Members of Congress and financial regulators from the Federal Reserve, U.S. Treasury, SEC, CFTC, and CFPB appear set on regulating the crypto trading system (traded coins and associated marketplaces, exchanges, brokerages, lending, staking, derivatives, intermediaries, and enablers) as part of the traditional financial services system. Policy discourse on this topic has centered around which – rather than whether – financial regulators should be in charge of crypto trading. In advancing this view, Congress and the regulators appear to be following a path laid out by crypto companies seeking legitimacy through inclusion (on their own terms), in regulated finance.
Supporters of “crypto inclusion” envision crypto trading flourishing under the imprimatur of financial regulators empowered to police markets for improper activities. They argue that individuals and institutions would feel confident investing in crypto coins in a familiar, regulated environment. SIPC-type protections (and FDIC-like protections where banks were involved) would ensure that investors would not lose their coins or cash if their providers failed.
The core assumption behind this view is that crypto coins are financial assets – like shares of stock, bonds, or commodity contracts – though particularly complicated ones housed on blockchain ledgers. That assumption, however, risks luring policymakers into a potentially catastrophic category error. Crypto trading isn’t economically similar to any part of the traditional financial services system and serves none of the productive purposes that define finance. In fact, despite the “dress-up” clothes it wears, crypto trading isn’t finance or financial services at all. It is a game emulating finance – or, perhaps more accurately, gambling emulating finance.
It is important not to let those advocating for crypto trading to be treated as financial services cloud our view of this critical categorical distinction. To avoid financial contagion and unnecessary risks to the traditional financial system, the best course of action is twofold. First, crypto trading should be separated as completely as possible from traditional financial services. Second, an effective non-financial regulatory regime should be established under new and existing state and federal laws to protect consumers from the much smaller but still meaningful risks that crypto trading will pose once that separation occurs.
Crypto and the Purpose of Finance
So why isn’t the crypto trading market finance? Like finance, it’s made up of “exchanges” and “brokers” and “lenders” and “deposits” and “hedge funds,” all busily trading coins and derivatives on Wall Street and its virtual extensions. Even the people doing the trading are often the same.
The answer is simple. Crypto trading is wholly unconnected to the productive purpose that defines finance: helping businesses, individuals, and governments raise, save, transmit, and use money for socially and economically useful ends. Banks allow savings to be pooled and turned into loans for fruit orchards, solar farms, automobiles, small business, and housing. The securities market supports the needs of larger businesses and the government in raising substantial amounts of capital and helps make the banking process more efficient by distributing risk broadly. Insurance and derivatives markets help manage risk. Participants in finance seek to maximize profit, of course, but in the context of a larger social and economic purpose. Crypto trading, by contrast, does not, and cannot, produce any economically or socially productive outcomes. It is, as Seinfeld’s George Costanza might have said, finance about nothing. And because it serves none of the purposes of finance, the law and policy should not recognize it as finance.
Despite its tendency toward periodic excess, traditional finance has largely served its purpose well. Its emergence played a leading role in economic growth and social advancement in capitalist economies. It goes wrong when it loses sight of that purpose. The further a financial instrument is from its reason to exist, the riskier it makes the system and the more likely speculative bubbles and crashes become. The CDO Squared market prior to the 2008 financial crisis is just one example of many.
But that is also why the finance industry is heavily regulated. Its tendency toward excess and speculation is well understood, and the need to control the social and economic costs incurred when finance becomes unmoored from its purpose and propagates speculative bubbles have been demonstrated repeatedly.
Adverse Consequences of Treating Crypto Trading as Finance
If crypto trading were to be integrated into traditional finance, the risk of systemic contagion, which regulators’ caution has largely avoided, would immediately become real and perilous. Crypto coins would become part of investment, pension, and retirement portfolios, which are critical pieces of people’s financial support structure. Unexpected connections and hidden leverage would arise, creating the types of systemic vulnerabilities that led to the 2008 financial crisis. Newly empowered regulators would be faced with the arduous task of taming the crypto Wild West and forcing participants into compliance with “traditional” standards, at great cost in time, money and attention diverted from other priorities. All this would be exacerbated by the “stateless” status of so much of crypto trading and the inability of our current regulatory structure to deal with offshore and virtual crypto trading providers. Avoiding excessive systemic risk would require, at the very least, a massive and likely futile attempt – given the regulatory arbitrage built into crypto trading – by regulators to reduce risk-taking in crypto markets.
Most important, crypto trading would inevitably come to benefit, like other parts of our traditional financial system, from the Federal Reserve’s ever-expanding role as lender of last resort. It would also become part of the calculus of the FSOC in its efforts to control systemic risk.
None of this sounds like good policy. Instead, Congress and regulators should develop a policy and legal framework around crypto trading as it exists.
Crypto Trading as E-Sports Gambling
Those playing the crypto trading game (as institutions or individuals) are seeking financial rewards. They contribute fiat currency and make direct (DeFi) or indirect (CeFi) bets in the hope that they will beat other players and ultimately convert their winnings back to fiat currency. The best analogy to crypto trading is probably the relatively new phenomenon of professional e-sports (electronic sports) gambling. E-sports are organized, multiplayer videogames between individual players or teams. E-sports gamblers bet in real-time, online, professional competitions. In the U.S., they arose from online multiplayer games where “skins” (providing enhanced game capabilities) were purchased from game developers to use in games and enhance player outcomes. They have since developed into legal (outside the U.S. and in many U.S. jurisdictions) cash gambling on outcomes and interim developments in professional gamer competitions streamed online, such as the well-known League of Legends competition.
One way to think about crypto trading is as a multi-player e-sports gambling competition based on an emulation of a financial trading market, deploying all the weapons of modern financial engineering – derivatives, options, high-speed execution etc. and all the tricks traders use in pursuit of gain. Because games and gambling reward risk-taking to make play more exciting and the potential prizes more enticing, it’s not surprising that the “finance” that the crypto game emulates is the type that society wants less of – the highly-levered and opaque type that creates financial crises. Crypto trading also shares a “closed loop” structure with gambling. Gamblers bring money – fiat currency – into a casino or online gambling game, wager on outcomes, and convert the winnings or losings back into money. The crypto trading system operates in essentially the same way.
Why is this particular form of gambling game so attractive now? For one group, the attraction is obvious. Crypto trading emulates the purest, most solipsistic form of finance. Its markets are driven by trading supply and demand, although both are heavily manipulated by intermediaries and traders unencumbered by fairness rules. Institutional quants and traders seem to love it because it can be modeled and played without distraction from the outside world – things like wars, weather, regulators, and the like don’t matter to crypto traders. New trading approaches can be invented, tried quickly, and discarded without fear of ethical or legal repercussions. It’s a trader’s paradise.
The crypto trading phenomenon also seems to be, as others have noted, related to social and economic trends that include the legalization and legitimization of gambling in the United States, historically low yields on bank deposits, and growing levels of wealth and income inequality. Three trends seem particularly closely correlated with crypto trading because they involve many younger men of similar social status: the rapid rise of sports betting and e-sports as new forms of legal gambling, the emergence of a broad “gamer” culture, and a “conspiracy theory” mindset about the world in general and traditional financial services in particular.
But whatever the reasons for its popularity and despite its façade of traditional finance nomenclature, one thing is certain: Crypto trading is not providing “finance” or “financial services” to anyone or delivering economically or socially productive investment.
Creating an Appropriate Crypto Policy
If crypto trading is a form of gambling, how should policy deal with it? There are three basic choices. First, Congress and financial regulators could include crypto trading within the regulatory perimeter of traditional finance through new legislation or the enforcement of existing rules. This post argues that this approach would be based on a fundamental category error and pose serious risks to financial stability.
Second, Congress could prohibit crypto trading entirely, as China has done. In a country like the U.S. where gambling of all sorts is permitted, there would not appear to be any principled justification for distinguishing between crypto trading and other forms of legal gambling by banning it entirely. Not surprisingly, there are no serious proposals in Congress to do so, although it would appear to be possible under the U.S. Constitution’s Commerce Clause.
The third and last alternative is a clear and managed separation of both risk and regulation. Crypto trading should be separated as completely as possible from the traditional financial system. Crypto trading should also be placed outside the perimeter of financial services regulation, and an effective non-financial regulatory regime should be established to protect consumers under state and federal law.
This separation contemplates that crypto trading would be completely isolated from the finance and banking systems. Banks, brokerages, investment advisers, money managers, and retirement funds – any entity or affiliate that is part of the traditional, regulated, financial infrastructure – must be prohibited from participating in, serving or supporting participants in, or adding leverage to crypto trading in any way. This will probably slow, or even reverse, growth in crypto trading. Given the many downsides of gambling, this is probably a good thing.
At the same time, the separated crypto-trading system should be excluded from the federal financial-services regulatory framework (the SEC, CFTC, banking agencies, and CFPB) and its state regulation equivalents. Crypto trading should be regulated for what it is – gambling emulating finance and not what its advocates say it is or what people believe it to be.
Comprehensive financial regulation exists for reasons that generally do not apply to other areas of the economy. It is necessary because traditional finance plays a vital role in supporting productive economic activity (and also because it creates associated systemic risks), and it makes no sense to impose the same regulations on the non-financial activity of crypto trading, a form of gambling that has no meaningful effect on the real economy. To put it another way, crypto trading is much closer to gambling than it is to finance, and yet no one has suggested that gambling should be deemed “financial” and regulated by the SEC, CFTC, CFPB or banking regulators.
There is one big exception to keeping crypto and financial regulation separate. So long as playing the crypto-trading game is legal, individuals will need to be able to transfer money into and out of the crypto-trading system, just as they do when they use cash or a debit card to make bets in a casino. That will require bank involvement, directly or indirectly, and raises technical problems about how crypto-to-fiat transfers system would be managed. Ironically, this might create a business case for regulated, fiat-backed, money-market fund equivalent stablecoins as the bridge between the two systems.
Regulating Crypto Trading Outside the Perimeter
If crypto trading isn’t regulated by financial regulators, then how should it be controlled? Fortunately, even without new laws, eliminating supervisory oversight by financial regulators does not mean that the crypto trading will be unregulated or that customers, particularly consumers, should or will go unprotected.
Crypto trading entities that are regulated as money transmitters under state law will remain subject to those laws. Federal BSA/AML and money-service business rules will also continue to apply. State laws specifically regulating crypto activities outside of a “blue sky law” securities/commodities framework, like New York’s Bit License law, shouldn’t be affected as they are tailored laws establishing consumer and business practice constraints on crypto traders and don’t rely on traditional financial services definitions to create jurisdiction.
Consumers hurt by abusive practices in crypto trading will continue to have recourse to state fraud and consumer protection laws, just as they do for any non-financial consumer activity, including traditional and online gambling, sports betting, and the like. At the federal level, the FTC’s jurisdiction over crypto traders and their enablers will be unaffected. That agency has the power to punish fraud and unfair or deceptive practices wherever they occur, and there is no reason to believe that it will not use that authority to protect crypto-trading consumers.
While these existing authorities appear adequate to protect consumers in theory, they may not be enough to protect them in practice, given the level of fraud that seems endemic in the crypto trading system and the lack of crypto-specific laws, outside of a few states like New York, that specifically target crypto trading abuses. State legislatures and Congress will need to closely monitor consumer impacts under the new system and add targeted consumer protections specific to crypto trading if the industry continues to grow even when separated from traditional financial services. An interesting issue, beyond the scope of this post, is whether state gambling laws could or should be interpreted or expanded to cover crypto trading.
Crypto and Finance After the Separation
Clearly separating crypto from financial services will bring some immediate benefits. Individual participants in crypto trading will still be able to use crypto ”lenders” and “brokers” and “exchanges” to gamble on crypto coins, so long as moving fiat money in and out of the crypto trading system is the extent of any connection with the real, regulated financial system. The interminable arguments about whether a coin or token is a security or a commodity or whether banking or securities or commodities regulation is appropriate for crypto trading will be a thing of the past. Financial regulators can go back to regulating traditional finance, which has plenty of problems that need attention.
.
There will be some drawbacks for crypto traders, enablers of crypto trading, and traditional finance players with ambitions in crypto trading. No crossover means no crossover. While individuals will be allowed to play in both areas, institutions – banks, brokerages, pension funds, custodians, and their affiliates – must choose to be all in with either traditional finance or crypto trading. We can’t have distressed crypto-trading firms or enablers causing real-world crises by liquidating assets held in banks and brokerages to cover losses. Nor can we have affiliated entities operating on both sides of the divide, as there is a long history suggesting that risks can’t be effectively segregated in commonly controlled enterprises. Luckily, the risk management infrastructure of the regulated financial system should be up to the task of anticipating and controlling individual exposure if it develops, so long as institutional risk is minimized.
Perhaps the biggest advantage of this exclusionary approach is that there will be no need for the Federal Reserve to act as a lender of last resort for crypto markets or for the FSOC to concern itself with crypto trading risks. What will the Fed or FSOC do if crypto trading firms collapse, and the crypto trading market blows itself up in a repeat of the FTX experience? Nothing. With no material connection between the crypto trading system and the real financial system, there will be no chance of contagion and no systemic risk to deal with. Individuals may lose out, but regulated institutions and the overall financial system won’t.
The biggest long-term challenge to the separation approach will be holding the line against inevitable attempts at encroachment and regulatory arbitrage by crypto traders claiming to be conducting finance instead of running a gambling game emulating finance. It will be a long, tough campaign for sure, but one worth fighting if it prevents metastasized crypto trading from causing the next financial crisis.
ENDNOTES
[1] Proposals currently under consideration include wholly new regulatory structures, revisions to existing regulatory jurisdiction and exhortations to enforce existing law within the perimeter without fundamental change. Bipartisan crypto bills could clarify current regulatory confusion – if they tackle Howey (2022) Davis Polk. Davis, Polk & Wardwell. Available at: https://www.davispolk.com/insights/client-update/bipartisan-crypto-bills-could-clarify-current-regulatory-confusion-if-they (Accessed: November 27, 2022).
[2]Ackerman, A. (2022) “Fed’s Michael Barr Says Crypto Turmoil Highlights Potential Risks to Financial System,” Wall Street Journal, 15 November.2022 https://www.wsj.com/articles/feds-michael-barr-says-crypto-turmoil-highlights-potential-risks-to-financial-system-11668516393.
[3] See, e.g., The Crypto Innovation Council. https://cryptoforinnovation.org/ and the Blockchain Association; https://theblockchainassociation.org/; Adrian, T., He, D. and Aditya Narain (2021) Global crypto regulation should be comprehensive, consistent, and coordinated , IMF. Available at: https://www.imf.org/en/Blogs/Articles/2021/12/09/blog120921-global-crypto-regulation-should-be-comprehensive-consistent-coordinated (Accessed: November 27, 2022); Kiernan, P. “FTX’s Collapse Upends Sam Bankman-Fried’s Washington Play” Wall Street Journal, 27 November, 2022.https://www.wsj.com/articles/ftxs-collapse-upends-sam-bankman-frieds-washington-play-11669545002?mod=hp_lead_pos11.
[4] Cf., the concept of congruent financial regulation, or “same activity, same risk, same regulation.” The principle, as defined by Metrick and Tarullo goes as follows: “Under this principle, the regulation of economically similar [emphasis added] activities would be coordinated across agencies, with the goals of minimizing regulatory arbitrage and ensuring that the social costs of systemic risk are internalized by private actors, regardless of their institutional form.”[1] nMetrick, Andrew and Tarullo, Daniel K., Congruent Financial Regulation (April 1, 2021). Available at SSRN: https://ssrn.com/abstract=3817621 or http://dx.doi.org/10.2139/ssrn.3817621.
[5] The dictionary defines a game as “an activity or sport usually involving skill, knowledge, or chance, in which you follow fixed rules and try to win against an opponent or to solve a puzzle.” Game definition and meaning | Collins English Dictionary. HarperCollins Publishers Ltd. Available at: https://www.collinsdictionary.com/dictionary/english/game (Accessed: November 27, 2022).
[6] The same kind of “trading bros” that work at traditional finance trading businesses are trading crypto,including some who worked at high-speed traders like Jane Street Capital and went on to found FTX and Alameda Research. Daniel Kuhn, X.L.and D.Z.M. (2022) Who’s who in the FTX inner circle, CoinDesk Latest Headlines RSS. CoinDesk. Available at: https://www.coindesk.com/layer2/2022/11/22/the-whos-who-of-the-ftx-inner-circle/ (Accessed: November 27, 2022).
[7] A good summary of the academic literature on the question of purpose in finance may be found at David Pitt-Watson and Hari Mann, The Purpose of Finance:Why Finance Matters:Building an industry that serves its customers and society, Pension Insurance Corporation, 2017. https://www.ucsia.org/wp-content/uploads/2020/11/the-purpose-of-finance-report-2017.pdf
[8] The usual reason cited for considering crypto trading to be a “financial” activity despite the lack of any tie to the productive purposes of finance is an analogy to commodities regulation of precious metals such as gold, which demonstrably have a price in the market higher than their value for industrial purposes. Commodities derivatives activity in general is clearly “financial,” as its purpose is tied to agricultural, mining, and other productive activities as well as to derivatives that serve the “real economy.” The argument that crypto should be treated like the “new gold” is specious, as the intangible value attributed to gold and its role as a store of value is a holdover from historic practice with no relation to modern economic activity. Gold is an exception based on ancient history, but there is no reason to use that exception to create new exceptions for crypto trading. See also, Pierre Vilar, A history of gold and money, 1450-1920 (1977).
[9] Kenneth S. Rogoff and Carmen M. Reinhart, This Time Is Different: Eight Centuries of Financial Folly. 2017.
[10] William N. Goetzmann, Money Changes Everything: How Finance Made Civilization Possible (2016).
[11] Stanford Rock Center (no date) Resource Library: Financial Crisis Inquiry Commission. Available at: https://fcic-static.law.stanford.edu/cdn_media/fcic-reports/ (Accessed: November 27, 2022).
[12] Johnson, K. (2022) US Bank Regulator Michael Hsu concerned about crypto industry risks, conflicts, Bloomberg.com. Bloomberg. Available at: https://www.bloomberg.com/news/articles/2022-10-11/us-bank-regulator-says-immature-crypto-industry-full-of-conflicts-and-risks?sref=pHjsxMFh (Accessed: November 27, 2022).
[13] In all likelihood, any regulator-driven risk reduction would reduce the attractiveness of the “game” and its financial rewards.
[14] Lipton, E. and Linvi, E. (2021) “Crypto Nomads: Surfing the World for Risk and Profit,” New York Times, 19 August.
[15] This risk reduction is ironically the best argument for the inclusion approach, although it could drive many crypto traders and their enablers out of business.
[16] E-Sports are completely legal in some states, e.g., Nevada, New Jersey, Tennessee, and West Virginia, regulated in some states and completely illegal in others https://www.jdsupra.com/legalnews/what-the-future-holds-for-esports-5332847/.
[17] There is even something called “GameFi” which makes the connection explicit. Fine, M. (2022) Leaders are leaving wall street for the high stakes world of Blockchain Gaming, Forbes. Forbes Magazine. Available at: https://www.forbes.com/sites/melaniefine/2022/10/30/leaders-are-leaving-wall-street-for-the-high-stakes-world-of-blockchain-gaming/?sh=5d146357980b (Accessed: November 27, 2022). Further research about the connections between the crypto trading phenomenon, game design, and social media may disclose deeper connections.
[18] “SEC Charges The Hydrogen Technology Corp. and its Former CEO for Market Manipulation of Crypto Asset Securities” (2022). Available at: https://www.sec.gov/news/press-release/2022-175 (Accessed: November 27, 2022). Auer, R., Frost, J. and Pastor, J.M.V. (2022) Miners as intermediaries: Extractable value and market manipulation in crypto and defi, The Bank for International Settlements. Available at: https://www.bis.org/publ/bisbull58.htm (Accessed: November 27, 2022). Lee, J. (2021) Research affiliates Quant warns of bitcoin market manipulation, Bloomberg.com. Bloomberg. Available at: https://www.bloomberg.com/news/articles/2021-01-14/research-affiliates-quant-warns-of-bitcoin-market-manipulation?sref=pHjsxMFh (Accessed: November 27, 2022).
[19] Fenich, G.G. (1996) A chronology of (legal) gaming in the U.S. – University of Nevada, Las … Available at: https://digitalscholarship.unlv.edu/cgi/viewcontent.cgi?article=1223&context=grrj (Accessed: November 27, 2022).
[20] Enrich, David “A Risky Wager: Key Findings From The Times’ Investigation of Sports Betting. New York Times, November 20, 2022.
[21] Video game culture, Wikipedia (2022), https://en.wikipedia.org/wiki/Video_game_culture; (last visited Nov 27, 2022).
[22] Stephen Diehl: Crypto is the commoditization of populist anger, gambling and crime, Henry Mance, Financial Times, November 20, 2022 https://www.ft.com/content/028e0109-6e87-42ed-8480-996cf645ce04.
[23] John, A., Shen, S., & Wilson, T. (2021). China’s top regulators ban crypto trading and mining, sending bitcoin tumbling. Reuters.com. https://www.reuters.com/world/china/china-central-bank-vows-crackdown-cryptocurrency-trading-2021-09-24/.
[25] Murphy v National Collegiate Athletics Association, 584 U.S. ___ (more) 138 S. Ct. 1461; 200 L. Ed. 2d 854.
[26]Versions of the third alternative have very recently been gaining traction in academic and nonacademic circles. Professors Cecchetti and Shoenholtz recently and colorfully suggested in the Financial Times that crypto trading should be kept outside of regulated finance and that we should “let crypto burn.” Robert Armstrong from that same newspaper added nuance to the argument by noting the need for consumer protections even if crypto were treated as non-financial in nature. Let Crypto Burn, Stephen Cecchetti and Kim Schoenholtz, Financial Times, November 17, 2022 https://www.ft.com/content/ac058ede-80cb-4aa6-8394-941443eec7e3; Don’t regulate crypto as finance, Robert Armstrong, Financial Times November 22, 2022.https://www.ft.com/content/ac058ede-80cb-4aa6-8394-941443eec7e3.
[26] This may seem a shocking idea given that public discourse on this topic has, as mentioned above, centered around “which” financial regulator should be in charge of crypto trading, and not “whether” any financial regulator should be involved. However, it follows logically from the conclusion that crypto trading is not actually a financial activity at all. It is important not to let crypto trading’s pose as “financial services” cloud our view of the critical categorical distinction we need to maintain.
[27] Nor should this proposal be viewed as a libertarian or free market argument for the deregulation of crypto trading activity. Crypto trading should be regulated because of its inherent risks. It should go without saying that bringing a nonfinancial activity inside the financial regulation perimeter to solve a non-financial problem isn’t good policy.
[28] Elliot Hentov and Jennifer Ale, A Financial Revolution in the Making: Mainstreaming Stablecoins. State Street Global Advisers, August 2022. https://www.ssga.com/library-content/pdfs/ic/stablecoin-whitepaper.pdf.
[29] (2022). Virtual Currency Businesses. Department of Financial Institution. https://www.dfs.ny.gov/virtual_currency_businesses.
[30] Zoltan, M. (2022). Cryptocurrency Scams in 2022 – Statistics & Trends. Privacyaffairs.com. https://www.privacyaffairs.com/cryptocurrency-scams-2022/.
[31] Davies, R. (2022). ‘Trading is gambling, no doubt about it’ – how cryptocurrency dealing fuels addiction. guardian.com. https://www.theguardian.com/technology/2022/jan/15/trading-is-gambling-no-doubt-about-it-how-cryptocurrency-dealing-fuels-addiction.
[32] McCormick, Liz, Treasuries Liquidity Problem Exposes Fed to ‘Biggest Nightmare’ Bloomberg, October 6, 2022. https://www.bloomberg.com/news/articles/2022-10-06/us-treasuries-liquidity-problem-exposes-fed-to-biggest-nightmare?sref=pHjsxMFh.
[33] An interesting question arises when the “individuals” are mega billionaires, e.g., Elon Musk. It may be necessary to limit individual exposures in some way so that the current generation of uber wealthy investors don’t create a financial crisis on their own.
[34] A few companies like Coinbase that have, in general, tried to play by the rules and operate a crypto trading business in the current, confused U.S. regulatory system will have to choose on which side of the wall their future business will plant its flag.
[35] There is, admittedly, a risk that the allure of gambling inside the separate crypto trading system becomes so great to the generation of gamer/traders raised during the crypto trading heyday that a material chunk of the risk capital currently supporting “real economy” options and derivatives migrates into the crypto ecosystem. In the unlikely event that this happens, Congress can reverse the trend. There may be some corporate losers as well.
This post comes to us from Todd H. Baker, a senior fellow at the Richman Center for Business, Law and Public Policy at Columbia Business School and Columbia Law School and a former senior bank executive and law firm partner.