Effects of Changing Regulations on Investments

Over the past few years, cryptocurrency has evolved from being obscure and predominantly associated with illegal activities into a mainstream financial instrument as adoption increased. The number of global cryptocurrency owners has risen nearly 350% over the last two years.

 

With increasing recognition from retail and institutional investors, governments are making a substantial effort to create regulatory frameworks for digital assets, thereby bestowing the crypto movement with a sense of legitimacy.

 

President of The United States' issuance of the crypto industry-specific executive order encouraging federal agencies to coordinate and propose a crypto regulation framework, a new bipartisan legislative bill empowering the Commodity Futures Trading Commission with exclusive jurisdiction over the digital commodities spot market, amendmentsfrom various countries to impose restrictions on cryptocurrency-related activities for the financial security of their citizens, are some of the highlights of regulatory strides industry has made in the recent past.

 

The state of venture capital funding in crypto depends on the growth in user adoption of different crypto products and services. Technological developments, the sophistication of consumer-centric use cases, and regulatory changes are a few of the crucial criteria that affect user adoption and, thus, the state of capital injection. 

 

In this section, we will assess the impact of crypto regulations on investments in the digital asset sector with a couple of examples.

The average deal size of a project in Trading/Brokerage has increased since 2021. It could have resulted from the sophistication of existing players in the market and/or evolving regulations in several jurisdictions. The evolution of market players and regulations coinciding with the change  in investment trends is a correlation, not causation.

The user experience of trading applications has improved, exchanges have become more sophisticated, and more consumer-centric products and services have been developed.

 

Regulations in crypto-friendly jurisdictions are evolving. Crypto-friendly countries' lenient approach towards centralized companies has morphed into selective business licensing to crypto service providers, which has also caused a decrease in the number of new exchanges entering the market. Consequently, more investments were poured into existing players, leading to category maturation as the average deal size increased.

 

Although there is a visible change in the perspective of the policymakers, there has been no internationally coordinated, concerted regulation of cryptocurrencies yet, according to the World Economic Forum's Global Future Council on Cryptocurrencies. This causes variations in countries' laws and regulations concerning the crypto industry. As a result, crypto companies like centralized exchanges are fleeing strictly regulated countries and/or setting up offices in crypto-friendly countries.

 

Countries like Singapore, Malta, the British Virgin Islands, Seychelles, etc., are consideredto be crypto-friendly because of their favorable regulatory and tax infrastructures.

On the other hand, China outlawed cryptocurrencies outright in 2021. As a result of the ban and global growth in users since 2020, a high number of crypto companies moved their bases to crypto-friendly countries.

China's crypto ban forced all the exchanges to shut down or shift their headquarters to Seychelles or Southeast Asia as they offered favorable tax treatment and ease of governance to set up foundations.

 

 

The number of venture funding deals specific to crypto-friendly geographies has also increased since 2020.

 

Impacts of friendly crypto regulations are observed most predominantly in the state of crypto in Singapore. Singapore is home to 32 centralized exchanges, 11 more than the industry leader in the United States. According to Ravi Menon, managing director of the Monetary Authority of  Singapore (MAS), the nation aims to become the global capital for crypto businesses. Singapore empowers cryptocurrency usage by offering a favorable legislative framework and tax regime. Nevertheless, the city-state also enacted consumer protection laws to protect its citizens by banning crypto service providers from advertising in public spaces.

 

$3.1 billion of the total $3.7 billion invested in Singapore-based firms corresponds to the last two years. More than 300 companies received business licenses in Singapore during the same time. Considering the two metrics mentioned above, Singapore's growth is only second to the United States.

 

Zipmex, Nansen, Multichain DEX, Sky Mavis, ADDA are some famous companies  eadquartered in Singapore.

 

In the aftermath of the great bull run of 2017, enthusiasts from many countries started exploring the digital assets space. This space also spawned interest in the traders and technophiles of India. As recognition from retail and institutional investors increased, the Reserve Bank of India imposed a ban on cryptocurrency trading in April 2018 that barred banks and other financial institutions from facilitating any service concerning cryptocurrencies. This ban was lifted in March 2020, which led to an exponential growth of the digital asset sector in India.

Since the ban was lifted, investments in the sector skyrocketed by 6350%. Polygon, a Commit chain for Ethereum offering scaling solutions, raised $450 million in a token sale led by Sequoia Capital and Softbank. Following the ruling, the country's top exchanges doubled down on advertising and educating users about the asset class. User sign-ups on crypto exchanges like WazirX jumped by 4937% since March 2020, whereas India's first crypto unicorn, CoinDCX, userbase grew by almost 700% in the same period.

 

Coinswitch Kuber and CoinDCX, both centralized exchanges, together raised ~$550 million to expand their product offerings. A digital cards collectible game, Fancraze, raised $100 million in a series A round.

The start of the bull run of 2020 coincided with the ostracization of the crypto ban in India. Compared to other countries, India has seen higher % growth in the amount raised since 2021 over 2017-2020.

 

As the country's top financial authorities, including the Bank of England and the Treasury, have  stepped up scrutiny over the sector, the United Kingdom saw a drop in investments for the first half of 2022.

The fall in investments in the United Kingdom was more significant than the drop in the United States and Singapore, which confirms that the drop was not necessarily only because of the plummeting crypto market cap.

 

In the aftermath of recent events of the Terra crash, 3AC's downfall, and the liquidity crisis surrounding many of the significant crypto lending providers, many countries have begun considering more stringent statutory compliance and consumer protection laws. Ideally, policymakers would want to balance tightening the rules for crypto service providers and its seamless integration with traditional finance. If countries can collaborate to avoid regulatory arbitrage and promote a universal set of guidelines, the obstacles for the entire digital asset sector will be dealt with in unison throughout the globe.

 

However, over-regulation of the industry and strict laws for stakeholders involved can be a curse. Inflexible harsh rules right from the infancy stage of the industry may hamper user adoption and result in the smothering of the market. The industry will thrive only if there are  users interested in availing of the products and services on offer.

 

For example, United States FinCEN's (Financial Crimes Enforcement Network) proposed amendment to the regulations implementing the Bank Secrecy Act requires companies to provide identity details corresponding to a wallet, but this may not be feasible as a wallet need not necessarily have an individual identity. This could potentially discourage the users from  availing of the crypto services.

 

Regulatory concern surrounding DeFi is the prime issue for all the stakeholders, ipso facto investors, to ponder over. Efforts to protect the citizens from a financial mishap are admirable, but over-regulation of decentralized finance may stifle the growth of an industry-defining use case of a potentially disruptive technology, as cumbersome KYC requirements may discourage anonymous or pseudonymous developers from building dApps. As a result, investments in the DeFi category largely depend on the evolution of regulatory frameworks.

 

The Tornado cash fiasco is a recent example of how regulations affect the state of the DeFi sector. Tornado Cash is a decentralized crypto mixer that can be used to conceal the trail of  transactions for privacy reasons. The Office of Foreign Asset Control (OFAC) barred Unites States' citizens from using the application on account of national security. An anonymous address sent a small number of tokens through Tornado to various celebrities, and those  celebrities' addresses, too, were sanctioned. Tornado Cash developer Roman Semanov's GitHub was suspended. People losing their ability to interact with a decentralized application and a developer's GitHub account being suspended are pressing concerns this incident sheds light upon.

 

Nonexistent or weak regulations over the burgeoning digital asset sector have resulted in illicit activities over the last few years. This is the primary reason the risk-averse population is discouraged from utilizing crypto services. Consequently, waned user interest creates a negative sentiment in the industry. The state of regulations in crypto directly affects user adoption and  cryptocurrency crime, thereby affecting investment trends in the digital asset sector.

 

Even though cryptocurrency crime transaction volume has reached an all-high of $14 billion in 2021, transactions involving illicit activities represented only 0.15% of total cryptocurrency transaction volume. According to the UN, it is estimated that between 2% and 5% of global GDP ($1.6 to $4 trillion) annually is connected with money laundering and illicit activity. We can infer that the crime rate in crypto is still lesser than in the global financial markets.

 

A decreasing % share of the illicit transaction to total transaction volume can be a positive for the industry's health.

 

Some investors are in the crypto game for the long run, banking on its technological advantages in building the new global financial infrastructure. Unquestionably, some investors are in crypto to exploit the infamous 'get rich quick' schemes. Sanctioning regulations may decrease industry scams and further curtail market volatility. Even if regulations cause market stabilizations to some degree, it is unlikely that an optimal level of regulation will repel investors who thrive on volatility, as the digital asset sector arguably would still be a more volatile asset class than most.