Analysis-U.S. Crypto-lending Firms Likely To See Greater Regulation After Celsius Troubles

Liquidity troubles at crypto lending platform Celsius Network, which have left its 1.7 million customers unable to redeem their assets, will increase U.S. regulatory pressure on the sector, which was already on the defensive amid other crises this year.

The industry has been battling scrutiny over concerns that digital assets are being used to evade sanctions on Russia and the May collapse of cryptocurrency TerraUSD, which sent the market plunging and raised systemic risk worries.

New Jersey-based Celsius's move this week to freeze withdrawals, citing "extreme" market conditions, has spotlighted other problems with the crypto sector: weak investor safeguards.

Securities regulators in Alabama, Kentucky, New Jersey, Texas and Washington have opened an investigation into the Celsius decision, the director of enforcement for the Texas State Securities Board told Reuters on Thursday.

Crypto executives say recent problems show U.S. regulators have been too slow to provide the clarity necessary to protect everyday Americans, but they expect that to change fast.

"We are now seeing the consequences of regulators failing to provide clarity," said Perianne Boring, founder and CEO of the Chamber of Digital Commerce. "I am hopeful that recent events will accelerate efforts to deliver clearer policies to the industry and certainty to those who invest in digital assets."

Recent turmoil in the cryptocurrency market underscores the "urgent need" for regulatory frameworks that reduce digital asset risks, a U.S. Treasury official said on Thursday.

Crypto lenders gather crypto deposits from retail customers and re-invest them. Sometimes touting double-digit returns, such products have attracted tens of billions of dollars in assets. As its investments soured amid the crypto market slump, however, Celsius was unable to meet redemptions.

Cryptocurrency and blockchain-related stocks fell on Thursday as Bitcoin dropped for the 9th session out of 10.

Unlike traditional financial firms, crypto lenders operate in a regulatory grey area which means their deposits are not insured by the government, a risk Celsius discloses on its website. Like many peers, Celsius has not registered with the Securities and Exchange Commission (SEC), meaning it was subject to few risk management, capital and disclosure rules.

As a result, its customers had little visibility over how it was investing their assets, and it's unclear if they will get them back.

"At bare minimum, depositors/investors need to understand the risks they are taking," said Todd Phillips, director of financial regulation at the Center for American Progress, a Washington think tank.

Celsius CEO Alex Mashinsky tweeted on Wednesday that the company was focused on customer concerns. Celsius did not respond to a request for comment regarding the states' probe.

While bank regulators believe they need Congress to give them oversight of crypto companies, securities regulators had begun cracking down on lending products over the past year or so.

To be sure, Celsius has been on their radar. In September, regulators in Kentucky, New Jersey and Texas hit Celsius with a cease and desist order, arguing its interest bearing products should be registered as a security.

The SEC meanwhile last year blocked a Coinbase Global Inc <coin.o> plan to launch a lending product and sued lending platform BitConnect for fraud.

In February, the SEC and state regulators fined BlockFi $100 million for failing to register its crypto lending product. The SEC said the deal should provide a roadmap for other crypto lenders to register their products, although its unclear how many companies are poised to follow.

Regulators in Kentucky and New Jersey did not respond to request for comment, while the SEC declined to comment. On Tuesday, SEC chair Gary Gensler warned that some crypto product returns my be "too good to be true."

Registering crypto lending products would not eliminate all risks to investors, but would increase transparency around such products and ensure some risk management controls, said experts.

Many companies, though, want to avoid that burden, putting the onus on regulators to bring enforcement actions, which take years to build. Still, lawyers said the SEC would likely increase such efforts.

"Given the SEC's general aggressiveness under Gensler ... the agency is likely combing through the statutes to find claims that can be brought regarding crypto lending," said Howard Fischer, a partner at law firm Moses & Singer.

Some industry executives welcome more regulation, which would see the best companies rise to the top. In February, rating agency Fitch said increased disclosures and requirements would be "credit positive" for the lending sector.

"Investors wants to know that their assets are secure," said Mike Belshe, CEO of BitGo, a digital asset trust company. "We're going to see a shakeout of healthy companies that manage risk well."

(Writing by Michelle Price; Additional reporting by Andrea Shalal in Washington;Editing by Nick Zieminski)