- Over the past year, at least 16% of Americans have traded cryptocurrencies – a $1.7 trillion industry that has grown significantly since 2017.
- Despite the size and growth of this market, cryptocurrencies have a number of regulatory gaps, and federal regulatory oversight of the market is severely underdeveloped.
- It is up to Congress to define the cryptocurrency industry and lay the proper regulatory groundwork before such decisions are made by existing regulators.
A market that didn’t exist before 2017 is now causing headaches for regulators and policymakers in Washington, as a growing number of Americans – around 16% – are investing, trading or using cryptocurrencies. Wyoming and Arizona are reportedly considering accepting tax payments in the form of digital currencies. The new mayor of New York has received his first salary in cryptocurrencies.
While (or perhaps because) the long-term economic implications of cryptocurrencies remain unknown, the market value of cryptocurrencies surpassed $3 trillion in November of last year. Any market or industry of this size deserves rigorous scrutiny by policymakers and regulators, forward-looking analysis and scrutiny, and this is especially true for a market in which individual Americans have little consumer protection. To date, Congress has yet to perform this review and analysis, but that may finally change. This week, Commodity Futures Trading Commission (CFTC) Chairman Rostin Behnam will testify before Congress in a hearing examining the risks, regulation and innovation of digital assets.
Below are five fundamental questions that Congress must seek to answer when considering how to appropriately regulate the cryptocurrency market. If Congress doesn’t take ownership of this fledgling industry, cryptocurrency issuers and users will likely face a patchwork of divisive agency-led initiatives, or worse, no regulatory oversight.
What is a cryptocurrency?
A cryptocurrency is a digital or virtual currency, backed by advanced encryption algorithms that allow cryptocurrency users to obtain cryptocurrencies without the use of third-party intermediaries – it is decentralized and is generally only not managed by a central authority. Encryption algorithms and advanced cryptographic processes are kept on blockchain, an open distributed ledger that creates a unified transaction record, promising real-time transparency to all users.
The biggest problem facing Congress and regulators is that it can be difficult to know what a cryptocurrency is. for. While the primary purpose of a currency is to exchange it for goods and services, most cryptocurrency users invest or trade in cryptocurrencies instead. Although the United States has over 30,000 Bitcoin ATMs, it remains difficult to actually use Bitcoin to pay for goods or services.
This raises the question of how best to define cryptocurrencies for regulatory purposes. Cryptocurrencies, like digital currencies, are unquestionably an asset, but what type of asset? If the primary purpose of a cryptocurrency is to be used to pay for goods and services, it would be appropriate to classify it as a commodity, like a metal. If instead a cryptocurrency is primarily a financially tradable instrument, it would be appropriate to classify it as a security. Bitcoin, the world’s first cryptocurrency, is regulated as a commodity, but the Securities Exchange Commission (SEC) has said that in its view most cryptocurrencies are securities. This distinction is important because securities are much more strictly regulated than commodities, including, among other requirements, restrictions on pricing.
Given questions surrounding both the current role and future evolution of cryptocurrencies, regulation of this asset class is something of a moving target.
How should we think about regulating cryptocurrency issuers?
Most cryptocurrencies are currently issued by a relatively new class of financial vehicles, fintech – so called because they share the properties of financial services companies and technology companies. Fintechs are typically fast-paced, nimble startups looking to challenge well-established financial service providers by providing better traditional services, reaching underserved markets, or delivering entirely new product combinations and product offerings. Where it gets difficult for regulators is where fintechs provide banking and similar services. By issuing cryptocurrencies and seeking to challenge the supremacy of established banks, most fintechs have evolved from back-office service providers to increasingly customer-focused funding options. In short, many of these quasi-banks provide quasi-bank-like services, without the comprehensive system of bank supervision and monitoring.
While relief from a cumbersome regulatory regime may be a good thing, particularly for a new industry, there is significant scope for customer abuse and, at the end of the scale, the potential for consequences for the economy in general. One of the defining characteristics of a bank is that it is required to carry insurance with the Federal Deposit Insurance Corporation (FDIC), which provides consumers and investors with some comfort if the bank gets into significant financial difficulty. . This same protection is not given to fintechs, although the scale of the vast majority of fintechs is not material to the economy – yet.
Who should regulate cryptocurrencies and cryptocurrency issuers?
The federal government’s reluctance to identify precisely what a cryptocurrency is makes it difficult to determine which federal agency should be responsible. No administration or Congress has yet taken a position. The necessary result has been that existing regulatory oversight has been a turf war between financial regulators. This is not to say that the decision is easy: the monetary aspects of cryptocurrency concern the Federal Reserve and the Treasury; commodity aspects of the CFTC; and securities aspects of the SEC. The responsible regulator may even differ by cryptocurrency issuer, with parties ranging from the Fed to the Office of the Comptroller of the Currency to the Small Business Administration. The FDIC waits in the wings if any of these fintechs require bank charters (usually to deny them). Even outside of the federal financial services regulators, there are broader privacy and security concerns that could concern the National Economic Council or the Financial Stability Supervisory Board.
The content, burden and characteristics of the regulatory response will differ greatly depending on the responsible federal agency (or worse, multiple agencies). Whichever federal agency or agencies are ultimately held accountable will then face a number of operational challenges, as this new file will require personnel, time and expertise to process, even if the new normal course of business, not to mention the time it will take to meet the needs of cryptocurrency regulation. The organization concerned may even need to review its charter for its applicability in view of these expanded responsibilities.
Even if the right agency can be identified and has an abundance of regulatory resources, it also remains true that cryptocurrency is inherently quite a tricky beast to regulate. One of the main reasons for this is the high volatility of cryptocurrency (technically a measure of the dispersion around the average value of a security, but more generally rapid or large fluctuations in value as defined by the Marlet). The chart below shows the daily daily return (a calculation of return on equity) of the first and second largest cryptocurrencies, bitcoin and Ethereum, compared to the average volatility of the S&P 500.
Any asset class that behaves unpredictably – and therefore unpredictably – will be a challenge for any regulator.
Should the US government support a cryptocurrency?
All of these concerns have so far been directed at cryptocurrency as represented by private industry. Congress may also later consider the idea of a federally backed cryptocurrency, or central bank digital currency (CBDC). Proponents of cryptocurrencies point to the speed and transparency offered to consumers by crypto and, in some cases, predict that not only the traditional banking sector is in danger, but also possibly the US dollar.
Since the Bretton Woods agreement of 1944, world currencies have been pegged not to gold but to the US dollar, on the grounds that it was itself pegged to gold. Despite President Nixon’s decoupling of the dollar from gold and the subsequent emergence of the fiat currency system in use around the world today, the US dollar remains the world’s reserve currency, and that is unlikely to happen. exchange given the stability and liquidity of US Treasury bonds backing the dollar as the most tradable currency in the world.
This situation could of course change if a sufficiently strong digital competitor emerges, the most obvious competitor being a Chinese government-backed CBDC. Although this risk may still be decades away, one of the most effective ways to prevent it would be the creation of a US CBDC. A recent Fed discussion paper examines the potential benefits and risks of a CBDC and represents the first step taken by the US government in this direction.
What is the right balance of regulation?
Even if the federal government can answer these preliminary theoretical questions to determine How? ‘Or’ What it should regulate cryptocurrencies, the government will also have to find the right balance as to How many. Push the balance too far in one direction, and the federal government will overburden cryptocurrency issuers, discourage innovation, and hurt the competitiveness of the US global market. Too far in the other direction, and the federal government may not adequately protect consumers and investors.
It is unclear whether cryptocurrencies will have the staying power to have a significant long-term impact on US or global economies. Even accounting for cryptocurrency volatility, however, the cryptocurrency market is going from strength (weakness) to strength. Congress has an opportunity to put in place broad industry safeguards, protect consumers and investors, and create a unified vision for the new marketplace that makes best use of regulatory resources and fosters innovation in US financial markets. This opportunity is quickly disappearing.