What Current Crypto Proposals Miss, and Why We Need to Get It Right
September 14, 2022
By Emily DiVito, Joseph Miller
Cryptocurrency’s booms and subsequent busts have dominated news cycles for the last several years. As detailed in the first blog post in our series, crypto’s inherent chaos—its volatility, fraud, scams, and financial risk—makes a strong case for robust regulation in the interest of both individual investors and broader macroeconomic stability.
However, as legislative frameworks for crypto regulation begin to take shape, some policymakers may not fully grasp—or are not prepared to prevent—the individual and systemic risks the industry poses. Indeed, many recent regulatory proposals not only defer to crypto’s industry insiders, but take active steps to facilitate crypto’s growth and greater entanglement with the traditional US financial system.
Crypto remains largely unregulated. In its nascent period, it is vitally important that any initial crypto regulation gets it right. In addition to the immediate benefit strong regulations will provide to crypto’s current users, early regulations will likely set the framework for future crypto-related legislation, thereby charting the long-term trajectory of both the industry’s expansion and the ways it interacts with American families and the wider US economy.
Just as the movement to deregulate derivatives in the late 1990s planted the seeds of instability that would eventually bloom into a full-blown financial crisis, the action we take on cryptocurrencies will have massive impacts on the economy for years to come.
Shopping for Regulators: What Even Is Crypto?
One of the most foundational, but not the only, open issues with crypto regulation is how to classify these digital assets. Such classification will have real consequences for the strength and scope of any regulatory regime.
Cryptocurrencies are relatively new: They don’t look or feel like more traditional types of currency or financial assets, like cash, stocks, or bonds—or so the crypto industry would have us believe. According to the industry’s argument, crypto doesn’t fit neatly within any existing regulatory framework, and therefore should be molded within the most favorable aspects of the existing regime. In this telling, the industry creates an opening for itself to shape its regulatory structure, including by shopping around for its regulator.
If a digital asset—or any other financial product—is considered a “security,” it falls under the jurisdiction of the Securities and Exchange Commission (SEC). The SEC has a FY 2022 budget of nearly $2 billion and just under 5,000 full time staff. If, however, a financial product is a “commodity,” it’s regulated by the Federal Commodity Futures Trading Commission (CFTC), which has a budget of $330 million and 760 staff.
While the CFTC serves a crucial role in market regulation and oversight, it is approximately one-sixth the size of the SEC. Classification as a security also triggers the SEC’s proactive—and protective—mandatory disclosure, enforcement, and investigations regime, which was designed with protecting investors and individual consumers in mind. The SEC also subjects all participating entities—which, for crypto, includes the currency exchanges, brokers, and digital wallet platforms—to their disclosure and enforcement rules and regulations. The CFTC, on the other hand, more heavily relies on self-certification and after-market regulation, which puts the burden of proof of wrongdoing on the regulator and not the firm conducting the financial transactions.
It’s no surprise that crypto wants to be housed under the CFTC.
Some of the recently proposed bills to regulate crypto would divide crypto’s jurisdiction between different regulators by classifying some digital assets as commodities and some as securities, but would default toward counting them as commodities. In fact, at least one proposal would categorize Bitcoin and Ethereum, the two cryptocurrencies with the highest market capitalization, as commodities subject to regulation by the smaller CFTC.
As a recent historical example of what happens when assets exist in a definitional gray area that its own industry manipulates for gain, we can look to the treatment of derivatives—a complex financial instrument with a value pegged to an underlying asset—in the lead-up to the Great Recession. For the first several decades of their existence, derivatives grew exponentially and without regulation. In 2000, Congress imposed a messy and weak regulatory regime, whereby oversight responsibility for the financial firms handling derivatives was inelegantly divided between the SEC and the CFTC. The division made no logical sense—but it wasn’t supposed to. Rather, it was partly the result of jurisdictional clashes between congressional committees: the House Financial Services and Senate Banking committees that oversee the SEC, and the House and Senate Agriculture committees that oversee the CFTC.
The rise of money in politics, in addition to the devastation it wreaks on our democratic system, creates incentives for certain elected officials to vie for certain committee seats, which they can then translate into campaign contributions from industry and corporate executives. In the fight over derivatives regulation, members who belonged to the House and Senate Agriculture committees discovered that they could raise millions of campaign dollars, not only from the stakeholders interested in traditional Ag committee work (like food and drug conglomerates and bioscience companies), but also from the businesses and billionaires with a vested interest in derivatives deregulation. As such, banks and other financial institutions were able to leverage and maintain murky regulatory authority to disseminate highly risky derivative products like credit default swaps–the same instruments that helped trigger the Great Recession.
Like so many other instances of regulatory arbitrage, this use of strategic ambiguities—intentional or otherwise—in regulatory structures and oversight mechanisms provides escape routes that industry can exploit in order to finagle friendly terms for itself, which creates vulnerabilities—sometimes catastrophic—in our economic system. This is the risk we run with cryptocurrency.
The Strength of Crypto’s Political Influence Is Apparent in Regulations Proposed
Industry-friendly regulation does not emerge from nowhere. Over the last several years, the crypto industry has spent considerable sums of time and money to influence electoral, research, and legislative processes in hopes of creating a favorable regulatory environment for itself.
Political spending is one clear way to measure industry influence on these processes. So far in 2022, crypto industry executives have poured millions of dollars into elections—across parties—to curry favor and install crypto-friendly allies in positions of power. A single crypto billionaire, Sam Bankman-Fried, has pledged to spend between $100 million and $1 billion in the 2024 cycle.
Crypto’s spending on lobbying is also sky-high. It’s quadrupled since 2018, and has totaled more than $9 million in 2021 alone. These lobbying efforts include recruiting well-connected DC insiders, including former President Bill Clinton, former US Senator Max Baucus, and former Treasury Secretary Larry Summers to shill crypto.
With an ability to spend immense sums to create the political conditions necessary for pro-crypto legislation, the industry has recently turned to the wider, apolitical policymaking ecosystem of think tanks and academic institutions funding research initiatives to circulate pro-crypto ideas.
The industry’s efforts are paying off: In this current Congress alone, members have introduced more than 50 crypto bills, and most have been incredibly friendly to industry. In fact, the crypto industry and its advocates have lauded many of the proposed regulatory frameworks introduced thus far.
Crypto’s First Regulations Will Chart the Course of Its Future—and Our Future with Crypto
Initial policy ideas—indeed sometimes verbatim legislative language—can get recycled for years as new iterations of bills until they’re either passed or abandoned. In fact, some of the current proposals outline preferential tax terms for crypto purchases to incentivize usage, which were first introduced as stand-alone legislation in 2017, again in 2020, and again in 2022.
Certainly, reintroduction can allow good ideas to be refined over time. But it can also trap bad ideas within policymaking debates, narrowing the scope of what’s possible. And, should those bad ideas be successfully codified into law, they become incredibly difficult to undo ex post facto.
What’s more, the presence of laws and regulations creates the appearance of dependability and soundness to the public. Consumer confidence that a particular product is safe and sufficiently regulated by the government increases and expands that product’s uptake. This is especially the case for a new industry that requires, almost more than anything, a stable regulatory environment for its growth. In the example of derivatives, lawmakers—persuaded by the financial industry’s arguments that these complicated products were good for “innovation” and “modernization”—left a dangerous and volatile industry under-regulated despite (or because of) the existence of regulations, letting consumers walk away with the impression that they were reliable investments.
We’re at risk of something similar with crypto: Industry-friendly legislation may legitimize and popularize inherently speculative digital assets, force greater entanglement with the US financial system through widespread use in retirement accounts, real estate sales, and banking, and therefore threaten the financial security of everyday consumers at the next inevitable crypto collapse.
Even more than the material consequences of the specific terms of any crypto legislation, the act of passing legislation will send a message to all Americans about whose interests Washington serves. The proposed crypto regulatory packages are right in that they recognize the importance of crypto regulation. Crypto should be regulated—and immediately. But it must happen in the public’s interest. And without the corrupting influence of the crypto industry.
Adequately regulating crypto—and so protecting the people who have been convinced to use it—is perhaps the only way to outline a long-term path for digital assets that prioritizes consumer interests and investments as well as macroeconomic soundness.
Up next in our ongoing crypto blog series: We explain how existing policy solutions can be used to address the economic problems that crypto claims—but fails—to solve.