Calls For Cryptocurrency Regulation

On 8^th July 2022 Lael Brainard, Vice-Chair of the Federal Reserve governors gave a speech entitled Crypto-Assets and Decentralized Finance through a Financial Stability Lens in which she writes:

Distinguishing Responsible Innovation from Regulatory Evasion
New technology often holds the promise of increasing competition in the financial system, reducing transaction costs and settlement times, and channeling investment to productive new uses. But early on, new products and platforms are often fraught with risks, including fraud and manipulation, and it is important and sometimes difficult to distinguish between hype and value. If past innovation cycles are any guide, in order for distributed ledgers, smart contracts, programmability, and digital assets to fulfill their potential to bring competition, efficiency, and speed, it will be essential to address the basic risks that beset all forms of finance. These risks include runs, fire sales, deleveraging, interconnectedness, and contagion, along with fraud, manipulation, and evasion. In addition, it is important to be on the lookout for the possibility of new forms of risks, since many of the technological innovations underpinning the crypto ecosystem are relatively novel.

The G20's Financial Stability Board followed with FSB Statement on International Regulation and Supervision of Crypto-asset Activities making a similar pitch for regulation. As did the European Central Bank with Decentralised finance – a new unregulated non-bank system?. Paul Krugman asks the right question in Crypto Is Crashing. Where Were the Regulators?:

Traditional banking is regulated for a reason; crypto, in bypassing these regulations, [Lael Brainard] said, has created an environment subject to bank runs, not to mention “theft, hacks and ransom attacks” — plus “money laundering and financing of terrorism.”

Other than that, it’s all good.

The thing is, most of Brainard’s litany has been obvious for some time to independent observers. So why are we only now hearing serious calls for regulation?

Below the fold I argue that these calls are both very late, and are couched in self-defeating language.

These calls from the regulators are not that new. For example, on 1^st November 2021 the US Treasury issued President’s Working Group on Financial Markets Releases Report and Recommendations on Stablecoins saying:

The potential for the increased use of stablecoins as a means of payments raises a range of concerns, related to the potential for destabilizing runs, disruptions in the payment system, and concentration of economic power. The PWG report highlights gaps in the authority of regulators to reduce these risks.

To address the risks of payment stablecoins, the agencies recommend that Congress act promptly to enact legislation to ensure that payment stablecoins and payment stablecoin arrangements are subject to a federal framework on a consistent and comprehensive basis.

According to the FT, Treasury claimed it would take direct action if congress failed to act. But congress was already failing to act. Nearly a year earlier, on 2^nd December 2020 Representatives Tlaib, García and Lynch had introduced the Stablecoin Tethering and Bank Licensing Enforcement (STABLE) Act to subject stablecoin issuers to banking regulation. Did Treasury take direct action? Not so much.

When the bill was introduced USDT and USDC together had issued about $23B, when the Treasury called for regulation they had issued about $105B — about $7.5B/month. Combined issuance peaked at around $132B before the Terra/Luna collapse since when it has declined to $122B, still more than 5 times the amount when the bill was introduced. USDT has suffered a marked loss in market share to USDC, whose claims of backing are deemed more credible, which in itself suggests the need for regulation.

It may be that the regulators' calls for regulation are intended to deflect blame for inaction by pointing fingers at the legislators. But if not, regulators are making a set of fundamental mistakes:

1. By saying the discussion, as Brainard does, is about "digital assets" or as others do, about "digital ledger technology" or "blockchains", the regulators are adopting the crypto-bros' frame. These terms conflate two completely different technologies; permissioned or centralized systems with an obvious locus of control to which regulations can be applied, and permissionless or decentralized systems which claim to lack a locus of control, and thereby to be immune from regulation.
   
   The major design goal of permissionless cryptocurrencies such as Bitcoin and Ethereum was to escape regulation; conflating them with permissioned systems allows the latter to claim immunity from regulation because they are "digital assets" just like Bitcoin. Regulators should focus the discussion on permissionless systems, and in passing mention that existing regulations apply to permissioned systems.
   
   
2. In focusing on permissionless systems, regulators again accept the crypto-bros' frame by accepting the claim that they are "decentralized" and thus lack loci of control to which regulations can be applied. As has been obvious all along, but has recently received support from Trail of Bits and Prof. Angela Walch, these systems in practice do have loci of control, and use the claim of "decentralization":
   

   as a veil that covers over and prevents many from seeing, ... the actions of key actors within the system.

   Regulators should not use the term "decentralized" but should instead focus on the many ways in which permissionless systems are in practice centralized, targeting these loci of control for regulation. Notice how the "digital asset" framing prevents them doing so.
   
   
3. Regulators typically start the way Brainard does, by praising the promised benefits of cryptocurrency "innovation" such as:
   

   increasing competition in the financial system, reducing transaction costs and settlement times, and channeling investment to productive new uses.

   Again, buying in to the crypto-bros' framing in this way is counter-productive for two reasons. First, permissioned blockchain technology is thirty years old, and permissionless blockchain technology is not that innovative either; Satoshi Nakamoto simply assembled a set of well-known techniques to implement a cryptocurrency. Second, the products built on these technologies are not at all innovative, they simply replicate existing financial products without all the pesky regulation that would prevent their promoters ripping off the suckers.
   
   

   

   Avg. $/Transaction

   Regulators should avoid any reference to pie-in-the-sky potential benefits and argue that permissionless systems are necessarily less efficient and slower than centralized systems because of the cost and time overhead of the underlying consensus mechanism. And that they are less secure because of the risk of 51% attacks and their increased attack surface.
   
   

   

   Median Confirmation Time

   They can support this argument by pointing out that over the last year (a) the average Bitcoin transaction cost has varied between $50 and $300, (b) the median time to six-block finality has varied between 24 and 80 minutes, and (c) the Bitcoin network is processing less than five "economically meaningful" transactions between individuals per minute. These are numbers that would not strain a centralized system running on a Raspberry Pi. Note again how the "digital assets" framing prevents them from making this argument.
   
   

Permissionless cryptocurrencies were designed to evade regulation, so fighting them on their own "decentralized" ground isn't a winning strategy. Permissioned cryptocurrencies arose because the permissionless systems were so slow, inefficient and unwieldy; lumping them together with permissionless systems obscures their vulnerability to regulation, and the permissionless systems' weak points.