Brian Feinstein and Kevin Werbach | Knowledge@Wharton
April 27, 2021
The confirmation on April 14 of Gary Gensler as chairman of the Securities and Exchange Commission has fueled worries that increased regulation of cryptocurrencies would hurt trading volumes and prices and stifle innovation in the nascent segment, and prompt industry participants to flee to less stringent jurisdictions. However, those fears are unfounded, and tighter regulation could purge the industry of bad actors and engender trust, which in turn would help it grow, according to Brian Feinstein and Kevin Werbach, Wharton professors of legal studies and business ethics.
The day of Gensler’s confirmation coincided with the $85 billion IPO of Coinbase, the largest cryptocurrency trading platform in the U.S. The Coinbase IPO was “a watershed moment for an industry that began a decade ago as an experiment in digital money,” according to The Wall Street Journal. Cryptocurrencies will be high on Gensler’s agenda. He had described them as “catalysts for change” in his confirmation hearings, but also said they raise “new issues of investor protection.” In the least, he promised that the SEC would provide “guidance and clarity” on regulating the cryptocurrency market.
“With the confirmation of a new SEC chair who has his eye on cryptocurrency, we can expect the imposition of securities law framework onto cryptocurrencies in the U.S. and new investor protection measures,” Feinstein said in an interview on the Wharton Business Daily radio show on SiriusXM.
A Wall Street Journal editorial titled “The SEC’s Cryptocurrency Confusion” echoed the concerns raised by critics who are worried about regulatory overreach, stating that “regulators are creating danger for currency developers and retail investors” in the cryptocurrency market, the size of which it estimated at $2 trillion in market capitalization.
Cryptocurrency regulation is clearly evolving. Former SEC Chairman Jay Clayton had stated in 2019 and 2020 that bitcoin and ether (a cryptocurrency of the Ethereum blockchain network) are not securities, thereby exempting them from regulations governing securities markets, although no formal rules about their exemption have been established, according to the Journal editorial. A day before Gensler’s confirmation, SEC commissioner Hester Peirce released a proposal for discussion that seeks to provide digital currencies a three-year exemption from most securities regulations while they develop their networks.
“With all this interest among regulators, crypto proponents fear that new regulation will spook market participants and drive down the price [and volumes] of cryptocurrencies and drive all of that trading activity offshore,” said Feinstein. “And that other countries will reap the benefits of the trading, while the risks are still imposed on a global level.”
Not Spooked by Regulation
Feinstein and Werbach put those concerns to the test and examined if price declines follow cryptocurrency regulation in a country. “The answer there is, ‘Almost always not,’” said Feinstein. That finding was the result of an exhaustive study by Feinstein and Werbach of trading activity at several exchanges worldwide following key cryptocurrency regulatory announcements.
Their study found “almost entirely null results,” they wrote in an article published April 25 in the Journal of Financial Regulation. “From the creation of bespoke licensing regimes to targeted anti-money laundering and anti-fraud enforcement actions, as well as many other categories of government activities, we found no systemic evidence that regulatory measures cause traders to flee, or enter, the affected jurisdictions.” Their findings “at last provide an empirical basis” for regulation of cryptocurrency trading, they added.
“Crypto enthusiasts assert that limited regulation encourages trading on domestic exchanges and thus attracts development activity around a promising frontier technology, while unfavorable regulations will cause trading to move offshore,” Feinstein and Werbach wrote in a recent opinion piece in The New York Times. “But that wasn’t the case in multiple countries, including the U.S., that are home to large and active cryptocurrency exchanges. Despite concern from some in finance that strong regulations would dampen enthusiasm for crypto or push trading to more laissez-faire countries, we found few hints of price movement around regulatory events and no evidence of capital flight.”
“When a country imposes a new restriction, we don’t see crypto traders fleeing that jurisdiction for more permissive countries.”–Brian Feinstein
For sure, the cryptocurrency market takes a hit when regulators crack down on illegal activities. “When countries enact anti-money laundering measures, we can see price declines, and that’s obvious to the extent that people using cryptocurrencies for illicit reasons are trading them,” said Feinstein. “But across all the other categories of regulation — think tax treatments, securities law treatments, cyber security and anti-fraud measures — none of that affects price [or] trading volume. So when a country imposes a new restriction, we don’t see crypto traders fleeing that jurisdiction for more permissive countries.”
Regulators also help temper cryptocurrency prices when they purge the market of illegal activities and thereby provide a safer environment for genuine investors. “[With regulation], a group of bad actors — people who are interested in using cryptocurrencies for money laundering and other sorts of illegal activities — would be spooked,” said Feinstein.
“But another group of investors is getting more and more prominent, and they are legitimate investors, from day traders to major investment firms,” he continued. “Those investors get more comfortable with cryptocurrencies, as its regulation drives out some of those bad actors.”
The valuation of Coinbase is an example of how regulation can inspire confidence, Feinstein said. (The share price of Coinbase has dropped since its IPO, taking its market capitalization down from $85 billion to $60 billion, but investor sentiment continues to be strong.) “[That valuation] is possible in part because they operate in the U.S., so investors are confident that their trades on Coinbase are subject to U.S. regulation, which tends to be quite strong,” he added. “With anti-fraud and cybersecurity measures, investors can be assured that trades on a U.S.-based exchange are more secure and safer than on some other jurisdiction’s exchanges.”
Shape of Things to Come
Feinstein said he expected to see “a divergence” between the U.S. and some other countries in how they approach cryptocurrency regulation. “Across the globe you see increased regulatory interests following increased investor interests,” he noted. “You’ll see Western countries moving towards more traditional securities regulation and other authoritarian countries banning private cryptocurrencies to try to create their own surveilled central bank cryptocurrency.”
“Across the globe you see increased regulatory interests following increased investor interests.”–Brian Feinstein
“The U.S. seems to be moving forward towards creating smart regulations that build trust. They’re focused on cybersecurity, anti-fraud, and other investor protection measures as you see with traditional securities,” Feinstein continued. “Another group of countries led by China and Turkey sees cryptocurrency as a strategic threat.”
China has in recent years banned cryptocurrency-based fundraising and trading, but is now developing its own digital currency. “They can see at a granular level what people are buying if they are using a currency that’s on the blockchain and controlled by the central government,” said Feinstein. Earlier this month, Turkey moved to ban cryptocurrencies as currency traders fled the lira to bitcoin and other foreign currencies.
Cryptocurrency traders left China for other markets after it imposed restrictions, but that did not affect prices or volumes at a global level, Feinstein continued. “Part of that lukewarm reaction to the ban is that it’s relatively easy for people in China to get around that ban by using VPNs (virtual private networks that mask user locations) and other kinds of spoofing techniques.”
In some cases, state regulators are taking the lead in protecting cryptocurrency investors, Feinstein said. He pointed to the recent investigation and punitive actions by the New York Attorney General into Tether, a cryptocurrency trading platform. “New York recognizes how having regulations that facilitate cryptocurrency trading and encourage exchanges to locate in its state can have real positive spillovers for its economy.” To build on their relationship with regulators, cryptocurrency firms and markets ought to focus on the fundamental issues such as ethical conduct, he noted.
Feinstein had some advice for regulators on how they could approach cryptocurrencies. “First, they shouldn’t worry that their actions will drive offshoring of [cryptocurrency] activity,” he said. “Instead, they should be focused on regulations that increase investor trust in their jurisdictions.”