Don’t regulate crypto as finance

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Good morning. Disney’s struggles are fascinating. It used to be that content was king, Disney was the king of content, and Disney’s stock went up. But distribution is royalty too, and now that streaming is the crucial form of distribution, the economics of the business have changed for the worse. We will write about the stock before long, but I’m curious to hear readers’ thoughts. Any Disney buyers out there? Anyone short? Email me: robert.armstrong@ft.com.

Do not regulate crypto like stocks and bonds

Michael Barr, the Federal Reserve’s vice-chair for supervision, told senators last week that the crypto sector “requires effective oversight that includes safeguards to ensure that crypto companies are subject to similar regulatory safeguards as other financial services providers”. Similarly, Securities and Exchange Commission chair Gary Gensler has said that the basic US laws governing securities, exchanges, brokers, funds and advisers, passed in the middle of the past century, should apply to crypto: “Nothing about the crypto markets is incompatible with the securities laws. Investor protection is just as relevant, regardless of underlying technologies.”

Barr and Gensler, and others who argue the same way, are wrong. It would be a mistake to apply the legal/regulatory/supervisory apparatus used for stocks and bonds to crypto. Luckily, efforts to ram crypto’s square peg into the round hole of the Securities Act of 1933 (et al) have proceeded slowly to date. But there is danger this mistaken project will accelerate now. Politicians, smelling the smoke from the FTX dumpster fire, are already asking financial regulators what the hell they were doing while Sam Bankman-Fried was merrily pouring the petrol.

The basic outline of a case against regulating crypto like stocks and bonds was laid out in an very nice recent op-ed over at Alphaville, written by business school professors Stephen Cecchetti and Kim Schoenholtz. Here’s the nut:

Just let crypto burn. Actively intervening would convey undeserved legitimacy upon a system that does little to support real economic activity. It also would provide an official seal of approval to a system that currently poses no threat to financial stability . . . 

[regulation] will encourage banks both to purchase crypto assets and to lend against them as collateral, making the banking system vulnerable to plunging market values . . . new rules would lead to a migration of financial activity from traditional finance to the still less regulated, but newly sanctioned, crypto world . . . 

The underlying problem is that we don’t really know yet what crypto assets are. Currencies? Commodities? Investment contracts? Ownership of payment infrastructure? Game pieces? Plain bullshit? We’re still fighting about this, and therefore have nothing like a settled view of the social value or crypto technologies. The securities/investment regulatory machinery has been developed to protect a bunch of stuff we have hundreds of years of experience with, and which has proven social value.

The Cecchetti/Schoenholtz insight is that we don’t even know if crypto assets are investment products at all, but if we regulate them that way, that’s what they will become, and as a result investor appetite for crypto risk will grow.

There are two amendments I would make to the basic Cecchetti/Schoenholtz view. The first is that it may be necessary to regulate crypto the way we regulate, say, gambling or smoking. Consumers may need protection. The crucial thing is that the Fed, the SEC, the Office of the Comptroller of the Currency and the Commodity Futures Trading Commission should not be involved, except to tell those they regulate that they can’t touch crypto, period. Second, as a fancy lawyer argued to me yesterday, an exception may have to be made for stablecoins (cryptocurrencies pegged to the dollar), which amount to the creation of private money and may have important uses in payment technologies (I’ll put this topic aside for now).

The intuition underlying the Barr/Gensler view is simply that when someone buys a crypto asset, they are giving someone money with the expectations of returns, and that is what the existing regulations are meant to capture. This intuition is summed up in US law by the so-called Howey test, which says that something is an investment contract if it involves (a) a person investing (b) in a common enterprise (c) with the expectation of profits (d) based on the efforts of others.

This four-factor test seems to have been written to be counter-exampled into oblivion. But the general objection is that making everything that someone thinks is an investment into an investment for regulatory purposes is a mistake. Lots of people think sports betting is a form of investment. Some bettors probably make it a successful investment, by treating it as an inefficient market waiting to be exploited. And it seems to pass the Howey test. But no one is arguing that the SEC should regulate sports betting, because (a) the SEC would be bad at that, and (b) it would send a disastrous message about gambling.

The point here is not that crypto is a less-than-zero-sum, rigged game (though it may turn out to be). The point, again, is that we don’t know what crypto is.

The good news is that we have not gone very far down the path of regulating crypto like stocks and bonds. The SEC’s most substantive guidance on the topic, as captured in Staff Accounting Bulletin 121, says that any SEC regulated platform that safeguards crypto assets for clients should have corresponding liability and asset entries on its balance sheet, and those entries should reflect fair value, and that the entity should offer clear disclosures about what the assets are and how fair value is determined. The OCC and the Fed say that entities they regulate should only take custody of crypto assets, use dollar deposits to back stablecoins, process payments via a distributed ledger, and so on, if they can do so in a “safe and sound” manner, and they reserve the right to determine if that standard has been met.

The regulator that has, lamentably, gotten in the deepest is the CFTC, which treats crypto assets as commodities and regulates crypto futures. One could argue that the CFTC’s implicit blessing opened the way for Bitcoin ETFs — a wretched product that attracted a lot of assets and vaporised most of them.

The tentative rollout of regulation may be part of the reason that only one US bank, BNY Mellon, has managed to launch a crypto custody programme. Regrettably, asset managers are further along. But both regulators and industry could turn back now without too much lost time, money and effort. All that is needed is a big regulator to summon the courage to say what is slowly becoming clear: we don’t know what crypto is so we are not ready to regulate it. For now, investors don’t need crypto rules, they need to be warned away from it, and told that they meddle entirely at their own risk.

One good read

In case you missed it over the weekend, Stuart Kirk’s first column as an FT investment columnist struck a blow for transparency.

Cryptofinance — Scott Chipolina filters out the noise of the global cryptocurrency industry. Sign up here

Swamp Notes — Expert insight on the intersection of money and power in US politics. Sign up here


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