Industry boosters say they’ve learned their lessons from the last crash, but regulators need to move faster to protect a new wave of mainstream investors from the same old story.

After more than a year, the freeze of a deep crypto winter has thawed. Bitcoin prices have surged to new heights, venture capital firms are raising funds to invest in cryptocurrency startups, and gloating crypto bros are back to mocking skeptics with the words “have fun staying poor.” Once again, the people pouring millions of dollars into memecoins that depict dogs in knit hats or drooling cartoon sloths are being described as the smart money. When the developer of the sloth coin, Slerf, accidentally destroyed $10 million of the funds he’d raised from early buyers, the attention only fueled a massive spike in trading volume—$2.7 billion worth in 24 hours.

This speculative mania is familiar to veterans of the last crypto boom, from 2021 to 2022. Instead of “the metaverse,” everyone now just says “AI.” What’s new is a veneer of normalcy, a reputational makeover. While the average crypto fan of the last boom talked in terms of Lamborghinis and get-rich-quick schemes, the industry’s new spokespeople are CEOs in suits who focus on regulatory compliance, politicians whose favorite word is “innovation,” and traditional financial institutions pitching cryptocurrencies as a sound way to diversify your portfolio. The problem for the rest of us is that the crypto markets remain fraught with manipulation and scams.

Throughout the years I’ve been watching the cryptocurrency sector, the grifts have been the constant. Even when prices crashed, there remained plenty of opportunities for crooks to exploit. Now, with new money being drawn in by rising prices and new financial instruments, it’s important to look closely at the state of crypto.

In January, the US Securities and Exchange Commission begrudgingly approved spot Bitcoin exchange-traded products, a financial instrument targeted to mainstream investors and investment funds more comfortable with brokerage accounts than crypto trading apps. (The ETPs function like exchange-traded funds, so the finance world just calls them Bitcoin ETFs.) Crypto advocates saw this as a watershed moment, a more traditional investment vehicle that could draw billions of dollars into Bitcoin from more respectable sources who had previously been worried about it being lost, stolen or outlawed. As he announced the ETF approval, Gary Gensler, the SEC chair and longtime crypto detractor, reiterated that “Bitcoin is primarily a speculative, volatile asset that’s also used for illicit activity including ransomware, money laundering, sanction evasion and terrorist financing.” Still, these ETFs are now being offered by staid firms including BlackRock and Fidelity, which emphasize their due diligence in their prospectuses even as they stress Bitcoin’s volatility.

Gensler is far from the only one with reservations. During the last hype cycle, the Department of Labor expressed “serious concerns” about the inclusion of crypto in employer-sponsored retirement plans and warned fiduciaries to take “extreme care.”

They were right to worry. Market manipulation is rampant on the hundreds of exchanges where crypto trades hands. Many in the sector seem to have accepted wash trading—self-dealing that makes the market look busier than it is—as a built-in. The same professor who reported heavy market manipulation driving the 2017 crypto boom has noted similar suspicious patterns more recently, suggesting that a relatively small number of large holders continue to artificially prop up prices. The SEC, Department of Justice and Commodity Futures Trading Commission are weighed down with more evidence of these crimes than they seem to know what to do with. Slow to act on an industry that shifts quickly, these agencies often stepped in only after businesses collapsed.

Despite all this, the industry has continued to push the narrative that crypto has outgrown its wild teenage years, with the ETFs representing a sort of coming-of-age moment. “This approval establishes crypto as a legitimate new asset class and underscores that it’s here to stay,” tweeted Emin Gün Sirer, chief executive officer of blockchain company Ava Labs. Boosters are loudly promoting ETFs as well as the underlying assets to lay investors and institutional funds alike. All the more reason, then, for greater reforms and more stringent enforcement.

The saving grace of the 2023 crypto winter was that average folks who opted to stay away suffered little or no fallout. It was nothing like the global financial collapse of 2008, which had ramifications far beyond the market for mortgage-backed securities. During the crypto downturn, as some speculators saw their life savings collapse along with token prices, the rest of the world went on relatively unscathed. If traditional finance becomes more entangled with crypto, the rest of us won’t be so lucky next time.

Perhaps more than any other part of the tech industry, crypto relies on storytelling. This is because the underlying technology, as it exists today, doesn’t have much to offer the average person in their day-to-day life. Instead, entrepreneurs conjure visions of what the tech might look like tomorrow, usually blockchain products powered by artificial intelligence or AI products powered by the blockchain. They pitch AI bots meant to automate crypto trading strategies, or the software to make those bots.

The moral of the story is subject to change. After the 2008 financial crisis, early Bitcoin advocates pitched the currency as a true alternative to the traditional banking system, one with greater stability for everyday savings and more privacy for all kinds of transactions. When the opposite turned out to be true—Bitcoin is far more volatile than the US dollar and all too easy to track—advocates flipped their scripts to focus on Bitcoin as a winning lottery ticket and to sell sophisticated blockchain analysis tools to law enforcement.

The dominant narrative during the last crypto boom was “web3,” a buzzword that skyrocketed in popularity during 2021. Building on distrust for Big Tech, crypto companies and their backers promoted the idea that blockchains’ decentralization could redemocratize the internet and reverse its profit-minded decay. Unfortunately, their solution was to turn every online interaction into a transaction. Anyone who used the internet to post to social networks or play online games or do their jobs would soon be doing so “on the blockchain.” Certain identical copies of digital files were more valuable than the rest. If you weren’t paying attention to this stuff at the time, suffice it to say it was even sillier than it sounds. As crypto has resurged, web3 has not.

Crypto advocates now point to the fallout from this period, along with the rise of Bitcoin ETFs, as evidence that the industry has grown up. FTX founder Sam Bankman-Fried, who controlled the second-largest cryptocurrency exchange until it imploded in late 2022, is beginning his first of 25 years in federal prison. Do Kwon, the man behind the massive, now-collapsed Terra/Luna stablecoin, was just found liable for fraud. Avi Eisenberg, a trader who boasted of his “highly profitable trading strategy” that siphoned more than $100 million from a cryptocurrency exchange, was just convicted of criminal market manipulation. This, the boosters say, means it’s time to pile into crypto—now that the biggest sharks are gone and before everyone else shows up.

To the SEC’s credit, it began cracking down on the industry after SBF became a household name. This has drawn it, however, into conflict with some of the same companies that claim to desire stronger oversight. In 2022, crypto exchange Coinbase Global Inc. petitioned the agency for a bespoke set of rules to govern the sector. Last year the SEC sued Coinbase for alleged violations of existing securities laws, including promotion of unregulated securities. Coinbase has vehemently denied the allegations and called the SEC suit “unfair.”

Although there’s a deterrent effect to legal actions against high-profile figures and firms, investors would be much better served by strong regulatory oversight that takes place before all their money is gone. Most crypto firms still don’t undergo anything resembling financial audits. Some say they have obviated the need for a traditional audit by producing a public report called a proof of reserves, a system of self-reporting. This, however, is a far lower standard than securities regulators accept. The disclosures and protections afforded to buyers of publicly listed stocks are nowhere to be seen for cryptocurrencies, and the same companies that say they want strong rules also say this standard would destroy their businesses. They may be right, but if an industry can’t coexist with basic consumer protection laws, that’s a condemnation of the industry, not the laws.

Outside of the appeals to authority, the industry is hard at work coming up with new problems their technology might solve. If all you have is a blockchain, everything looks like a use case. This time, it’s AI. Some are adapting old crypto projects to catch up with the trend. Every trading bot that promises to predict coin price movements or give speculators an inside scoop on the next big token is “AI-powered.” Blockchain security companies boast that they’re using AI to audit smart contracts or detect attacks. Crypto markets have emerged for people to buy and sell AI models, training data and computing power. Trading platforms offer chatbots that they claim can analyze market signals to help customers place the best bets.

But blockchain systems are inherently slow and inefficient, a bad match for resource-hungry AI models. More important, if you’ve tried ChatGPT, you know that AI models are prone to getting things wrong or just making them up. That isn’t a risk factor most people want to combine with their finances.

Nevertheless, a great many startups promise to use blockchains alongside their AI models for one reason or another. Much as web3 boosters saw an opportunity in the techlash, those in the blockchain-AI space have taken note that the secrecy built into the AI models of OpenAI and Google can freak people out. Although the hows aren’t exactly convincing, it’s an attractive idea that the decentralized computing of the blockchain might magically decentralize AI and return some power to the people.

Other startups say their blockchain applications will address the problems of AI bias or factual accuracy, or figure out how to compensate people whose data has been used to train AI models. Some even say their blockchain tools will, given enough funding, protect the world from some theoretical humanity-threatening AI superintelligence, by making AI development more inherently reviewable and therefore safe.

The problem with all of these sales pitches is that decentralized computing isn’t the same as decentralized control. Even if people willingly outsource their computing power to larger AI ambitions, there’s little to suggest the collective will get a say in how these models are designed or used. And it just so happens that some of the people creating the scary AI models are the same people selling the blockchain solutions.

OpenAI Inc. CEO Sam Altman also founded Tools for Humanity Corp., a benevolent-sounding company that manufactures a malevolent-looking chrome sphere about the size of a basketball. The sphere scans people’s eyeballs to issue them an account on the World App and some crypto tokens, called Worldcoins. Altman says these tokens will amount to a universal basic income to offset the job losses from the AI models he and OpenAI are developing. The token’s price, however, has fluctuated wildly over the past year, within a range of roughly $1 to $11, and most users receive about 75 of them a year, not much of an income. The enterprise has served mostly to draw the ire of data privacy agencies in multiple countries. The nonprofit Worldcoin Foundation has said it’s moving deliberately to ensure regulatory compliance.

The world of AI-blockchain hybrids remains light on products. Speculators can buy related tokens, but few of the underlying projects have developed much beyond glitzy websites and low-effort clones of existing AI models. That hasn’t stopped them from luring cash from retail investors and ostensibly savvy VC funds, just as some of web3’s worst offenders did.

As history repeats itself and the specter looms of a new crypto mania that could even overshadow the last, it’s far past time to consider new solutions to the familiar downside. Blockchains have been around for 15 years. The industry’s scammers must no longer be allowed to bleed dry the everyday people who are drawn in, year after year, by promises of revolutionary technology that’s always just around the corner.

Crypto firms and their lobbyists love to threaten that a crackdown on the industry would stifle innovation. But what innovation has the sector produced, besides new avenues for ransomware payments and new types of pump-and-dump schemes? People get scammed so often by crypto founders running off with the money raised for some project or other that there’s now a term for it: the rug pull. Perhaps it’s time we realize that not all innovation is inherently good and that preventative measures are needed before more people are swindled.

Even some crypto skeptics, however, are worried about the potential consequences of oversight. Any attempts at regulation, they argue, will probably leave open loopholes for exploitation while assuring more investors that crypto has gone legit. It’s true, as the past year has shown, that the industry will use any new rules as evidence that all of its problems are solved. But regulators spent more than a decade mostly ignoring crypto in the apparent hope that it would go away, and the results are in: That didn’t work.

Now that key financial firms have bought into crypto, it’s all the more essential that thoughtful, carefully crafted regulation be put in place. To protect investors, yes, but also to install a firewall limiting the contagion any future crypto disasters can transmit to the rest of the financial world. Careful limits on what assets can be sold, who they can be sold to and what disclosures are needed to go with them could help limit the damage to those who choose to engage with the sector, and help them make more informed decisions.

Stronger attention to the promises being made by crypto companies and those hired to promote them could make a huge difference in avoiding the types of disasters that came to define the sector in 2022, after swaths of customers were drawn in by crypto firms comparing themselves to banks. Many of those companies promised a new level of transparency and inclusivity to groups often ignored by traditional finance, and one consequence was that some of the pain in the crash that followed spread to people with few ways to absorb it.

Those within the industry have a role to play, too. Self-regulation will never be the sole solution, but crypto’s reputation as a fraud factory might be improved somewhat if leaders started holding one another to account. They should push those arguing against strong consumer protections to find another line of work, or at least pursue a business model that doesn’t require fleecing the customer. They will also need to support models of government regulation that require rigorous outside scrutiny, and even burdensome changes to their business models, rather than continuing to seek carve-outs that would essentially lock in the chaotic status quo.

For now, although crypto is hot once again and the number is back to going up, another crash seems inevitable, part of a vicious cycle that no one has had the strength to break. Although promises of mainstream safety and security unite the latest crypto boosters in a way that web3 did not, the current crop of ETF hawkers and AI startups weren’t the first to the idea. Before its collapse ruined many of its customers, “safe and easy” was a tagline of FTX, too.

Written by: @Bloomberg

The post “The State of Crypto Is Anything But Strong” first appeared on Bloomberg

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