Crypto crash not expected to dampen investor interest

While the crash of cryptocurrency exchange FTX caused widespread alarm, institutional interest in crypto will remain strong in the long term, and the path to regulation will continue, industry players said.

"There's no doubt that what's gone on the last month has been a reputational killer for the industry," said Jeffrey Howard, North America head of business development and institutional sales at OSL, a Hong Kong-based digital assets trading platform.

While recent events will likely delay new buyers, for institutional investors already invested in crypto, "they're continuing to make new investments into their systems and into the market," said Mr. Howard, who is based in Miami.

According to Dario de Martino, New York-based partner at Allen & Overy LLP and co-head of its blockchain and fintech practice, the bankruptcies of companies such as FTX and BlockFi were "foreseeable" due to "a massive amount of leverage in the crypto markets that sort of built up over the years, and especially during the bull markets." He added that he doesn't think recent events will affect "the long-term sort of outlook on blockchain and cryptocurrencies."

But what is causing "mayhem" for the industry is a lack of regulatory clarity, Mr. de Martino said.

As the crypto world grapples with recent events, those on Capitol Hill still haven't reached a consensus on how to regulate the industry. Congress has heightened its interest in the matter, with the House Financial Services Committee, Senate Agriculture Committee and Senate Banking Committee all holding hearings on the collapse of FTX in December.

"My fear is that we'll view Sam Bankman-Fried as just one big snake in a crypto garden of Eden. The fact is crypto is a garden of snakes," said Rep. Brad Sherman, D-Calif., chairman of the Subcommittee on Investor Protection, Entrepreneurship and Capital Markets, at the House Financial Services Committee's hearing on FTX.

Sens. Elizabeth Warren, D-Mass., and Roger Marshall, R-Kan., also introduced a bill in mid-December aimed at combating the risks they said digital assets pose to U.S. national security. This includes extending the Bank Secrecy Act to the crypto industry, which would require crypto entities to follow anti-money laundering regulations to which banks and other financial institutions are subject.

"It is time for Congress to make the crypto industry follow the same money laundering rules as everyone else," Ms. Warren said during the Senate Banking Committee's FTX hearing.

According to several players in the crypto industry, the collapse of FTX was the case of a single bad actor, and shouldn't be attributed to the broader blockchain technology.

"It's important to acknowledge that recent events are the result of failed centralized intermediaries of crypto, and not crypto nor the blockchain technology itself," said Craig Salm, New York-based chief legal officer at Grayscale Investments LLC, a digital asset manager with $14.7 billion in assets under management as of Jan. 3, in an email.

Richard Murray, London-based CEO of Hilbert Capital, the asset management division for Hilbert Group, a digital assets-focused company listed on the Nasdaq First North in Sweden, said there's been a "rapid recognition" that the FTX collapse was one bad actor.

While the crisis was a "stress test for many people in the industry," he said it will ultimately "wash out weaker players … and leave those remaining in a much stronger position."

John Delaney, senior director of investments and a portfolio manager at Willis Towers Watson PLC in Philadelphia, noted in an email that "asset owners are generally in the 'asking questions' state of their investment process as it relates to crypto investments."

"There are a lot of headlines around the general topic, as well as some initiatives by the investment management community which have led to questions and discussions, but we have not seen asset owners move toward dedicated implementation of crypto investments," Mr. Delaney added.

Mr. Murray said achieving regulation could lead to mass institutional adoption of crypto.

"Progress of regulation is going to be a multistep, multidimensional process," he said. "But that process has begun, and I think it's accelerated because of events (in 2022)."

Kari Larsen, New York-based partner at Willkie Farr & Gallagher LLP and co-head of its digital works practice, said that 2023 will continue to bring "robust enforcement action," as well as more movement toward legislation.

"I think that what the focus has been is on potential for legislation, and that the administrations and the commissions will continue to work with legislators on moving the various bills that are already introduced and in play forward," Ms. Larsen said.

Many industry leaders said they expect stablecoin regulation to be passed first, though there are a handful of other crypto-focused bills that were introduced last Congress. Now that a new Congress is in session, these bills will need to be reintroduced.

OSL's Mr. Howard said stablecoins became the focus in Congress after the fall of the Terra network, which issued the algorithmic stablecoin terra and the luna token. The crash occurred in May, when the terra stablecoin depegged from its standard value of $1, also depleting the value of luna.

Sen. Pat Toomey, R-Pa., who previously served as ranking member of the Senate Banking Committee, originally introduced a bill in April solely focused on stablecoin regulation. He then introduced a subsequent bill in December, shortly before retiring from Congress, in an effort to inspire future legislation, he said.

"I hope this framework lays the groundwork for my colleagues to pass legislation next year safeguarding customer funds without inhibiting innovation," Mr. Toomey said in a December news release.

Sens. Cynthia Lummis, R-Wyo., and Kirsten Gillibrand, D-N.Y., introduced a bill in June, known as the Lummis-Gillibrand Responsible Financial Innovation Act, which addresses stablecoin regulation as well as SEC and Commodity Futures Trading Commission jurisdiction of crypto assets and the treatment of digital assets for tax purposes.

SEC Chairman Gary Gensler has previously said crypto legislation should focus on regulating stablecoins and giving more authority to the CFTC to regulate digital commodities.

Leaders of the Senate Agriculture Committee introduced the Digital Commodities Consumer Protection Act in August, which would allow the CFTC to regulate the trading of digital assets that act as commodities, such as cryptocurrencies bitcoin and ether.

Mr. de Martino said he supports that bill, and "market participants tend to agree that the CFTC has taken a more nuanced and knowledgeable approach to this space than the SEC."

However, according to Omid Malekan, adjunct professor at Columbia Business School in New York, "there's certainly a turf war going on" between the SEC and CFTC, and it's "actually getting worse, not better," as there's still no clear definition of what constitutes a commodity vs. a security.

"I think that kind of clarity would be extremely helpful because the U.S. is increasingly falling behind," Mr. Malekan said. "What we've seen in the last couple of years is that Europe and Asia are starting to pull ahead with providing more regulatory clarity."

This has led crypto firms to take their business outside of the U.S., he added, which hurts U.S. businesses as well as consumers, "because either there are services that they don't get access to, or if they want access to it, they're forced to rely on these loosely regulated or perhaps even unregulated offshore solutions."

Mr. de Martino added that many market participants have moved their business offshore "not because they wanted to not be in compliance with regulations, but because there was no way to be compliant in the United States."

While U.S. regulators work through their differences, experts say it's time for crypto to learn from its mistakes.

"This is going to be a big moment for the industry to sort of grow up and professionalize itself," Mr. Malekan said.

Niclas Sandstrom, Malta-based CEO of Hilbert Group, said the same, adding that "the due diligence process is going to be much tougher going forward. And rightly so, I think."

Mr. Malekan said that one of the main lessons from the FTX collapse will be that "too much leverage always ends badly."

He added that regulators could set limits on leverage at crypto firms, but the industry could also choose less leverage as a best practice.

Mr. de Martino reflected a similar sentiment, specifying that "bitcoin is not an asset that's supposed to be leveraged, and I think a lot of people missed that."

According to Mr. Malekan, the history of disruptive technologies reveals "there is this tendency, for various reasons, that the first generation of businesses that rise to provide the technology are often not very good, and some of them are downright fraudulent and criminal, like FTX was."

However, Mr. Malekan contended that "what determines the success of the technology is whether it actually solves the core problems," and crypto's appeal, to him and several others, is its ability to solve problems in the modern world. In a follow-up email, Mr. Malekan said that crypto creates digital scarcity, offers universal access to financial services, increases efficiency in the financial system, and provides property rights to more of the population.

"Something like what happened this year will ultimately end up a footnote" in crypto's history, Mr. Malekan said.