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Crypto’s lesson in trust—more regulation to come

Crypto’s lesson in trust—more regulation to come

The issue of whether to regulate cryptocurrencies is long past. It is merely a matter of degree at this point. How much regulation will there be and who the regulators are?

Nor should the cryptocurrency regulation be seen in isolation. Crypto’s collapse in trust will help propel a drive to more federal regulation generally as well as internationally.

Financial assets are like buying a patch of clear blue sky as the term “Blue Sky Laws” for state securities regulation implies. Blue Sky Laws grew from the understanding that trust lies at the heart of securities pricing. That is a lesson for crypto regulation too.

The financial literature is now replete with models to price crypto assets. But it does not matter if the financial model is simple or complex, deterministic, or stochastic. All models rely on an assessment of the implicit trustworthiness of the agreements in order to assess the probability of payments. This problem of trustworthiness has long been at the core of crypto pricing. It is a problem that is being resolved with the proposed regulations now coming to the fore. Crypto agreements are no more trustworthy than any other.

Regulatory design becoming clearer

The US has been a regulatory laggard with crypto regulation. Much of this has been a result of SEC and CFTC battles. This has created a congressional impasse on cryptocurrency regulation which the White House has stepped into.

On September 16, 2022, the White House produced a reasonably detailed outline of the Administration’s approach to crypto regulation. For crypto advocates, the Framework is truly disheartening since it begins with a recitation of the extensive fraud in the industry. The first priority of the Framework is consumer protection. And there is little in the press to support any other responsible approach to handling crypto regulation at this point, though crypto advocates are likely to disagree.

Among the Framework’s various proposals, the implementation of a digital U.S. dollar stands out. While it is a directive to “explore” the use of a Central Bank Digital Currency (CBDC), the section reads much more like a directive to implement one. Certainly, the section stands in opposition to the general reluctance of monetary authorities to implement a CBDC.

Perhaps the most striking element of the current Framework is its tone. The current version of the Framework repeats the structure of the one issued in March but reflects a general change in attitude toward cryptocurrencies as the degree of criminality in the area surges. The current Framework cites the FBI data showing that crime in the area surged around 600 percent in 2021 alone.

What else will this affect?

The collapse of the cryptocurrency market and the loss of confidence by regulators will have a long shadow on our culture. Crypto is, of course, not the only new technology to collapse. Immediate comparisons to the 1999-2000 dot com crash are obvious. The overvaluation of tech firms in this period eventually was corrected. The NASDAQ fell about 77 percent and did not recover for 15 years.

Tech collapses like this are not in the minds of the countless number of young crypto investors. They are, however, in the collective consciousness of regulatory agencies. The crypto experience, with its ever-growing picture of fraudulent behavior, will energize regulators as new technologies in biotech, quantum computing, AI and others come to market. Trust in financial markets is essential to economic growth.

Trust in finance can be lost because of fraud and misinformation. But it can be recovered by judicious regulation. We should hope that develops soon.

Investor Implications

1. Expect tough federal regulation to be forthcoming in the next few months.

2. Exercise caution and due diligence when investing in the crypto space.

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This article is not intended as investment, tax, or financial advice. Contact a licensed professional for advice concerning any specific situation.