Crypto breaks the rules. That’s the point.

by Arthur · August 19, 2022

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One of the most common criticisms of cryptocurrency is that it is simply a way to circumvent financial rules and regulations. That criticism isn’t entirely wrong — but with crypto, as with many other innovations, regulatory arbitrage is a feature, not a bug.

Very often, regulatory arbitrage is most successful when the innovation improves some aspect of the older methods. The arbitration conveys the message that the old regulations must be changed.

Consider a concrete example. Many crypto institutions issue tokens, which for many regulators have the characteristics of securities and should be regulated as such. But they are not, at least not consistently. So if you issue a crypto token but don’t have to register it as a security and go through the process of satisfying securities laws, you’re doing regulatory arbitrage.

It is worth considering why some of the regulations should be changed in this new context. In the pre-crypto world, issuing a security involved a lot of institutional preparation and investment and legal planning, even apart from the regulatory constraints that had to be met. Issuing crypto-tokens is usually easier and faster, and fairly immature institutions have done so. Software and blockchains do much of the work that once required offices, personnel and a lot of hands-on management.

It can be software that automatically issues crypto tokens, based on smart contracts that specify terms of issuance. This very possibility is a sign of how much things have changed.

Standard US regulatory practice typically focuses on regulating hosting companies and intermediaries, rather than software. But when a blockchain verifies, stores and communicates information, it is difficult for regulators to step in and make a meaningful difference. Thus, the old regulatory model no longer applies to a significant part of the crypto experience.

And the lower cost of issuing tokens means that the issuing intermediaries can be capitalized quite thinly. Often they are either unable or not encouraged to comply with many regulations. In addition, an institution can fully participate in the crypto space without being based in the United States or tied to any specific nation-state.

You can research these features in the market. Either way, they’re going to mean a radically different set of regulatory constraints. They also mean that certain types of securities (if it is appropriate to call them that) can be issued far more cheaply than before.

Given this reality, shouldn’t the regulations be changed – and significantly? This may include some areas where regulation is even tighter, although overall regulations are likely to become looser. The regulators must learn to live with a more decentralized market structure that has lower costs and is more difficult to control. It is common sense that when software can replace large capital investments, regulations should change, although observers disagree on how.

Unfortunately, the regulatory process is static and usually slow to change. Regulatory agencies often stick with the status quo until it is no longer tenable. One of the benefits of regulatory arbitrage is that it forces their hand and creates a new equilibrium.

Even if you think current regulations are appropriate, you should recognize that they, too, are the product of past episodes of regulatory arbitrage: In the 1980s, for example, junk bonds helped circumvent some equity regulations. Regulatory arbitrage has long been a means of keeping regulations at least somewhat up-to-date.

To return to the example at hand: It is true that many crypto-token schemes are marketed under false pretenses or are part of a “pump and dump” strategy. These negative aspects of the token phenomenon should not blind us to their possible benefits as a new method of raising funds or using markets to value projects. Many valuable innovations—railroads and the Internet come to mind—were also plagued early on by investor fraud.

The argument is not, to be clear, that regulatory arbitrage is always good. It can lead to regulatory overreaction or, conversely, to regulatory gaps that remain too long and allow persistent fraud or systemic risk. The argument is that regulatory arbitrage is fundamentally part of a process that leads to lower costs, greater innovation and better rules.

People often ask me what crypto is good for. It’s good for a lot of things, and I’m happy to recite a few, but surely one of its more underrated benefits is that it’s a form of regulatory arbitrage.