Why BlockFi's $100 Million Settlement Is A Watershed Moment For Crypto Industry

To investors,

BlockFi, a leading crypto lending company, announced yesterday that they have reached a resolution with the SEC pertaining to the regulatory scrutiny that they have faced over the last 8 months. As many of you know, I am a large investor in the business, but today’s letter is only my personal opinion. I do not speak for the company and nothing below should be attributed to BlockFi or their team.

BlockFi’s suite of products includes lending against crypto collateral, interest-bearing accounts, crypto exchange, and a credit card that pays rewards in bitcoin. The company was a pioneer in developing, launching, and scaling a number of these products, but most notably was the interest-bearing accounts and the bitcoin credit card.

Their interest-bearing accounts, known as the BlockFi Interest Account (BIA), came under regulatory scrutiny during the summer of 2021. The product is very similar to your checking or savings account at a bank — you deposit funds, the company lends them out to generate yield, and the company shares some portion of the yield with you before keeping the remainder for themselves. The big difference is that the banks pay an average of less than 0.05% nationally, while BlockFi has been paying up to 9% APY with their interest-bearing product.

The delta between the legacy world and the crypto world seems steep, right? It is. But there is a simple explanation for how BlockFi and other lenders can pay such high interest rates — there is an imbalance in supply and demand for deposit funds in the market. Quite literally, there are tens of billions of dollars worth of borrowing demand, but total deposits (supply) haven’t been able to keep up at a similar pace. This imbalance leads to borrowers paying a high interest rate to lenders.

Another contributing factor is that companies like BlockFi pass through a large portion of the yield they generate to their customers. For example, your bank makes more than 0.03-0.05% on your deposits but shares only a small percentage of that yield with you. BlockFi, and other crypto lending companies, have made a habit of sharing majority of the yield they generate with their customers. So if you combine the imbalance in supply and demand with a large portion of interest yield being passed on to the customer, you can see why BlockFi can offer up to 9% APY.

This comparison to the legacy banks is important for another reason as well though — the banks are able to offer interest-bearing accounts to their customers without having to register them as securities, nor do the banks have to abide by securities law for that specific product. The general thought process in the crypto industry was that if a company offered interest-bearing accounts with bitcoin and crypto, rather than US dollars, the company would be required to follow the same legal and regulatory frameworks as the banks.

As you already guessed, the regulators have a different perspective. The SEC and state regulators took a position that BlockFi is offering a debt security, which would require them to register the interest-bearing product and operate under securities law. I won’t bore you with the negotiation details, but it is safe to say that the regulators and the BlockFi team spent a lot of time discussing various options on how to proceed.

The company announced yesterday that they have reached a resolution with the SEC and state regulators. This agreement entails the following:

BlockFi will register the BlockFi Interest Account product as a security offering

BlockFi will pay a $100 million settlement

BlockFi will be able to offer the BlockFi Interest Account to all Americans once the SEC approves the S-1 submission

There are a few aspects of this resolution that I want to cover today. First, various market participants in crypto have been asking for regulatory clarity for years. This agreement between BlockFi and regulators creates crystal clear regulatory clarity related to interest-bearing crypto accounts. Some people won’t like the outcome, but that is one of the risks that come with seeking regulatory clarity. Now that the rules around this type of product are clear, every company in the industry will be able to offer this functionality to their users with the confidence that they are playing within the regulatory guidelines.

Second, BlockFi’s resolution is highlighting an interesting development in the crypto market. They are being asked by US regulators to treat their customers in the United States differently than their international customers. BlockFi is able to offer a wider range of assets and products to those outside the United States than those within our domestic borders. While this may not seem like a huge deal, my personal opinion is that this trend will create a competitive disadvantage for US-based companies in the crypto industry.

Third, the critics of the crypto industry have long claimed that it was opaque, filled with criminal activity, and a systemic risk if there was too much adoption. BlockFi’s resolution will create an adherence to the highest degree of transparency, audibility, and risk management that is available in public markets. Regulators will have direct oversight of the product and company, which negates the critics argument around opaque operations.

Fourth, the $100 million settlement amount is grabbing headlines and for good reason. This is a record amount for a crypto company to pay in a regulatory matter. It is important to understand that the $100 million is split between the SEC and the various state regulators. Additionally, the current SEC administration has said publicly that they believe past financial penalties were too small because they did not deter market participants from continuing their unregulated activities. My view is that the big number that BlockFi is paying here is the manifestation of the SEC’s view that penalties in crypto will only grow in size moving forward.

Fifth, it must be explicitly stated that BlockFi is pioneering a way for American citizens to earn up to 9% APY in a regulatory compliant way. There are a lot of individuals, organizations, or institutional investors that have sat on the sidelines waiting for regulatory clarity. Now these investors will have the opportunity to benefit from high-yield interest-bearing accounts, which has increasing importance in a high inflation environment. The positive impact on portfolios with a product like this can’t be understated.

Sixth, the BlockFi resolution showcases the maturity of the business. In order to succeed in the crypto industry, companies are going to be required to have expertise in technology, finance, and regulation. Most teams have native experience in technology and finance, but BlockFi’s ability to navigate this regulatory environment will likely serve them well as they continue building one of the leading businesses in the industry. Everyone from customers to public market investors are likely to have increased confidence in the companies that can build the regulatory muscle needed to thrive in a fast-paced, ever-changing industry.

Lastly, if regulators are willing to engage with centralized, well-funded companies like BlockFi, then the industry must realize that the “decentralized” offerings will come under pressure as well. Many of these platforms are referred to as “DINOs” by regulators, which stands for Decentralized In Name Only. This belief that the decentralized platforms are actually centralized operations would suggest that regulators have plans to pursue these teams and bring them within their regulatory purview. This is essential to understand because true decentralization is likely to become more and more important over time.

The BlockFi situation is a watershed moment for the crypto industry. It is clear that regulators are not playing around and the market is going to become bifurcated — one group will represent those who want to work with regulators and the other will represent those who want to fight the regulators. Either strategy can be appropriate depending on the situation and details. BlockFi has chosen the path of working with regulators to pioneer regulatory clarity for one of the most exciting parts of the crypto industry.

Clarity reduces risk. Reductions in risk lead to increased market participation. Increased market participation creates maturation of the industry. Slowly, but surely, we continue to push these innovative technologies into the hands of hundreds of millions of people around the world.

Hope each of you has a great day. I’ll talk to you tomorrow.

-Pomp

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