A Multi-level Regulatory Approach to Crypto
It was a cold, late Christmas afternoon and already the skies were darkened with a heavy overcast. Perfect time for people to be at home with their families enjoying the Christmas cheers and anticipating the classic holiday dishes -roast gammon and pork chops. Surely a feast to die for. And they did.
The couple, Nicolae and Elena, with their hands tied, were led against a wall. While Nicolae sang a patriotic song, the wife simply said, “‘You motherfuckers!”. A quick burst from the executioners’ Ak-47s deposited 120 bullets into the couple, ending the 21-year reign of the Romanian tyrant.
Nicolae actually sowed the seeds of his own demise in 1966 when he banned abortion, taking a page from Stalinist economic notion to expand one’s economy through sheer population growth.
Birthrate immediately doubled from 1.9 to 3.7 in the. But the Ceaușescu government was unable to provide much of its promised assistance to families and soon Romania became a dystopian horror of overcrowded, filthy orphanages, and untold thousands of abandoned, street babies.
Two decades later, the neglected babies grew up to face a hopeless socioeconomic reality , exacerbated by the austere programs in the waning subsidies of the collapsing Soviet Union. This was in stark contrast to the Ceausescu’s opulent, over-the-top lifestyle. The babies were the force behind the revolution that ended in the Ceausescu execution, an unforeseen byproduct of his abortion policy.
What does this have do to Cryptos?
US Congress lawmakers will vote today on the $1.2T Infrastructure bill which is a thinly veiled alternative to the money printing stimulus from the economic downturn from the pandemic. I actually support infrastructure investment as one of the best monetary measures to jumpstart the US economy.
One thing I learned from the Ceausescu story is irony. Dictator bans abortion, neglected children grow up in a hapless economy. Then rise up and execute dictator. And that is where we are headed in the US when Congress is likely to pass the infrastructure bill which is laden with an imposing tax compliance and reporting responsibility onto the crypto industry.
Chaos theory postulates that long term behavior is difficult or impossible to predict once multiple dimensions of complexities are modeled. Stock forecasting models comes to mind as there are so many factors: economics, finance, fundamentals, and technical indicators. And not to the mention human factor. Ceausescu banned abortion as a means of growing the economy, only to see it backfire and ultimately leading to his own demise. The US is at an important crossroad, and like Romania, the unpredictable unknown, and it often in many systems is the human factor.
The US legislative and executive branch has no chance of getting regulatory correct. They shouldn’t even try. The crypto revolution is way too complex to predict. Instead, US policy needs a more proactive, continuous, and reiterative approach. Otherwise, this is not going to end up well for the US as it is effectively turning the crypto business away and handing it over to other states which will be more than happy to take a chance at being the new financial czar.
I know US Treasury Secretary Janet Yellen when we were both at the Fed in 2014. I had authored a paper as the Fed’s Treasury Architect on the future of cryptos. Madam Secretary Yellen was and was visiting the SF Federal Reserve Bank, which she formerly headed as the Bank President. Madam Fed Chairperson Yellen at the time, incidentally she is the only person to have served both Fed Chair and Treasury Secretary, asked me where I thought cryptos were headed.
Now Madam Secretary is a brilliant and accomplished person. But her follow-up question was a tell-tale sign of her inkling towards cryptos. She asked me if I thought cryptos needed to be “seriously” considered? I will admit that my paper was rather rudimentary since it was 7 years ago and Ethereum was still more than a year away. She simply was not getting it and there are others like her such as Nobel laureate economist, Paul Krugman, who refers to cryptos as a mere Ponzi-scheme.
In my previous article, I talked about how complex regulating crypto is. The US, having essentially weaponized the US dollar as the de facto global reserve currency does not want to jeopardize that position. What is interesting is that the crypto market has already discounted the fact the bill will probably pass as is, and Bitcoin and Ethereum have actually strengthened in the past week.
However, I believe that some regulatory is needed to help onboard even more potential crypto participants which still remains fairly limited.
1. A Simple Crypto Regulatory Approach
Capital and financial markets regulations aim to protect the integrity and efficiency of capital and financial markets, consumers and investors, and financial stability.
2. Current Regulatory Approach
At a very basic level, capital and financial markets regulation generally involves a three-step approach:
a. Analysis of whether an activity is a regulated activity.
b. Assessment of which person provides the regulated activity.
c. License and registration requirements with ongoing compliance.
In the past, the second step has not played a crucial role in the analysis. This has changed, however, with the emergence of DeFi. Today, much of the analysis is concerned with the question of whether there is a person engaging in regulated activities or not.
3. Shortcomings of the Current Regulatory Approach
The current regulatory approach has various shortcomings, both in design and execution. These shortcomings do not only negatively affect projects in the crypto space but also national regulators, investors and consumers, as well as the overall market.
From a design perspective, the current approach provides a one size fits all solution. As a result, entities engaging in regulated activities must comply with the same regulations irrespective of their size. This is meant to level the playing field and to ensure that only entities with sufficient resources provide regulated services.
As regulators do not only deal with registered or licensed entities but also with entities providing regulated services without being authorized to do so, the current approach means that they must deal with a rapidly increasing number of new market participants. While FinTech has already posed a challenge to regulators, it is fully integrated into the existing infrastructure and run by profit-seeking companies. Crypto, on the other hand, does not necessarily have these ties with traditional finance and is typically run by open-source software on the blockchain. As anyone can fork the code and integrate it into their own projects, the number of regulated services provided via smart contracts is likely to grow exponentially. At the same time, the resources of financial regulators are only expected to grow modestly — if at all. Similar findings were made by the Blockchain Governance Initiative Network (BGIN) and presented to the Financial Action Task Force (FATF) in 2021.
According to data from Dune Analytics, the number of newly deployed smart contracts on Ethereum reached 2,702,142 in June 2021 alone. Assuming that most of these contracts can be used to provide regulated services, the supervision of the crypto space would bind a tremendous amount of resources. These resources would then be missing elsewhere, for example, the supervision of regulated entities. If this happens, regulators can no longer fulfill their mission to protect the integrity and efficiency of markets, consumers and investors, and financial stability, and the system becomes dysfunctional.
The increasing scope and increasing decentralization add further complexity to the one size fit all approach. As can be seen from the communication of various regulators, already today, they act increasingly helpless. Without being able to enforce regulations outside their jurisdiction, they follow a name and shame policy and issue warnings. Even in the US, DeFi projects have not been the target of a probe by the Securities and Exchange Commission (SEC) so far.
The regulators’ problems at a glance:
- international scope
- exponential growth of crypto space
- increasing decentralization
3.2 Projects and Companies
Despite the problems outlined in the previous section, teams without sufficient resources may still decide not to proceed with their project because they do not have sufficient resources to comply with the regulations.
Compared with international projects targeting their home market, they are at a disadvantage as enforcement against them is easily possible.
3.3 Investors and Consumers
Investors and consumers are not necessarily the winners of regulation. While they are protected against certain failures, they are also likely to get access to less products and services.
A good example is the Japanese market. As one of the first countries, Japan introduced crypto regulations in 2017. The regulations were updated in 2020 and provide market participants a clear picture of what activities are regulated. Because of the strict regulations and a lack of resources on the regulator’s side, the Japanese market has not seen any innovation over the last few years. Only 24 tokens are currently listed on the 31 registered exchanges. None of them is a DeFi token. Staking services do not exist except for very few projects. Other forms of passive income are not available.
Investors seeking yield or access to certain products and services are therefore forced to go offshore. The strict regulatory environment therefore achieves exactly the opposite of what it aimed to achieve — less protection for Japanese investors.
At the moment, regulations benefit those who can afford to comply with them. These are not necessarily the best, but the best-funded projects. Innovation, however, in particular in the crypto space, does not necessarily happen within these projects. More happens outside.
If the primary concern of all projects in the space would have been regulation, the crypto industry would not be where it is today. This applies even more if one considers that the regulations in all 195 countries vary to a certain degree.
4. New Regulatory Approach
Because of the shortcomings outlined in the previous section, a new regulatory approach is urgently needed. Ideally, the approach should not only overcome the outlined shortcomings but also promote innovation and the free flow of capital.
Stated differently, what we need is a fundamentally new regulatory approach — an opt-in approach.
Under the opt-in approach, crypto projects would not be regulated unless they explicitly opt in. A certification scheme would ensure that consumers and investors can easily identify regulated projects and are sufficiently protected.
While the approach sounds rather disruptive, it is not as radical as one might first think. In fact, the situation is similar to today, where consumers and investors can opt out from the protection granted under their national laws. If a consumer, for example, wants to use an offshore exchange, he might simply open an account with the exchange, well-knowing that he is not protected under the laws of his home country. The opt-in approach on the other side, would require a user actively look for certified projects.
5. Benefits of the New Approach
The opt-in approach has benefits for regulators, consumers and investors, market participants, and the market overall.
Currently, regulators do not have sufficient resources to police the crypto space properly. Overall, this makes approval procedures slow and enforcement actions random.
The opt-in approach would allow regulators to focus on the projects that have decided to opt in. The number of regulated entities would there-fore be much smaller than it is at the moment. Being able to allocate their resources more efficiently would also mean better services and stricter law enforcement, and as such, more products and a higher level of protection across regulated projects.
5.2 Projects and Companies
The opt-in approach would further allow projects to decide freely whether they want to be regulated or whether they want to innovate freely.
In many cases, projects might start in the unregulated space and migrate to the regulated space once they have sufficient traction and resources to comply with the regulations.
The opt-in might also be considered as a good way to signal quality to the market and attract investments from entities that cannot interact with unregulated projects.
5.3 Investors and Consumers
Having both regulated and unregulated products and services at the same time allows investors and consumers to choose freely from a large variety of products and services. For those who prefer to remain in the regulated space, it is possible to identify and verify regulated projects through the certification scheme easily. Investors who want to earn higher yields can easily access unregulated services without necessarily leaving their home jurisdiction. This is important, as it allows them to sue the teams behind those projects more easily. Just because a project is not regulated, this does not mean that investors and consumers are unprotected. In case of negligence or willful misconduct, the teams can still be held liable. Criminal sanctions in cases of fraud and other financial crimes also apply and offer a minimum level of protection. This disciplines the market and ensures a better quality of projects in the mid to long term. Despite being unregulated, the level of protection would, therefore, naturally increase.
To prevent consumers from being exposed to unregulated projects, it should be considered to restrict financial intermediaries from promoting unregulated products and services to consumers.
The market would significantly benefit from the rapid innovation driven by unregulated projects. As indicated further above, much of the innovation would not have happened — or at least not at the same pace — if projects were primarily concerned about regulation from the very beginning.
What is built in the DeFi space today can be used in a different context tomorrow. The unregulated space should be considered an excellent opportunity and driver for further innovation in the financial markets and elsewhere. Central Bank Digital Currencies (CBDCs) or programmable money, as they are sometimes called, may be one of the biggest beneficiaries of free innovation.
The US is only one country although still a significant one. Much of today’s research focuses on AML/CFT regulations only but the other issues, e.g., taxation, currency control, monetary policy, and privacy will make it impossible to craft a single coherent policy while the crypto industry is still in its early stages of transformation. Instead of avoiding and calling cryptos a Ponzi scheme, US regulatory should instill a regulatory framework which promotes innovation.
Other nation states meanwhile can see this as a rare opportunity to play musical chairs and leapfrog to the front of financial dominance, made easier if the US declines to participate. Proper risk weights, liquidity requirements and other measures must be implemented for financial institutions to ensure financial stability in stress scenarios. The requirements may be different for regulated and unregulated projects. More research is needed here. The same applies to market efficiency and integrity considerations.
The approach outlined here should also ensure that projects and funds can move freely between the regulated and unregulated space.
Finally, the opt in approach should not be misunderstood as an approach where existing regulations are applied blindly to regulated projects. In fact, many of the regulations are still unclear and require further updates. Clarity by case law must be avoided at all costs.