Investing: regulators in China and the US crack down on cryptocurrency (afr.com)

Timing the regulatory cycle can be as important as timing the economic cycle when it comes to investing.

Now it’s the turn of cryptocurrency investors to worry that regulators are about to land the hammer blow on their investment returns.

China has moved to ban the use of private crypto coins for financial transactions and is instead piloting a digital version of the yuan. The Federal Reserve is working on the cost benefit analysis of introducing a digital US dollar, which would effectively remove a lot of the “benefits” of the more than 11,000 crypto coins. Certainly, the relative appeal of stable coins as a digital currency would be instantly challenged.

What is very clear is that the rapid growth in cryptocurrencies is also attracting the full attention of US regulators. Securities and Exchange Commission chair Gary Gensler told a Senate inquiry earlier this month that that the regulator was working overtime to create a set of rules to oversee the volatile cryptocurrency markets.

Federal Reserve chairman Jerome Powell has previously said that cryptocurrencies pose risks to financial stability and that they should attract greater regulation. The US Treasury Department has flagged its concerns that wealthy individuals could use the largely unregulated sector to avoid tax and said it wants big crypto asset transfers reported to authorities.

Understanding the regulation cycle is critical in investing in any industry at any time. Often new markets emerge that are outside the existing regulatory framework. Their innovation is breathtaking and the benefits and applications for end consumers are often obvious and boundless.

Early participants and adopters often enjoy super normal profits as applications explode and funds flow into investment opportunities. But eventually something happens to attract the attention of the sleepy regulator, and their laser-like focus can bring unpredictable and significant damage to investment returns.

So why now and why at all?

Blockchain technology and cryptocurrencies have been important building blocks underpinning the innovative world of decentralised finance (DeFi). DeFi is the broad term used to define a variety of applications and projects in the public blockchain space geared toward disrupting the traditional finance world.

Using smart electronic contracts, anyone with an internet connection will be able to instantaneously transact in lending, borrowing or other financial contracts without the need for intermediaries such as banks or brokers.

The finance industry has always been a fertile ground for disruptive business models and the explosion of possibilities arising from DeFi has the capacity to fundamentally change the finance system.

While the benefits of a frictionless financial system are obvious, much of the current regulatory framework that exists to protect the community relies on the status quo. Obligations such as know your client, anti-money laundering and counter-terrorism financing rules rely on traditional banking intermediaries monitoring and reporting certain types of normal and suspicious transactions.

So it is no surprise that regulators are starting to take notice.

To avoid turning up late to a problem, regulators have been trying to be more proactive via “anticipatory regulation” frameworks.

Working with industry at earlier stages, regulators have been looking to become more inclusive and collaborative, anticipate the future, and have an iterative mindset by taking a test-and-evolve rather than solve-and-leave approach.

The objective has been to become more outcomes-focused and embed a regulatory mindset in early stage opportunities even before global policies and standards have been established.

While this is a noble objective, the reality of precisely calibrating regulation to fit the evolution in new markets is incredibly difficult. What is more likely is that regulators will continue to be called into action when a major crisis has been exposed. Industry self-regulation hardly ever works, even when there are enough good actors trying to do the right thing.

After a crisis, the regulatory pendulum can often swing from non-existent to overly restrictive. Usually, the cost of compliance goes up and industry returns get severely curtailed. Participants are often forced to merge to obtain the benefits of scale to offset the costs of the heightened regulatory burden. As the industry matures, so the returns become normalised.

The sub-prime crises over a decade ago triggered a raft of regulatory changes in the finance industry, and the royal commissions into the banking and aged care sectors are recent examples of sectors that have undergone significant scrutiny and enhanced compliance costs impacting returns.

Investors who play in lightly regulated markets know the risks. Eventually the regulatory framework will tighten and affect the profitability of many in the industry. Given the recent comments from the US regulators, that time for crypto might be right now.