‘A Warning Shot’: Regulators Are Coming for the Massive Crypto Loan Industry

Three states issued regulatory actions against cryptocurrency savings and loans service BlockFi this week, with New Jersey, Alabama, and Texas each alleging that the firm is selling unregistered securities with its service that lets users earn interest on crypto holdings. BlockFi is one of the largest and best-known entities in the emerging multi-billion dollar crypto loan industry.

Even as cryptocurrency enters the mainstream, the industry still feels like the Wild West in some ways. That’s true of wacky, experimental tokens and flagrant scam projects, but also regulation. Decentralized finance (DeFi) and cryptocurrencies are still so new that the legality of certain products and services remains unclear, and regulators are trying to catch up with the rapidly-evolving industry. Crypto regulation is on the rise, particularly in Europe and China of late, and it’s taking root in the United States too.

BlockFi is the latest target. At issue is BlockFi’s premier product offering: the BlockFi Interest Account, which lets users deposit Bitcoin and other cryptocurrencies and earn interest on their holdings. It’s akin to the practice known as “yield farming,” a staple of the emerging DeFi ecosystem, in which investors “lock up” their own money to support some aspect of the entity that’s paying them a dividend.

In BlockFi’s case, it’s much like a traditional bank savings account for Bitcoin, Ethereum, and other crypto coins, except with much higher returns than a typical savings account. Customers’ deposited assets are commingled with those from other users, which BlockFi then uses to offer loans to both retail and institutional clients. Currently, you can earn up to 8.5 percent annual interest depending on the cryptocurrency or dollar-pegged stablecoin in question (Bitcoin is up to 4 percent), with the interest calculated monthly and compounding over time. Users can also borrow against their own coins with BlockFi and take a loan without selling their crypto.

BlockFi was an early mover in the space and is the best known, although it’s no longer alone: Gemini Earn, Celsius Network, and Canada’s Ledn are other popular services offering crypto interest accounts. Amid this explosion, such crypto accounts have become a much-lauded option for investors seeking high returns. On the Modern Finance podcast in May, BlockFi CEO and co-founder Zac Prince said that the firm had more than $20 billion in assets on the platform, and had paid $60 million in interest to customers during the previous month.

“We think that our team and investors, and the regulation, and us being based in the U.S., is a pretty good mitigant against [fraud],” Prince said on the podcast, regarding BlockFi’s approach to risk management. “The U.S. is great at law enforcement.”

It’s key to note that although BlockFi is sometimes lumped in with the DeFi movement, it’s actually a centralized firm that handles decentralized, blockchain-based assets rather than a decentralized finance project itself. That’s because it doesn’t rely on automated smart contracts to handle transactions and manage assets. DeFi services offer other ways to generate yield on crypto holdings, such as earning rewards by staking tokens in a blockchain network or by providing liquidity at a decentralized exchange (DEX) like Uniswap. Some centralized crypto exchanges, like Coinbase and Binance, also pass along staking rewards to customers.

So, why are regulators focusing on BlockFi? At issue here is the question of whether such interest accounts should be treated as a security, which means they would need to be registered and regulated as such. New Jersey was first to act on Monday, as its Attorney General issued a cease and desist order to BlockFi claiming that it had violated securities law in the state. The order said that BlockFi must stop accepting new customers in New Jersey beginning on July 22, although the firm can continue to service existing customers for now.

Alabama followed suit on Wednesday, with its Securities Commission issuing a show-cause order—effectively demanding the BlockFi justify why the state should not issue a cease and desist order similar to New Jersey’s. Finally, Texas entered the fray on Thursday, with the state’s State Securities Board issuing its own notice of hearing regarding a cease and desist order to BlockFi and its subsidiaries over alleged unregistered securities offerings. Texas regulators alerted BlockFi to its alleged violations in April, and the hearing is scheduled for October.

“We are in active dialogue with multiple regulators to demonstrate that the BlockFi Interest Account (BIA) is not a security and should not be regulated as one,” the firm tweeted yesterday, following the Texas filing. “We firmly believe that the BIA is lawful and appropriate for crypto market participants, and we remain steadfast in our commitment to fight for consumers’ rights to earn interest on their crypto assets.”

The United States Securities and Exchange Commission (SEC) has yet to weigh in on the matter, although that may be coming. Crypto lawyer Preston Byrne, partner at Anderson Kill, tweeted through the legal theory behind the BlockFi situation on Thursday, and wrote, “At this point there's no way the Feds are sitting this one out.”

In an op-ed for CoinDesk, Byrne elaborated on what increased regulatory scrutiny could mean for BlockFi. If the firm is forced to register its BIA accounts as a security product, then it might “limit substantially the availability” to U.S. customers, including potential discontinuation in certain states or across the country. Still, he suggested that this is a “fundamentally a more borderline case” than the situation that faced the SEC after initial coin offerings (ICOs) blew up back in 2017, leading to a wave of regulatory actions.

Even so, the threat of enforcement could have a chilling effect across the cryptocurrency services industry.

“Crypto is a novel asset class and regulators have considerable discretion in deciding where and when to bring enforcement actions,” Byrne told Motherboard. “The notice of pending enforcement against BlockFi will be interpreted by other companies offering similar products as a warning shot. They are likely conferring with their counsel, assessing the risk that their offerings will also be found noncompliant and making decisions about whether to discontinue those offerings.”

Even amidst such pressure, BlockFi shows no sign of slowing its expansion. The firm recently launched a Bitcoin rewards credit card and is reportedly raising a $500 million Series E funding round at a valuation of nearly $5 billion. BlockFi is also reportedly eyeing a public stock offering, per CoinDesk, with plans to roll it out in 12 to 18 months.