Since November 2022, three ventures related to cryptocurrencies have filed for bankruptcy, raising the issue of regulatory protection for retail consumers. Thomas Kalafatis and Richard Nesbitt write that cryptographically enhanced commerce is here to stay and keeping externalities under control is the best we can hope for. They say regulators will become more aggressive not just with coins but also with the programming code that creates them.

We have been concerned that retail consumers are not protected in an environment of cryptographically enhanced commerce, even though they may have a legitimate need for an alternative currency. While we may trust our banking system, many people in this world have very real reasons for not trusting their own systems and hope for an alternative that deals with risks. These are often the consumers that have not been able to fully participate in the nation’s economy or financial systems or people from parts of society that are excluded from sharing economic success. Smartphone technology has made it possible for a much larger part of society to participate in alternative crypto currency vehicles, even though they receive none of the protections provided to traditional financial markets. This imposes a disproportionate cost of failure onto these disadvantaged consumers who often can afford it the least.

Since our last publication, here is a short list of follow-on debacles:

• FTX –  November 11, 2022 bankruptcy filing
• BlockFI – November 28, 2022 bankruptcy filing
• Genesis/Gemini – January 20, 2023 bankruptcy filing

The cascading problems with centralised exchanges have even started to create stress with US federally chartered banks – Silvergate and Signature. Meanwhile, some “legacy” coins and newer coins such as Solana are having record returns since January. This juxtaposition of debacle and continued frenzy begs us to try to answer the obvious question, “where do we go from here?”

Firstly, cryptographically enhanced commerce is here to stay. The supply of the technology is too widespread, and its demand too pervasive to be reversed. As cryptographic technology inexorably moves forward and is intertwined with other technologies, the best that can be hoped for is that its negative externalities are kept under a measure of control.

Secondly, as the impact of these failures and negative externalities on investors is in the multiple billions of dollars, it will take years to know the actual impact on markets and public policy. In contrast to our calls for more regulation, some people argue that what is needed is not more regulation, but more enforcement, or more clarity of regulation. To this end, we retort, the policies, where they exist, are clear, and enforcement is part and parcel of regulation. Most important, it is not the regulators’ role to be a department of “pre-crime”. Just as it is not the justice system’s role to tell us whether it is “ok” to do something before we do it. The regulators do not have the resources to vet and opine on every financial instrument and transaction. This is the role of responsible intermediaries, who ideally are regulated with the interests of the public in mind.

Thirdly, regulations are quite clear. Market participants simply need to ask whether their stablecoins such as FTT (whose insolvency contributed to the downfall of the cryptocurrency exchange FTX) are deposits or securities. They are either one or the other to the extent they are exchangeable for other financial instruments. In either case, they need to be subject to the same regulation as other traditional forms of deposits or securities. And those purporting to put themselves out as exchanges need to be regulated as such and should not custody assets on behalf of counterparties. Broker dealers or custodians, not exchanges, should hold assets. They are each subject to different regulations and inspection, given the operating risk of their activities.

Despite the current chaotic situation, we have learned nothing that we did not know before. Financial markets are prone to fraud by a small number of unscrupulous actors whenever they are left unregulated. Even with the best of regulation, financial services organisations are still prone to the actions of people who seek to cheat when incentives to do so are high. Of course, we teach business students that leverage is the most feared excess in business. In fact, overleverage, or borrowing short and lending long, has been partly responsible for every single financial market debacle since Roman times.

Unfortunately, our fourth prediction is that there will continue to be more and new frauds until the general public’s latent demand for the benefit of cryptographically enhanced commerce is met by honest actors and through more uniform and less arbitrageable regulation. For example, the US Securities and Exchange Commission (SEC) has recently led the charge on stablecoins being a security. Why is this not happening in other jurisdictions with similar regulations?

So, who is getting hurt? Why not let the markets sort themselves out and punish the offenders through bankruptcy and reduced future business prospects? Unfortunately, it is not that simple. These are lessons we learned the hard way in other organised markets such as stock exchanges. The unprotected in society suffer disproportionately in the case of large financial frauds. The Brooking Institute has a comprehensive article discussing the challenges of offering crypto assets to retail investors. Here is one of their concluding comments:

“When examined closely, crypto’s current capabilities do not match the needs of the groups it purports to serve, and it carries a host of risks and drawbacks that undermine its benefits. More alarming, we can observe parallels between crypto and other predatory products, which highlights crypto’s potential to exacerbate unequal financial services to historically excluded groups.“ 

Previously, (see here, here and here) we proposed that private stablecoins would be permanently troubled by their inherent risks that cannot be remedied, no matter how hard promoters try. If you re-examine the list of failed private exchanges above, you will see some or all of these factors contributing to their demise.

This leads to our final prediction. We believe that another question needs to be asked when investing in, intermediating or promoting crypto, or applications which intermediate crypto: Does crypto-enhanced commerce, in the way it is currently used, promote money laundering or the avoidance of know-your-client (KYC) requirements? We believe regulation and enforcement may intertwine with national security and political interests. This will lead to the regulation of “code” itself, including how it is used and whether it can be used at all.

The US government, via the US Treasury, set precedent in its sanctioning of cryptocurrency mixer Tornado Cash. Historically, code has been protected based on case precedent as free speech. But in this instance, where Tornado cash was an application which “tumbled” and “reprocessed” coins with the purpose of making senders and recipients unrecognisable, the code was arguably malicious. There were allegations that North Korean hackers laundered some $100 million via the tool. The coders were sent to jail while they await trial.

Decentralised finance (DeFi), which is often an attempt to bypass regulated finance through the lack of intermediation, regulation, administration and corporate governance via distributed servers is still coded by individuals. It may be that DeFi is targeted by future legislation to regulate code. Its current structure may be treated as malicious. There is much legislation that already exists where malicious code and their coders are treated criminally. DeFi may literally find itself on the wrong side of cybersecurity law.

So, where do we go from here? The world cannot pack it all up and declare cryptocurrency a failed experiment even if it wanted to! In many countries there is strong public demand for alternative currencies instead of their own, given the level of mistrust they have for their governments and banking systems. After all bitcoin still exists at a price greater than zero, meaning many hundreds of thousands of people ascribe a utility value to this instrument. We suggest that the analogy is that crypto-currency is in the early stages of being a high-utility technology, but with clear negative externalities whose costs need to be managed (much like carbon–based energy, which had massive utility, but whose externalities were understood much later). We believe the pursuit of controlling these societal costs will become more aggressive and involve regulating not just the coins themselves but also the very programming code that creates them.

• This blog post first appeared at LSE Business Review.
• Featured image by André François McKenzie on Unsplash
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• Note: The post gives the views of its authors, not the position USAPP– American Politics and Policy, nor of the London School of Economics.
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