On March 9, 2022, President Biden signed an executive order (“the Order”) requiring federal agencies to submit reports on how cryptocurrencies relate to various issues, including money laundering, investor protection, international cooperation, central bank digital currencies (“CBDC”), and systemic risk. Here, we offer some perspective and suggestions on those issues.

First, consider money laundering. Typically, anti-money-laundering regulation aims to block money received from crime or terrorism from flowing into traditional financial institutions. Cryptocurrencies create concerns because they can be purchased (more or less) anonymously and without intermediaries. That raises two questions: (1) who should regulation target in the absence of a central authority, and (2) how should money laundering through crypto be deterred? One possibility, highlighted by Jabotinsky & Lavi, is to target crypto-exchanges – online platforms for trading cryptocurrencies – or other service providers (e.g., firms offering a “crypto wallet” or issuing new tokens). Most crypto-exchanges are centralized, managed by an entity with control over the platform. This allows regulators to impose bank-like obligations, such as “Know Your Client” procedures, on the exchanges. The EU seems to be going in that direction, adopting anti-money-laundering directives and regulatory proposals (e.g., “MiCA”) targeting exchanges. However, people could respond by simply switching to decentralized exchanges, which operate automatically (and without direct control by anyone). Then, one would need to target entities profiting from (rather than controlling) the trade, e.g., by holding them liable for facilitating criminal activities,

A different approach is to rely on general deterrence concepts by improving monitoring (e.g., using AI algorithms that identify suspicious transactions) and seizing tokens related to criminal activity. A major obstacle to that is pseudo-anonymity: People can hold cryptocurrencies in an online “wallet” without being recorded as the owner. One possible response is to provide law enforcement officials with tools to unmask the identity of owners. For instance, regulation can obligate token-issuers to add a line of code to every new token, which would generate an unmasking mechanism, conditional on a court order. Ideally, judges could feed such orders directly to the blockchain, avoiding the need for redundant interim steps. To add such codes to existing tokens, one could use so-called “hard-forks”: radical changes to the digital protocol that would adjust tokens and make them compliant.

Second, as to investor protection, Jabotinsky identifies initial coin offerings (ICOs) and “initial exchange offerings” (IEOs) as the times when cryptocurrencies are particularly vulnerable to scams. Jabotinsky & Sarel elaborate on “pump-and-dump” schemes, where sophisticated investors pump up demand to lure uninformed investors and dump tokens once the price is high. The Order mentions the need for “disclosures of risks associated with investment,” but this would address only part of the problem, as pump-and-dump schemes seem more likely to occur when large investors gain enough market power to affect the price of a cryptocurrency. Instead of disclosure, a better response might be to target the large investors by, for example, barring them from acquirting a dominant position (EU’s MiCA follows that route).

A third issue raised by the Order relates to international cooperation. Global regulation seems promising, since local regulation might lead some countries to “free ride” on others’ regulations, creating legal uncertainty and forum shopping. One approach would be to grant an international body regulatory authority. One could also adopt international standards (as is done with some banking regulations, such as the Basel Accords). As discussed in a working paper by Jabotinsky & Yarkoni, this may lead to positive network effects. However, as pointed out by Jabotinsky & Sarel, unified standards might have the negative effect of increasing investors’ tendency to herd (i.e., to mimic each other’s investment strategies for behavioral reasons), which is especially problematic when pump-and-dump schemes occur.

A fourth issue concerns systemic risk: a collapse in the cryptomarket that cascades into a general financial meltdown. Jabotinsky & Sarel identify this as partly resulting from externalities (investors not caring how their crypto-trading affects other markets). In order to mitigate systemic risk, financial regulation can either reduce connections between markets (e.g., prohibiting investment firms from holding large stakes in cryptocurrencies or limiting insurance companies’ ability to insure crypto-assets) or introduce some technological stop-loss mechanism to restrict trading during crashes.

The Order also discusses CBDCs. On the one hand, if CBDCs become useful substitutes for other crypto-assets, they could mitigate systemic risk because of central bank control. However, the opposite could also occur: People might get used to crypto in the form of a CBDC and, therefore, become more likely to invest in other crypto-assets. It is then unclear which effect dominates. With regards to CBDC, it is also important to note that, if the government wants to move forward with the development of a token, that is best accomplished on a blockchain programed and owned by the government. The rationale is straightforward: the management of the U.S. economy is a public good, and hence should be publicly owned and managed. Otherwise, one runs a higher risk of malicious cyber attacks on the U.S. monetary system (e.g., by hackers backed by foreign governments) or an undesirable influence of private interests. A private blockchain might also contain back doors through which money could be stolen and which would not be easily detected by the government.

Finally, the Order defines cryptocurrencies broadly but refrains from explicitly addressing non-fungible tokens (NFTs). Regulatory questions surrounding NFTs typically focus on property rights (as discussed, e.g., by Sarel), but are far broader. The risk lies in the fact that NFTs allow creating unique tokens that can serve many different purposes, some of which are legitimate (e.g., art and music), but others nefarious and illegal (e.g., child pornography, theft, copyright infringement, and, as noted in a working paper by Jabotinsky & Lavi, even terrorism). Hence, ignoring NFTs leaves a regulatory gap that needs to be addressed.

This post comes to us from researcher Dr. Hadar Yoana Jabotinsky at the Hadar Jabotinsky Center for Interdisciplinary Research of Financial Markets, Crises and Technology (founded in collaboration with Tel Aviv University Law School) and professor Roee Sarel at the Institute of Law and Economics, University of Hamburg.