High-profile crypto startup blow-ups like FTX or the Celsius Network may be embarrassing for investment firms dabbling in the space—but Gary Gensler’s reaction to the mayhem could be just as damaging to the sector.
Gensler, the Securities and Exchange Commission Chair, has been on a media blitz since last Thursday, getting on CNBC’s Squawk Box or Bloomberg TV to talk about the SEC’s recent enforcement action against Kraken, the crypto exchange and trading company that was last valued at more than $10 billion at the beginning of 2022, per PitchBook. Gensler suggested that “the runway is getting shorter” for crypto companies to register with the SEC, and he even posted a video to his Twitter profile, explaining how staking, which has become an increasingly important part of the crypto ecosystem, works, and where it could harm investors. (Naturally, Gensler used steak, as in the red meat, to explain it.)
What’s complicated is that the SEC’s complaint against Kraken last week took particular issue with a certain revenue stream very common among some of the major crypto startups. It’s called “staking as a service,” and it refers to a practice where crypto companies offer token incentives to users in exchange for locking up their tokens with them. Coinbase, Binance, Crypto.com, and Gemini all offer this to customers in some shape or form. In the case of Kraken, the SEC alleged that the startup’s staking service was an unregistered securities offering. Without admitting to nor denying the SEC’s allegations, Kraken agreed to pay the SEC $30 million and stop offering the staking service in the U.S., though the company is continuing to do so abroad. The settlement sent waves throughout the rest of the industry.
“The labels don’t matter,” Gensler said on Squawk Box on Friday. “This really should put everyone on notice in this marketplace, whether you call it lend, whether you call it earn, whether you call it yield, whether you offer what’s called an annual percentage yield, APY, that doesn’t matter. If somebody’s taking their tokens and transferring it to that platform, [and] the platform controls it, guess what happens if they go bankrupt? You stand in line at the bankruptcy court.”
All this SEC business has ignited a lot of pushback over the last week from some of the industry’s biggest players, including assertions that the SEC was using enforcement to define its regulatory position, rather than proactively making new rules. Coinbase CEO Brian Armstrong said Sunday that his company’s staking offering was not a security offering and that the company would “happily defend this in court if needed.” SEC Commissioner Hester Peirce, who is known to come in swinging when she disagrees with an SEC action, published commentary that the SEC had “again chose to speak through an enforcement action” and argued that “using enforcement actions to tell people what the law is in an emerging industry is not an efficient or fair way of regulating.”
Crypto has been in the hot seat for a really long time—but it feels different this time around. The plethora of crypto bankruptcies, with FTX leading the charge, appears to have ushered in a new sense of urgency to get on with the crypto regulatory agenda. And it’s easy to speculate about what, in the future, the SEC will be eyeballing next.
In mid-December, Sens. Elizabeth Warren (D-Mass.) and Roger Marshall (R-Kans.) introduced the “Digital Asset Anti-Money Laundering Act,” a bipartisan bill that would recategorize some cryptocurrency companies to subject them to anti-money laundering and know-your-customer rules. The New York Department of Financial Services recently ordered blockchain infrastructure platform Paxos Trust to stop minting crypto exchange Binance’s stablecoin. And fears are swirling that the Office of the Comptroller of the Currency is going to clamp down on crypto applications seeking to become federally chartered banks.
Meanwhile, investors are pulling back from the sector. Venture firms invested nearly 48% less into crypto projects in the fourth quarter of 2022 than they did in the third quarter—the third consecutive decline in investments going to crypto startups last year, according to PitchBook. While funding is down across most segments, it’s hard not to notice the narrative shift with crypto, in particular. Venture investors are giddy to talk—and write—about the transformative potential of A.I., even as they’ve gotten much quieter about once-buzzy crypto lingo like Web3 or NFTs.
As you’d expect, some specialized crypto investors are celebrating an exit of crypto-tourist capital, so they can buckle down and focus on serious innovation in a sector they’ve gone all-in on. And, if you read this newsletter every day, you know from recent editions of Term Sheet that crypto startups such as VRRB or Sesame Labs have announced raising millions in funding just in the last few days.
But this new wave of regulatory attention could lead to further regulatory liabilities in an industry that already had a lot on the agenda, such as whether board seats could lead to regulatory penalties or lawsuits, or a lack of meaningful proactive legislation. And, with the value of coins severely deflated from 2021 or 2022 levels, crypto returns don’t seem so plump as to make up for the risk—at least, for now.
While scandals like FTX or Celsius may drive investors to be more rigid on due diligence, or more wary of bad actors, the crypto regulatory roadblocks may be harder to pinpoint, and—by the looks of the last week—may be really hard for venture capitalists to avoid.
Harvey Schwartz’s big day…Harvey Schwartz—the towering 6-foot-4 black belt in karate—officially becomes CEO of Carlyle Group tomorrow. You can find out everything you need to know about one of the most powerful executives in private equity in my colleague Luisa Beltran’s piece here.
Oh, and Happy Valentine's Day to those who celebrate. See you tomorrow,
Jessica Mathews
Twitter: @jessicakmathews
Email: jessica.mathews@fortune.com
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