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How Should We Regulate Crypto?
Maybe cryptocurrency is gambling, but "crypto" is not.
Nicholas Weaver, writing in the Yale Law School’s digital whitepaper on "The Death of Cryptocurrency” is blunt about the current state of the art. He says:
The supposedly “decentralized” and “trustless” cryptocurrency systems, both technically and socially, fail to provide meaningful benefits to society—and indeed, necessarily also fail in their foundational claims of decentralization and trustlessness.
Nicholas argues that no new regulation is needed (which I generally agree with, but with one particular case that I will return to later on) because the harms are “directly addressable by existing regulatory frameworks” in which the regulations should be imposed without fear of stifling innovation because there is no innovation to stifle.
He is not the only informed person looking from a legal perspective and arguing that there is no need for new regulation. Writing in the Colombia Law School blog on capital markets, Todd Baker challenges the view that cryptocurrencies are financial assets, saying that this risks luring policymakers into a "potentially catastrophic category error” because their markets are not economically related to the financial system and do not serve the productive purposes of the financial system. He regards cryptocurrency players as finance LARPers* and calls their activities “gambling emulating finance”.
In a similar vein, Fabio Panneta (a member of the board at the European Central Bank) recently said that trading in unbacked digital assets should be treated by regulators like gambling as they “are rarely used for payments and do not fund consumption or investment”. As a form of investment, unbacked cryptos lack any intrinsic value, too. They are speculative assets."
They have a point. In many ways, the cryptocurrency markets have more in common with electronic sports (e-sports) than e-finance. E-sports, by the way, are a growing sector where there are serious players already competing for large prizes in tournaments, leagues and other events that have millions of viewers tuning in to watch them battle it out. There are professional teams and players sponsored by major gaming companies. Just to set a benchmark, October’s “League of Legends” world championship in the USA had five million viewers!)
While e-sports are clearly a legitimate form of competition, I have to say that being rather conservative I have no real interest in them. I much prefer the old-fashioned tabletop pleasures of Dungeons & Dragons or Aliens: Another Glorious Day in the Corps), although perhaps my attitude will change now that I have discovered that there is a Excel World Championship that was streamed live on ESPN3. Yes, you read that right. Excel is an e-sport.
(In competitive Excel, players take part in test-taking showdowns, earning points each time they answer a question correctly. When they have a Powerpoint World Championship — with a handicapping system for management consultants of course — I might well appeal for sponsorship and have a go.)
Is “crypto” best seen as an e-sport then? And should we regulate “crypto” as gambling then? Should be forget about regulating “crypto” at all? No, but we should be smart about what we regulate: crypto assets and digital assets are really very different things.
There is already some crypto regulation, of course. In Europe, we have the MiCA (Markets in Crypto-Assets) regulations, a set of rules proposed by the European Commission to regulate the crypto-asset market. The objectives of the MiCA are to ensure the safety of crypto-assets, protect investors and consumers, promote market integrity, and prevent money laundering and terrorist financing. The regulations themselves are rather focused on stablecoins (because the regulations are to some extent a response to Meta’s Libra efforts) but they do set out some useful requirements around registration, governance and disclosure. They also require crypto-asset service providers to obtain a license from the relevant national competent authority.
Similarly, here in the U.K. the government is preparing to regulate crypto assets under the auspices of the Financial Conduct Authority (FCA), which currently lacks the necessary powers to protect consumers in areas such as mis-selling, false advertising, fraud and mismanagement. Given the proposed new powers it will be able to oversee crypto more broadly. The powers will be part of the forthcoming financial services and markets bill, a wide-ranging piece of legislation that is currently going through parliament. The bill, which underpins the UK’s post-Brexit approach to financial regulation, was amended in late October to include future provisions for cryptocurrency.
Meanwhile in the U.S., Elizabeth Warren says that it is "past time" for crypto to be subjected to the same basic rules as other financial activities and while her current proposal, which was described by noted cryptocurrency lawyer Stephen Pallet as insane, overly broad, unsalvageable, unconstitutional and octupusine (I am no expert on linguistics, but I think “octopine” sounds better, to be honest), will almost certainly go nowhere, she is surely right that something must be done.
But what? JPMorgan’s December 2022 demographic analysis of U.S. crypto-asset holdings found that the median crypto user is more likely to come from a lower income background and is more likely to be young and male. With consumer protection in mind, they suggest that such assets “may therefore merit a differentiated policy approach—compared with the existing architecture for traditional markets (e.g., stocks and bonds)” to effectively protect investors and the economy.
This supports the view that the crypto market is not a financial market as we currently understand and regulate as such. What’s more, as Todd cautions, were the crypto market integrated into traditional finance, the risk of systemic contagion would become "real and perilous” as cryptocurrencies become part of investment portfolios, because unexpected connections and hidden leverage would create the types of systemic vulnerabilities that led to the 2008 financial crisis.
The collapse of 3AC and Terra has already demonstrated just how interconnected key players are. Note that I highlight these examples rather than FTX because the depegging of Terra’s UST token and the collapse a few weeks later of Celsius and Three Arrows Capital (3AC) drove far bigger losses: Investors (or gamblers, depending on your perspective) lost around $20 billion in the case of UST and around $33 billion in the case of Celsius and 3AC, versus a mere nine billon for FTX.
Some observers have gone so far as to call cryptocurrency regulation a “Trojan Horse” because not only is there that risk of contagion (and the collapse of Silicon Valley Bank and the USDC depegging has shown that there is a risk of contagion from both directions), there is a further risk that traditional financial assets will migrate into a new crypto regime precisely in order to avoid existing financial regulation!
(This problem may well be an inescapable doom because of the problem of trying to define crypto assets in such a away as to exclude traditional assets.)
With regulated institutions already beginning to explore digital assets of various kind (under existing regulations), it is not clear at all precisely what cryptocurrency regulations should do and I see this as an argument for rethinking regulation rather than an argument for necessarily extending existing financial services regulation.
Much as the Law Society of England and Wales have proposed that “digital objects” (ie, tokens, essentially) are a new kind of property that does not fit within the existing legal categories, so we can probably determine that digital objects used for financial transactions (I am not a lawyer, but this seems to me to be the category of Digital Settlement Assets, or DSAs, that the FCA talks about) might need their own legislation.
In Europe we managed to respond to the technological changes of the last generation by coming up with the Electronic Money Institution (ELMI) and Payment Institutions (PI) licences — rather than try to shoehorn everything into banking regulation — so I don’t see why we can’t do the same thing again and have some sort of Stablecoin (i.e., token backed by currency) and some sort of Digital Asset (i.e., token back by something else) Licenses as a way to move beyond MiCA.
Towards Radical Transparency
Meanwhile, Howard Adler, a former deputy assistant secretary of the Treasury for the Financial Stability Oversight Council, and Alex Pollock, a former Principal Deputy Director of the Treasury’s Office of Financial Research, advocate a more laissez-faire approach: Why regulate crypto at all?Their view is that we should allow investors to proceed at their own risk under the protections of general commercial law and existing anti-fraud and criminal laws. As they point out, since cryptocurrency originated as a libertarian revolt against the government monopoly on money, this approach is consistent with its founding ideas.
I think that this actually makes a lot of sense. But for such an approach to work, it must be combined with transparency. Such a combination is the most promising path forward for cryptocurrency regulation, which is why I agree with David Solomon, the CEO of Goldman Sachs, who talks about using “smart” “contracts” with trade terms and settlement instructions written directly into the code to reduce risks and build confidence in the financial system. His view is that this new technology is about making the financial system more transparent and I think that is actually the core to a workable regulatory environment. In fact, as I have written before, a market built up from “glass banks” trading with each other, serving their customers, working with regulators in entirely new ways, is an attractive prospect and suggests that a new financial market infrastructure (FMI) may be on the horizon.
The lasting impact of “crypto” will not be to implement existing banking processes using new technology but to create new kinds of markets and therefore new kinds of institutions that answer Marc Benioff’s DAVOS call for radical transparency to restore trust.
Here is an obvious example to support that view. There is a current problem concerning the solvency of cryptocurrency exchanges. Changing Zhao, the CEO of the biggest exchange, Binance, recently tweeted about how they are working with the accountants Mazars on more transparency and then published a "proof of reserves" report (to be honest, I’m not an accountant so I’m not sure what this actually is) showing customer assets and liabilities for a day in November.
Many observers said that such as report was not comprehensive enough to show a full picture of the company’s finances and it was not too long afterwards that Mazars suspended services for cryptocurrency firms who will no longer provide services such as proof of reserves for Binance, KuCoin, Crypto.com and others because such a report is widely misused as some sort of audit report.
Implementing Radical Transparency
How can the sector regain trust then? The obvious answer is to move to radical transparency and use cryptographic mechanisms to demonstrate solvency. What sort of mechanisms? Well, some years ago Eric Hughes, author of the cypherpunk manifesto of the early 1990s, wrote about “encrypted open books” using clever cryptography to perform public operations on private data: In other words, a mechanism to build “glass organisations” where anyone could see inside to calculate that assets exceed liabilities without actually being able to read what any of these assets or liabilities actually were. All that would be needed (yes, digital identity again) would be digital signatures to attest to the data.
(This kind of accounting would be based on the use of homomorphic encryption to store records in a form where they can only be read by authorised parties but can nonetheless be subject to some basic computation while still encoded. In other words you can determine that encrypted 2 + encrypted 2 = encrypted 4 without ever being able to read the “2” or “4” .)
It sounds odd but it is a perfect example of what I've previously labelled counterintuitive cryptography and is yet another reason why I think that Solomon’s view, that using the new technology actually allows us to build a different, better financial system, is the right one.
Crypto has a trust problem so let us use cryptography to solve it and create the kind of radical transparency needed to bring about new financial markets and institutions for a new era.
* LARP is an acronym for Live Action Roleplaying. If you don’t know what this is, then run, don’t walk, to your nearest Blockbuster and pick up the DVD of “Role Models”, one of my favourite films of 2008.