Let Crypto Burn
“Crypto should not be regulated like banking products (that would give crypto access to the government support that we afford to banking because banking is critical to broader economic growth). Banking regulation should, however, continue to keep banks away from crypto.” Professor Hilary Allen, Testimony before Senate Banking Committee, December 14, 2022.
On December 20, one of us (Steve) engaged in a debate with Professor Peter Conti-Brown of the Wharton School on whether crypto should face federal financial regulation. Hosted by the Hutchins Center on Fiscal and Monetary Policy at Brookings, and moderated by Kelly Evans of CNBC, you can watch the one-hour debate here. We found both the questions and the discussion very enlightening. In this post, we will summarize our views, as well as those of Professor Conti-Brown.
To start, we have not altered the opinions that we expressed in FT Alphaville in the aftermath of the FTX collapse: let crypto burn. We offer five reasons against new federal financial regulation.
First, such regulation often provides legitimacy, and legitimacy creates responsibility. The online game World of Warcraft has more than 120 million players and has an economy inside of it. Fortunately, no federal financial regulator has the responsibility to oversee the World of Warcraft, even though there is money involved. And none of the players has any expectation of government intervention should they suffer losses. Like a massive online multiplayer game, crypto does nothing to support the real economy. So legitimizing it simply drains creative resources from productive activities. In economic terms, this would amount to encouraging deadweight losses.
Second, we already have a set of laws and enforcement mechanisms to address fraud, theft, and facilitation of criminal activity. It is essential that prosecutors address the misbehavior that is a defining feature of the crypto world. They should enforce existing laws aggressively, and where appropriate go after the celebrities that promote crypto swindles.
Third, new light-touch rules for crypto would fuel a migration of financial activity from traditional finance to the less regulated, but newly legitimated, crypto world. Both crypto and traditional finance are simply combinations of a database and computer code. It would be straightforward for a group of technicians to convert one into the other. New rules that fuel regulatory arbitrage would be a disaster.
Fourth, some people argue that regulation of crypto will promote financial innovation. We do not see why this is necessary. So long as regulators promote competition, there is nothing to prevent traditional intermediaries or nonfinancial high-tech firms from investing in new technologies that reduce costs and improve access. Indeed, the fintech revolution has already spurred innovations in payments, credit evaluation, insurance, stock trading, and elsewhere. Surely the prospect of capturing some of the rent in the financial industry is enough to spur further innovation without crypto.
Fifth, legitimizing crypto will encourage banks and nonbanks to purchase crypto assets directly and to accept them as collateral. Imagine where we would be if leveraged intermediaries had been holding crypto in November 2021 before the plunge in value. If we need any new rules, they are rules that prohibit exposure of traditional leveraged intermediaries and financial market utilities to the crypto world. If virtually all the transactions remain internal to the crypto world without links to the real economy, the process might as well be occurring on Mars, leaving traditional finance safe. That should be our goal.
In the debate, Peter made three major points (which we quote from his blog post): “1. Do not make technology-specific exceptions for crypto assets. 2. Permit banking and securities regulators to enforce existing laws. 3. Embrace epistemic humility about crypto’s potential – for good or ill.”
We strongly agree with the first two. As noted, creating different regimes for different types of databases and code that serve the same functions would invite regulatory arbitrage of the worst kind. And, since nearly all crypto looks like a combination of fraud and pure gambling, we should vigorously prosecute what is illegal. To paraphrase Alex Mashinsky, the founder and former CEO of the bankrupt Celsius Network, when a traditional bank offers a zero interest rate and a crypto lender offers 18%, someone is lying. We agree and want everyone to know who it is.
We disagree with Peter on his third point. We see no evidence that crypto is the future of anything. This is not an issue of humility. Crypto has had more than a decade to demonstrate meaningful economic benefits. Instead, experience has strongly reaffirmed the case of deep skeptics including BIS General Manager Agustín Carstens, who once blasted crypto as “a bubble, a Ponzi scheme, and an environmental disaster.”
Even the permissionless blockchain technology is unlikely to bear fruit. Professor Eric Budish at the University of Chicago has shown that such trustless mechanisms are either going to be extremely expensive (as in proof-of-work systems like the one underpinning Bitcoin) or be vulnerable to attack and to sudden slowdowns (as in proof-of-stake systems like the one now used by Ethereum). Rather than flocking to permissionless blockchains, people are abandoning them.
Furthermore, it is not just crypto that is nonsense. The concept of decentralization, either a decentralized ledger or decentralized finance more generally, turns out to be a pipe dream. In every case, “DeFi” involves some form of centralization. Aramonte, Huang and Schrimpf show this to be an Achilles heel. For both the blockchain and DeFi, control is in the hands of a small number of people who govern it and maintain the code. More generally, centralized forms of intermediation, like broker-dealers and exchanges (e.g. FTX) that provide scale economies and benefit from network externalities, are critical to attracting activity from new participants. Without that source of expansion, crypto will wither and die (or perhaps survive as an enhanced video game, just as World of Warcraft does).
The advocates of crypto and DeFi claim that they are creating a financial system that will cut costs and improve access. However, experience has taught us that crypto and DeFi recreate all the problems in traditional finance—problems with consumer and investor protection, market integrity and efficiency, illicit activity, and systemic stability (see our earlier post). In the case of the traditional financial system, we have developed an extensive regulatory and supervisory structure over many decades to address these issues. There is no reason to create a parallel regulatory system for crypto.
This brings the most important message we took away from the debate. Peter raised critical questions about whether it is possible to apply existing laws and regulations to crypto. Not being jurists, we are happy to defer to him on this matter. His point is that current rules are sufficiently vague that their usual enforcers are hesitant to apply them. Naturally, we support his call for clarity where needed.
What we will say is that there seem to be three possibilities for how to treat crypto. It can be a commodity, a security, or simply gambling.
Starting with the distinction between commodities and securities, this strikes us as idiosyncratic to the regulatory framework in the United States, where there is an unfortunate division of responsibility between the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC). The result of this unique arrangement is that the jurisdictional battle plays out in the legal definition of crypto itself. Because this problem does not arise in other jurisdictions, it seems artificial. (If we were to take a side in the debate, the fact that the crypto industry views the CFTC as more friendly immediately leads us to side with the SEC, if only to limit regulatory arbitrage.)
As for whether crypto is a financial instrument or primarily a tool for gambling, here we see the weight of evidence tilted heavily toward the latter. As Todd Baker argues, it makes sense to apply gambling laws to crypto. The key advantage of designating crypto as gambling is the clear message it sends: it is not fit for financial duty. In practice, the fragmentation of U.S. gambling regulation complicates this approach, but pursuing this reasoning seems worthy of attention from legal experts.
To conclude, creating a new federal framework for regulating crypto conveys undeserved legitimacy upon a system that does little to support economic activity and currently poses no threat to financial stability. It would lead to calls for public bailouts when crypto inevitably erupts again. At the same time, we support Professor Conti-Brown’s calls for clarifying existing rules where needed to make enforcement of rules against criminality feasible and effective.
There also is one sort of crypto regulation that we strongly support. As Professor Allen says in the opening quote, keep banks away from crypto. We would go further and ban all regulated intermediaries—traditional banks, broker-dealers, insurers, pension funds, custodians, and clearinghouses—from any participation in the crypto world. They should not be allowed to own crypto, accept crypto as collateral, or even provide customers with access to crypto.
The primary goal should be to prevent crypto from infecting and undermining the existing financial system. Every other objective is no better than a distant second.
Acknowledgement: We thank our friend, David Wessel, Director of the Hutchins Center, for organizing the debate and nudging us to think about these issues.