What CGL is Reading: “Beware the Dangers of Crypto Regulation” by Tyler Cowen

As a chorus of voices calls for strong prescriptive measures to be taken in the wake of the implosion of FTX, Tyler Cowen, an economics professor at George Mason University who co-authors the “Marginal Revolution” blog, counsels restraint.

With legislators and regulators weighing a response to ongoing turmoil in the crypto space, Cowen notes that investments in even highly-regulated financial products like equities can result in significant losses for all types of investors.  Additionally, recent adverse developments in the market for digital assets does not have appear to have spilled over into other financial sectors.  If there had been such contagion, Cowen appears to argue, the case for regulation would have been heightened due to the systemic dangers posed by the asset class.

Cowen also does not see crypto exchanges and other marketplaces growing significantly more enmeshed with traditional banking institutions.  If reverses in digital assets had led to the actual implosion or fears of the failure of a bank, the case for oversight would be heightened.  The degree to which banks actually establish robust trading and lending relationships as well as other linkages with crypto operators should be actively monitored by banking regulatory bodies.

Many like Cowen believe that crypto innovation will be stymied by—or at least exist in tension with–the premium placed on stability by the traditional financial sector.  At the same time, plenty of new financial instruments and trading strategies have developed within Wall Street, which itself has been accused on an ongoing basis of cutting corners.

Cowen wonders what the goal of regulation of the crypto space should be:  “[t]o make stablecoins truly stable in nominal value? Is that even possible?  Or to encourage market participants to see those assets as inherently fluctuating in value?”

A possible starting point for a sophisticated crypto regulatory strategy which Cowen does not explore in the piece is external cognizance of the stability of funds and other market participants in the crypto space.  To comply, digital asset firms would likely need to staff up, becoming more like banks and established hedge funds in the process.

Crypto entrepreneurs would be expected to resist such an oversight initiative and could easily evade it, if undertaken in only one or a few jurisdictions.  This would point to an oversight process being broad-based (perhaps encompassing the Organisation for Economic Co-operation and Development (“OECD”)) or voluntary (where a digital asset player would be able to hold itself out to the public as having submitted itself to the jurisdiction of a credible self-regulatory rule-making body (like the Financial Industry Regulatory Authority (“FINRA”).

Cowen suggests that “[w]ith systemic risk currently low, perhaps it is better to wait and learn more before moving ahead with regulation. And on a purely practical level, very few members of Congress (or their staff members) have a good working knowledge of crypto and all of its current wrinkles and innovations.”

If the FTX debacle actually does qualify as a genuine crisis, policy makers may rush to legislate (one could argue that it may have already blown over), overreacting with needlessly punitive, overly-broad and ill-considered rules.  At the same time, there are rarely any “good” times to initiate regulatory initiatives in any sphere of finance.  As the market for mortgage securities boomed in the mid-2000s, for example, there was no realistic possibility that legislators would undertake any serious attempts to enact regulation to address the excesses and abuse which had arisen in such area, even after some voices in the financial community raised serious concerns about them.  Rather, their voices were drowned out by a loud chorus of views promoting this financial instrument.  As applied to crypto assets, there may be a stronger argument for taking deliberate and sophisticated action on a more accelerated basis than Cowen appears willing to acknowledge.

Cowen also discusses the possible impact of crypto regulation on future innovation in the space.  In other words, if we do not understand what crypto is for, then how can we regulate it effectively?  Interestingly, Cowen describes a primary use case for crypto as getting “capital out of China, Russia, Venezuela and other financially repressive countries. That is one reason for the US to support rather than undercut the current crypto ecosystem.”  As to such worthy goal, it is hard to argue with Cowen.  But what about other objectives that involve the same basic modality?  If crypto can be used to move capital surreptitiously across national borders toward the US and other less closed economies, then crypto can be employed to move capital into jurisdictions subject to US and other sanctions regimes.  That prospect alone offers support for the idea that digital asset firms should be subject to the same sanctions-related regulations applicable to banks that want access to global payments systems.

By claiming that he is “not arguing, by the way, for zero regulation of crypto”, Cowen attempts to present his arguments around any potential regulation of the digital asset space as nuanced.  At the same time, Cowen seems to present the prospect of crypto oversight as an “all or nothing” proposition.  That approach is not as nuanced.  In other financial spaces, initial regulatory energy directed thereto may be heavy-handed and demonstrate a lack of enlightenment and sophistication in terms of the arena to be supervised.  This approach to regulatory oversight may be relaxed over time as authorities grow more uncomfortable with the excessive aspects of earlier strictures or are “captured” by the constituencies they have been charged to oversee.  Enforcement energies may wax and wane as administrations and individual regulators arrive and depart.  Thus, even if supervisory authorities unwisely adopt an overly harsh regime with respect to crypto players, that doesn’t mean that innovation unleashed within such sector will be doomed to be suffocated forever.

Do you have regulatory-related questions with the crypto space or any other financial products or services? If so, reach out to Castle Garden Law’s White Plains Equity Investments & Business Funds lawyer to schedule an initial consolation.