Coinbase, crypto or bust: who loses out when crypto fails?

It’s no secret that crypto is prone to market volatility. For some, volatility is the very thing that makes it exciting and keeps them investing. However, the call for stability through regulation is becoming increasingly deafening. We take a look at what’s happened, who could lose out, and what the future holds for crypto regulation.

The week that crypto crumbled

The week starting 9 May 2022 was a bad week for cryptocurrencies and digital assets – described by some as “the week that shook crypto”. Many have come to expect instability in this space, but this week was exceptional.

9 May 2022 – terraUSD (UST) – a stablecoin that should stay at $1 fell below $1. The crypto token that supports UST, Luna, lost almost all of its value in one day. This is particularly significant because, while many cryptos are volatile, terraUSD was designed to be stable and simply track the dollar.
10 May 2022 – Bitcoin fell below $30,000 for the first time since July 2021.
11 May 2022 – Coinbase Chief Executive, Brian Armstrong, said there was “no risk of bankruptcy” after Coinbase lost almost a quarter of its value in one day. Later that day, a regulatory filing was published that suggested that the crypto that Coinbase holds for its users “could be subject to bankruptcy proceedings” meaning that customers could be treated as “general unsecured creditors”. At the end of the week starting 9 May 2022, Coinbase had lost 67% of its value since the beginning of the year.
16 May 2022 – Investors pulled $7tn out of Tether – a stablecoin – in light of terraUSD’s collapse.

Are individuals protected when crypto fails?

This isn’t the first time cryptocurrencies have dipped and there is no doubt it will rise again, like a phoenix from the ashes. It’s worth noting that while some coins and exchanges looked close to the edge this week, assets such as Ethereum and Bitcoin have shown signs of picking back up.

As above, for some it is exactly this volatility that makes crypto an exciting investment option. For others, especially the more risk-averse, concerns are being raised about what might happen in the event that crypto firms go bankrupt, or if they become the subject of criminal or fraudulent activity. Not all who invest in crypto are looking for high-risk returns, but when even stablecoins start to look fractious, many will start to worry.

US protections

In the US, the federal government provides insurance for cash and conventional securities, but it does not cover cryptocurrencies. There is an independent body – the Federal Deposit Insurance Corporation (FDIC) – that will insure individuals’ deposits of up to $250,000 per bank, however cryptocurrencies are not included here. That is not to say, however, that the FDIC if not exploring insurance options for crypto and has more recently partnered with the Federal Reserve and the Office of the Comptroller of the Currency to investigate crypto engagement and regulation.

While cryptocurrencies are not insured by the FDIC, cash up to $250,000 that is held in some crypto exchange accounts will be insured – though it is unclear how much cash would be returned in the event of a firm going under or suffering a cyber-attack or other criminal activity. The FDIC recently issues a letter to financial institutions in which it expressed “concern” over the “significant safety and soundness risks” posed by crypto and crypto-related activities. In short, cryptocurrencies are not protected in the US.

UK protections

In the UK, cryptoassets are largely unregulated. In fact, the Financial Conduct Authority has gone to great lengths to warn customers that they may not get their money back in the event that things go wrong. As recently as April 2022, FCA CEO Nikhil Rathi warned “if you invest in crypto, you need to be prepared to lose all your money”. The FCA has put its money where its mouth is with these warnings, launching an £11 million marketing campaign in 2021 to warn consumers of the risks of investments without education.

While most investments and deposits in the UK would be covered by the Financial Services Compensation Scheme (FSCS), cryptoasssets are not. This means that if a person trades in cryptocurrencies – and the business then fails – the individual will most likely be unprotected. The FSCS notes on a page entitled “Five things to consider about cryptoassets” that crypto is also unregulated, meaning that “if your investment is stolen, there isn’t an easy way to get it back and FSCS can’t protect you”. In short, there is little redress for UK consumers where crypto fails.

Individual legal action

Another route for redress – though one that is not without risks itself – is individual legal action. In the last few weeks, for example, we have seen consumers take legal action against Coinbase for promoting the GYEN token as a “stablecoin” (a coin designed to only be as volatile as conventional currencies) when in reality consumers allege it was “anything but”.

In a class action that was filed in the middle of May 2022, a number of investors have attempted to sue Coinbase on the premise that they were given misleading information about the stability of the token, leading to losses amounting to millions. This legal action was instigated when the value of GYEN – a coin which is touted as being equal to Japan’s yen – fell by 80% in one day.

It will be interesting to see the outcome of this case, which may set a precedent for other consumers who have lost money on crypto. Given the unregulated nature of crypto, however, the burden of proof will likely be high for the investors.

So where is cryptocurrency protected?

The Chinese government have banned cryptocurrencies altogether. However, some countries have taken entirely the opposite approach and have legalised crypto in most instances, as well as legalising and regulating crypto exchanges. in most instances, whether or not a cryptoasset is regulated depends on how the country chooses to classify them.

In Switzerland, for example, cryptocurrencies are classified as assets. Broadly speaking, crypto is treated as legal and are therefore subject to tax implications etc. This offers consumer protections far higher security in the event that something goes wrong. Switzerland is often cited as being extremely progressive in this respect – with very few countries able to boast the same protections.

Regulation is needed, fast

It’s no secret that investing in crypto is risky business. While it no longer remains a fringe currency, the lack of regulation paired with market volatility and high-value investments makes it the perfect melting pot for risk and loss.

It could be argued that individuals know the risks they take when investing in high-risk vehicles such as crypto, so they should bear the brunt of any losses. However this argument falls short on a number of levels.

Firstly, crypto is highly accessible as an investment option. Novices are able to access crypto investments through apps with little to no prior investment knowledge. Unlike other investment products, the risks of crypto are not always made clear and some may go into it naively. In the last weeks, individuals who are not highly-skilled investors will have lost large sums of money without warning.

Secondly, cryptocurrencies and digital assets pose a wider risk if left unregulated – a risk to the stability of global financial markets. While we may not be there yet, the pace of change and take-up for crypto means this scenario is not out of reach.

Indeed, according to Deutsche Bank’s Marion Laboure, the two essential regulatory triggers have been activated:

Crypto now has enough retail access to warrant regulation (17% of consumers in US are using it).
It is big enough to cause financial stability issues.

As such, crypto is now reaching a turning point in which the risks are becoming insurmountable – regulation isn’t just wanted by the industry but is needed in order to remain innovative and profitable.

Using existing regulations for emerging crypto

There have been efforts to expand current regulatory parameters to manage crypto. Thus far, these efforts have been broadly unsuccessful and serve to create a hugely complex, fragmented regulatory framework which is difficult to understand and even harder to implement from the perspective of compliance. Many have been critical of this approach as shoe-horning crypto into a mould that is not fit for purpose.

What does the regulatory future hold?

We recently heard that the US Securities and Exchange Commission (SEC) has moved to double the size of its crypto unit. This is likely spurred on by the signing of an executive order by President Biden, which asked government and industry bodies to look at creating a sustainable regulatory framework for crypto.

In the UK, the FCA has placed crypto firmly on its regulatory agenda, with plans to “appropriately evolve” for innovation alongside crypto registration rules.

The EU stands out as the first international organisation to propose a specific regulatory framework in the form of the Markets in Crypto-Assets Act – also known as MiCA – which aims to define the regulatory treatment of crypto-assets that are not covered by existing legislation. However, owing to the complexity of digital assets, there is no multinational agreement on what cryptos are let alone how they should be regulated. This leaves MiCA in a difficult situation – one which lacks mutual global recognition and could stand to make crypto regulation more complex.

So, despite clear signals from the regulators, we are yet to see any regulations coming into effect– and given the complexity of cryptocurrency this is of little surprise. The breadth of coins alone – the variations in their functions – is a mammoth undertaking. Then consider the decentralised, un-owned, untraceable nature of much of cryptocurrency and you can (somewhat) forgive regulators for not knowing where to start.

I recently overheard an academic – focussed mainly on digital finance and crypto – say “if anyone professes to be an expert in crypto, they’re lying…there are no experts”. This may be a generalisation – no doubt there are experts out there – but whether financial regulators are able to hire them and harness their expertise to create a regulatory framework is quite different. No doubt they are in high demand.

So yes, regulation will come – all the triggers have been pulled and the regulators are making the right noises. In the meantime, firms should be getting ready for whatever may come, and putting tools in place to scan the regulatory horizon.

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