Crypto Breaks the Rules. That’s the Point.


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One of the most common criticisms of cryptocurrencies is that it is just a way to circumvent financial rules and regulations. That criticism is not entirely wrong, but with cryptocurrencies, as with many other innovations, regulatory arbitrage is a feature, not a bug.

Very often, regulatory arbitrage is most successful when the innovation improves on some aspects of older methods. Arbitration conveys the message that the old regulations must change.

Consider a concrete example. Many crypto institutions issue tokens, which for many regulators have the properties of securities and should be regulated as such. But they are not, at least not uniformly. So if you issue a crypto token, but don’t have to register it as a security and go through the process of complying with securities laws, you’re engaging in regulatory arbitrage.

It is worth thinking about why some of the regulations should change in this new context. In the pre-cryptocurrency world, issuing a security involved a great deal of institutional preparation and investment and legal planning, even aside from regulatory restrictions that had to be adhered to. Issuing crypto tokens is usually easier and faster, and quite immature institutions have done it. Software and blockchains do much of the work that previously required offices, staff, and a lot of hands-on management.

There could be software that automatically issues crypto tokens, based on smart contracts that specify the conditions for issuance. This very possibility is a sign of how much things have changed.

Standard US regulatory practice generally focuses on regulating host companies and intermediaries, rather than the software. However, once a blockchain is verifying, storing, and communicating information, it is difficult for regulators to step in and make a meaningful difference. Therefore, the old regulatory model no longer applies to a significant part of the crypto experience.

And the lower costs of issuing tokens mean that issuing brokers can be very under-capitalized. They are often unable or incentivized to comply with many regulations. Furthermore, an institution can fully participate in the crypto space without being headquartered in the US or tied to any specific nation-state.

You can criticize those characteristics of the market. They are going to mean a radically different set of regulatory constraints anyway. They also mean that some types of securities (if it’s appropriate to call them that) can be issued much cheaper than before.

Given this reality, shouldn’t the regulations be changed, and substantially? This may include some areas where regulation is even stricter, although general regulations are likely to become more flexible. Regulators will have to learn to live with a more decentralized market structure that is lower cost and harder to control. It is common sense that when software can replace large capital investments, regulations should change, even if observers disagree on how to do so.

Unfortunately, the regulatory process is static and usually changes slowly. Regulatory agencies often maintain the status quo until it is no longer sustainable. One of the benefits of regulatory arbitrage is that it forces your hand and creates a new equilibrium.

Even if you think the current regulations are appropriate, you must recognize that they are also the product of previous episodes of regulatory arbitrage: in the 1980s, for example, junk bonds helped circumvent some equity regulations. Regulatory arbitrage has long been a means by which regulations are kept at least somewhat up to date.

Coming back to the example at hand: it is true that many crypto token schemes are marketed under false pretenses or are part of a “pump and dump” strategy. These negative aspects of the token phenomenon should not blind us to its possible benefits as a new method of raising funds or using the markets to value projects. Many valuable innovations (railroads and the Internet come to mind) were also affected by investor fraud early on.

The argument is not, to be clear, that regulatory arbitrage is always a good thing. It can lead to regulatory overreaction or, conversely, to regulatory loopholes that remain too long and allow persistent fraud or systemic risk. The argument is that, fundamentally, regulatory arbitrage is part of a process that leads to lower costs, more innovation and better rules.

People often ask me what cryptocurrencies are for. It’s good for a lot of things, and I’m happy to mention a few, but surely one of its least appreciated benefits is that it’s a form of regulatory arbitrage.

More from Bloomberg’s opinion:

• Be Thankful for Crypto’s Timely Crash: The Publishers

• Crypto loves its shadow banks: Matt Levine

• This crypto winter will be long, cold and hard: Jared Dillian

This column does not necessarily reflect the opinion of the editorial board or of Bloomberg LP and its owners.

Tyler Cowen is an opinion columnist for Bloomberg. He is a professor of economics at George Mason University and writes for the Marginal Revolution blog. He is the co-author of “Talent: How to Identify the Energizers, Creatives, and Winners Around the World.”

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