread cautiously in any dealing with cryptocurrencies and the sector more generally. The Federal Reserve also denied an application made by crypto-sector bank Custodia Bank, to join its payments system.

Binance Holdings, the company behind the Binance Exchange, has also said it is looking at whether to sever ties with intermediary firms it works with in the USA, such as banks and services firms. And that it is reassessing venture-capital investments in the US, according to a source spoken to by Bloomberg, who asked not to be identified discussing details that had not yet been made public. The exchange will consider de-listing tokens from any US-based projects, including Circle’s stablecoin USD Coin, the person said.

After Paxos announced it would stop issuing Binance-branded stablecoin, the Binance Chief Executive Officer Changpeng Zhao, known as CZ, signalled a potential retreat from the market, commenting via Twitter:

“Given the ongoing regulatory uncertainty in certain markets, we will be reviewing other projects in those jurisdictions to ensure our users are insulated from any undue harm.”

Binance is present in the USA via Binance.US, a much smaller exchange to the main international Binance exchange and one the holding calls completely independent. The company has stated firmly it has no plans to consider the future of Binance.US in the country.

What are the most likely short, medium and long term outcomes of the current crypto crackdown by U.S. regulators?

The most obvious result of a continuation of the current wave of regulatory action by American authorities against leading cryptocurrency companies is, as has happened in other regulated sectors like sports betting, the big players simply avoid the USA and its citizens. J. Austin Campbell, adjunct professor of Columbia Business School, comments:

“When you choke off access in the US financial system, you will see two effects — in aggregate there’s less dollars going into the system, but it’s also important to remember the US is not the only place to move money, so you will be empowering offshore providers.”

Unless U.S. authorities are convinced there will never be a place in mainstream financial markets for cryptocurrencies they will want to protect the financial system and consumers without closing the door entirely. There is, however, a perfectly possible scenario in which the U.S. does decide to set itself up in opposition to cryptocurrencies and tries to strangle the sector on its shores.

If that happens the crypto sector will have a considerably harder task to establish itself as any more connected to mainstream financial markets than it currently is. It won’t be impossible for the crypto movement to make global progress without the cooperation of U.S. financial markets, institutions and infrastructure. But it will be very hard indeed.

One of the major issues is that U.S. regulators are approaching cryptocurrencies as they would existing classes of securities and attempting to apply the same rules and standards to, for example, crypto exchanges as would be expected of a traditional commodities exchange.

Quoted by The Economist, Tuongvy Le, formerly an SEC enforcement lawyer and now employed by the crypto arm of investment firm Bain Capital, comments “there really are novel structures in crypto. Unlike Europe and Singapore, which have come up with new rules, America has so far relied on existing approaches.”

The different approaches of other international regulators highlighted by Le is significant. They also highlight that the current crackdown on the crypto sector by U.S. regulators does not necessarily represent a complete closing of the shutters to the sector over the long term.

China has taken a hawkish approach to clamping down on cryptocurrencies, all but banning them on the mainland. As a result, says Henri Arslanian, managing partner at crypto asset management firm Nine Blocks Capital Management, “many large crypto firms had difficulty operating out of Hong Kong in recent years..” despite the fact the city financial centre has its own independent regulators and rules.

However, a new consultation announced in the last couple of days will assess changing rules to allow retail crypto traders to buy and sell digital assets on licensed exchanges. They currently have to use unregulated exchanges.

The Financial Times reports on plans announced by the Hong Kong Securities and Futures Commission, to allow retail customers to trade the industry’s two largest crypto tokens — bitcoin and ether — on licensed exchanges that would be required to ensure clients have “sufficient knowledge of virtual assets” before they are allowed to trade. All digital asset trading platforms operating in Hong Kong or actively marketing to Hong Kong investors would need to be licensed by the SFC.

Arslanian believes the move “sends a powerful message that Hong Kong wants to reclaim its status as a global crypto hub.”

Hong Kong SFC chief executive Julia Leung commented on the role of regulation in the city’s move to re-open for crypt sector business with:

“In light of recent turmoil and the collapse of some leading crypto trading platforms around the world, there is clear consensus among regulators globally for regulation in the virtual asset space to ensure investors are adequately protected and key risks are effectively managed.”

Hong Kong’s approach is another route U.S. authorities could follow with the current “crypto carpet bombing” eventually evolving into negotiations between the crypto industry, regulators and other stakeholders on a regulatory framework that would protect investors and against systemic risk without an outright ban.

However, reaching a workable consensus on a regulated crypto sector in the U.S. will be difficult unless regulators are willing to be more innovative than the current approach of applying existing rules to the new asset class. Much will depend on whether or not compromise can be reached on the debate around if cryptocurrencies should be classed as securities – investment contracts.

A waiting game for the U.S. crypto sector

Amongst all the uncertainty around the future of the crypto sector in the U.S., one thing has become clear. Crypto sector stakeholders from companies and investors to regulators themselves now face a waiting game. The string of lawsuits currently in progress between regulators and crypto companies operating in the U.S., dealing with U.S. citizens or coming into contact with U.S. financial markets and services infrastructure will create precedents.

These precedents will be the starting point for wrangling around a regulatory framework if one is to be arrived at. Ultimately, much will depend on how the sector develops in financial centres like Hong Kong and Singapore, and to some extent Europe, that are proactively seeking a slice of the crypto pie. If the pie looks tasty enough that continuing to miss out causes uproar in the U.S., regulators will start to look for a compromise.

In the meanwhile, it would appear that U.S. authorities will wait for the market to force their hand on cryptos. In the near term, the regulatory climate looks like it will continue to be an unforgiving one for crypto players seeking to do business with retail investors in and from the USA.