Crypto poses serious challenges for regulators

by Arthur · August 15, 2022

The author is the author of ‘The future of money: How the digital revolution is transforming currencies and finance’

Whatever the fate of decentralized cryptocurrencies like Bitcoin, other forms of cryptocurrencies and blockchain technology are here to stay. Decentralized finance can create innovative ways to deliver and expand access to financial products and services, while the added competition forces traditional institutions to improve their efficiency.

This creates challenges for regulators who recognize the potential benefits. How to facilitate innovation while keeping the risk contained?

Answering some basic questions will help harness the technology and improve the inevitable benefit-risk trade-offs.

Crypto finance

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First, is blockchain technology the best answer to existing shortcomings? Digital payments in the US, for example, are still characterized by high costs due to regulatory and other barriers. International payments everywhere are still expensive, slow and difficult to track.

Blockchain technology is hardly the only or optimal solution. Mobile phone-based and other technologies enable broad and easy access to affordable digital payments. Regulators should favor simpler technologies that best meet the real needs of consumers and businesses, rather than those that promise speed and efficiency but make it harder to trace payments and facilitate illicit trade.

Second, how to protect investors and consumers? Regulators cannot always limit how much risk an investor can take on. But they must protect unsophisticated investors. Public blockchains are transparent and accessible, but there is no substitute for disclosure that makes downside risks understandable, supported by steps to strengthen financial literacy.

Third, how to prevent a product or protocol from infecting the wider financial system? Stablecoins backed by high-quality government bonds and securities may not face panic-driven runs. Nevertheless, a wave of redemption requests can trigger large-scale collateral liquidations, disrupt underlying securities markets and have a cascading effect across the financial system. Regulation should take account of systemic risk, which increases as the sector expands.

Fourth, how to avoid regulation that simply entrenches incumbents and intensifies market concentration by increasing entry costs? Simpler, more transparent rules will enable newer and smaller companies to compete on a level playing field. A certain degree of churn among financial institutions is not necessarily harmful, as long as it does not damage confidence in the system.

And finally, how to maintain market integrity? Decentralized architectures and governance, while appealing and secure in principle, open up vulnerabilities such as front-running of certain protocols. Technology is unlikely to eliminate the need for effective supervision.

Questions of definition are also important. Is a stablecoin issuer a narrow bank or a money market fund? Is Ethereum a commodity or a security?

The answers to such questions are crucial in deciding what, who and how to regulate. The crypto industry has an interest in turning the tide. This increases the need for swift action, recognizing that some innovative technologies only improve the packaging and delivery of existing products. Definitions are also important for emergencies. Classification as a bank will give a stable coin issuer access to, for example, central banks’ liquidity facilities, but this should trigger capital requirements.

When an industry demands regulation, it usually demands the legitimacy that comes with it while trying to minimize oversight. That is the biggest risk regulators must guard against – giving the crypto industry an official imprimatur while subjecting it to light-touch regulation.