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Cryptocurrencies are on the radar of regulators.

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When cryptocurrency prices skyrocketed last year, hordes of new digital millionaires emerged. We are now seeing real-world consequences. 

Fidelity, an asset manager, revealed that in 2021, its clients donated $10 billion to its charitable arm, including $331 million in crypto assets, mostly bitcoins. This represents a 12x increase over 2020. 

Some of these gifts may have been made out of pure generosity (or guilt). However, anticipatory “tax optimization” strategies are also likely to have triggered it, as investors await “clarification from the Inland Revenue Services on what crypto taxation will look like in the future,” according to asset manager experts. 

In any case, the pattern indicates that the once anarchic and anti-establishment world of crypto is increasingly mingling with the more sober realms of tax planning and mainstream financial entities.

Is this a positive development? Many Fidelity investors (and the charities they support) would say “yes.” However, regulators are becoming increasingly concerned as the G20 leaders meet this week. 

The report, released ahead of the G20 by a global committee of regulators and central bankers, notes that the crypto world has so far posed no systemic financial risk. Because, even if its market capitalization more than triples to 2.6 billion dollars in 2021, it “remains[s] a small part of the total assets of the global financial system.” Furthermore, the “episodes of price volatility” have “so far been contained in crypto-asset markets and have not spread to financial markets or infrastructure.”

The FSB report, on the other hand, indicates that regulators are concerned that this benign image is beginning to deteriorate. A warning that crypto-asset markets are rapidly changing and could pose a threat to global financial stability. 

Until recently, most FSB and central bank regulators appeared to regard crypto assets as analogous to poker chips in a digital casino — that is, tokens that occasionally unleash wild dramas at the betting table but have little impact on the “real” world. 

The FSB’s concerns can be summed up in four words: legality, leverage, liquidity, and leakage. 

The first of these is relatively simple to explain: cryptography’s pseudonymous and borderless nature has made it a breeding ground for money laundering and other nefarious practises. 

However, the FSB believes that the risks of contagion or leaks are increasing. One reason for this is that the issuance of so-called stablecoins – crypto tokens backed by real assets such as dollars – has risen from $5.7 billion at the end of 2019 to $155.6 billion in January. 

Another reason is that traditional investors and institutions are beginning to incorporate cryptocurrency into broader portfolio strategies. This means that any future cryptocurrency price drops could spread to other asset classes if investors need to liquidate their portfolios. 

The other two “Ls,” leverage and liquidity asymmetries, could amplify these jerks.

According to the FSB, the latter pose a problem because cyber entities issuing stablecoins may not have enough cash to redeem investor claims. This raises the possibility of leaks, such as those seen in the banking industry (and observed with credit vehicles during the 2008 financial crisis). 

Meanwhile, anecdotal evidence suggests that debt is increasingly being used to accelerate crypto betting, raising concerns about the leverage issue. To give you just one example: FTX Trading, a cryptocurrency firm, recently listed bitcoin products with 20x leverage on the Austrian exchange.

And while anecdotal evidence also suggests that leverage has declined recently, in line with the price of bitcoin, that ‘L’ word tends to trigger a Pavlovian reaction from regulators today, given the role that the effect hidden leverage played into the 2008 crash.

The crypto enthusiasts say that worrying about crypto seems a bit ironic, given all the other leverage issues that the FSB has downplayed at times. A crash in Treasury prices would be more destabilizing than one in bitcoin. 

While implementing these proposed reforms may take time (and global implementation will inevitably be uneven), these would-be crypto-millionaires must prepare for a new world. In other words, in 2022 we will hear a lot more about crypto tax planning; not all “charities” are purely charitable.

However, whether or not you agree with the FSB’s concerns, the key point for investors to understand is this: regulatory scrutiny is increasing – fast. Indeed, the G20 is likely to agree to FSB calls for new data reporting requirements and other prudential controls.

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