In January, the MIT Digital Currency Initiative (DCI) welcomed Gary Gensler as a collaborator and senior advisor. Gensler previously served as the chairman of the Commodities Futures Trading Commission, a regulatory body that will play an important role in the future of cryptocurrencies. One of the goals of the DCI is to serve as a neutral voice and facilitator of thoughtful conversation on technology and policy.
This week my colleague Gary Gensler was profiled in The New York Times talking about how Ethereum and Ripple should be classified as securities. I’ll defer to others on the letter of the law, but I think we should have a conversation about how cryptocurrencies and tokens should be regulated. It’s not as clear cut as exempting the technology from regulation entirely or, at the other extreme, following the existing regulation to the letter of the law. We need to bump up a level and revisit how to achieve our original public policy goals in a new paradigm.
Goals of financial regulation
In finance, regulations create clarity that facilitate participation. They are also how we protect investors and maintain market integrity—two important objectives, which the current trends of token offerings and cryptocurrency exchanges don’t fully achieve. When these goals aren’t met, investors can be defrauded and will have less confidence overall. There have been a slew of scams and frauds with initial coin offerings (ICOs). Even when an ICO is not an outright scam, it’s clear that there is not as much disclosure as there should be for the amounts being raised, and many ICOs are skirting securities law.
How regulation can help and harm new technologies
It’s important to note, however, that regulation can have a significant impact on how new technologies develop. Whether that’s constructive depends on how the regulations are designed and implemented. Sometimes regulation can help new technology flourish: Having space to experiment was critical for the development of the Internet.
The 1998 Internet Tax Freedom Act that protected the Internet from sales tax was an important regulatory move by the U.S. government that contributed to innovation in the budding ecommerce sector. Today, net neutrality is a hotly debated topic which can, if the government rules appropriately, protect startups and small projects against incumbents trying to limit their innovation. Other times, regulation can be a hindrance to development. Copyright, for instance, was implemented in a heavy-handed way on the Internet and continues to hamper access to knowledge and the realization of some of the most exciting attributes of the Internet’s power to allow people to collaborate.
When it comes to cryptocurrencies, the challenges for regulators to find the right balance are especially acute. Part of the reason the Internet flourished in the U.S. instead of Europe was because of a light regulatory touch. In some cases it can be onerous, unnecessary, or simply impossible to comply with the letter of the law in a decentralized system.
Cryptocurrencies are creating a new regulatory paradigm, and while regulation is important for this space it would be unfortunate if over-regulation caused exciting projects to move outside the U.S. or for us to enter a prolonged “Crypto Winter.” If a space is too restricted, then smart people leave to work on other areas, investment is reduced, and the pace of development slows. That said, the time after a bubble can be productive.
A technology designed to resist regulation
Even more interesting, I think much of this technology will resist being regulated in the current regulatory paradigm, or might require completely different types of regulation; sometimes, regulation is built in to technology. One of our challenges is figuring out which existing regulations should apply and which are no longer effective in helping us achieve our policy goals. For example, much of existing regulation is based around the existence of intermediaries, such as exchanges and custodians. In truly decentralized networks, there’s no single entity to track and audit and there’s no CEO to put in prison. But, as in Bitcoin, the network can transparently maintain records and transfers, and everyone can audit and validate.
One example I find helpful to illustrate how technology can self-regulate is that of transfer agents. Transfer agents are typically required when dealing with publicly-traded securities, and there are pages and pages of regulation about what qualifies a transfer agent for its responsibilities. This regulation is written with some higher-level goals in mind; for example, one job of a transfer agent is to assign rights and to track who owns what to prevent double spending. This is something a blockchain does trivially. Another goal of a transfer agent is to identify buyers and sellers in order to help prevent money laundering. Identity looks different in a blockchain world; no matter what course we take to solve that problem, it’s clear that in the new space the responsibilities of a transfer agent should change.
There are currently more questions than answers, and we must start a dialogue. What does custody mean when funds are locked in a payment channel requiring multiple signatures, some with keys in cold storage? Who is the management team in a decentralized network that can be forked at any time? Should we define how to execute forks responsibly? How do you regulate an exchange when exchanges are replaced by protocols? How can we leverage cryptographic protocols to prove compliance without exposing customer data?
It seems that U.S. regulators are viewing ICOs as securities; this doesn’t mean all tokens are securities. People can disagree on whether or not this is a correct reading of the law, and work to update the laws, but we should not stick our heads in the sand.
Regarding cryptocurrencies and blockchain technology more broadly, there are three important, interrelated things to consider: (1) Our high-level public policy goals like investor protection and market integrity, (2) the specific regulations we use to try to achieve them, and (3) the way market participants actually implement systems that comply with those rules. Right now, the last two are very intermingled. The laws and regulations are prescriptive; they contain many implementation details that apply to the old world but should not be readily applied to the new one.
We should figure out how to bring projects in alignment with public policy goals, but note that asking a project to come into full compliance with all of the existing laws just doesn’t make sense; sometimes the technology can self-regulate. And as with the Internet, there’s an enormous opportunity here to create regulation that helps innovation. This is something that doesn’t happen often: a chance to revisit the details of achieving the core goals of public policy in finance.