The Crypto Winter is Coming

Investors in crypto often believe that cryptocurrency prices cycle from highs to sudden lows only to reverse direction to achieve new highs in a cyclical fashion. Cryptocurrencies have not been in existence long enough to establish such cyclicality mathematically. That said we are now in a major correction. If crypto prices establish equilibrium at the bottom of the cycle and stay there a long time, they will be in a “Crypto Winter.” The impending regulation from US agencies is likely to produce such a winter.

Both the size of the crypto market and the amount of fraud are driving rapid regulation. As the amount of cryptocurrency heads into the trillions, it becomes a systemic threat to monetary controls. In addition, the stunning brazenness of crypto frauds is a direct challenge to legal authorities. The usefulness of cryptocurrency is well-founded, but the fraud is forcing the regulators to rein in the growth of the coins.

Fiat currency depreciates

One of the primary benefits of crypto money is its avoidance of the fiat currency’s devaluation problem. Fiat currency has faced devaluation from the beginning.

Fiat currency is money that is not backed by a physical asset. The Chinese are credited with the invention of paper money. They printed it with wood blocks from around 618 to 690 AD. This worked well enough throughout the centuries, supplanting a shortage of physical coins. Of course, later when it became the official and only currency, the usual disaster for a fiat currency happened—inflation. By the mid-1500s, Chinese paper money had become virtually worthless.

Another example nearer to home happened with the American colonies. The Colony of Massachusetts was in the practice of paying its army from the booty collected in raids on the French colonies in Canada. In 1690, the Colonials from Massachusetts lost, and the troops came home empty-handed. Facing a revolt, the colony printed paper money, the so-called “script.” Of course, even though the Colony promised that there would be only one printing, they printed wantonly. And all the colonies began an inflationary race to print their version of the script. The British finally had to step in to stem the hyperinflation.

Problems with the dollar are driving crypto

Inflation is a chronic problem for the dollar too. The dollar has depreciated steadily over the years. For example, a dollar in 1921 is worth fourteen cents today. And this fall in the dollar has led to a steadily rising demand for cryptocurrency.

The perpetual inflation driving down the dollar encourages crypto miners to make more crypto. It also motivates the Fed to protect the dollar from a competing source of currency.

Monetary authorities like the Federal Reserve and the Treasury have been very aware of the enormous potential for crypto growth. Both the size of the cryptocurrency market and its volatility are a concern for these regulators. There is no intent to ban cryptocurrencies, or to unnecessarily inhibit private sector innovation, but the current collapse in crypto value by around one trillion dollars would concern any central bank.

Fraud is a direct challenge to regulators

The depreciation of the dollar and the growth of crypto create the environment for a surge in securities regulation. The faster crypto grows, the more fraud becomes manifest. The front-page frauds force the hands of the regulators, feeding the growth of regulation.

Despite the appeal of a decentralized currency, the fraud running through the market is a direct affront to the mechanisms of enforcing criminal laws worldwide. CipherTrace’s Cryptocurrency Anti-Money Laundering Report estimates that for 2019 crypto funds losses due to crimes will exceed $4.3 billion. One can only speculate that the losses are a multiple of that now.

In the applications finance sector of cryptocurrency, estimates are that fraud and theft losses were up 600% in 2021 and those one-month losses exceeded $12 billion. Congress has addressed some elements of fraud, and these alone will severely impact the cryptocurrency market.

Money laundering rules will have an enormous impact

Money laundering has been a long-standing complaint about cryptocurrencies, and one which the exchanges themselves have moved to limit illicit funds transfer. The US Government took definitive action with the passage of the Infrastructure Bill in November 2021. This legislation extended the anti-money-laundering rules to include digital assets for transactions more than $10,000 in cash to encompass digital asset transactions, starting Jan. 1, 2023. The Act envisaged a broad interpretation of the law from the Treasury Department.

The SEC is, of course, deeply concerned about the fraud in cryptocurrencies. Chairman Gensler has been actively supporting increased regulation. He, however, is concerned about the scope of his regulatory authority, especially the test for what a security is under current Supreme Court law.

Taking the hype out of crypto

The SEC and other agencies are mindful not to destroy the innovation in the crypto space but the flagrant nature and growing number of frauds, as well as scandals, are forcing their hands. Investors should be aware that the implementation of securities regulations will change the entire climate of the cryptocurrency area.

A common regulatory response when the authorities are not clear on how to act is to hit the pause button. The effect may well be that crypto investing will lose some of its hype (and fun). We should expect that regulations will take out the highs and that we are in a crypto winter pause.

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This article is not intended as investment, tax, or financial advice. Contact a licensed professional for advice concerning any specific situation.