Cryptocurrency: A Failed Regulatory Innovation

The cryptocurrency ecosytem passed an interesting milestone in mid-November when the SEC settled charges against two companies that had conducted ICOs. The SEC had previous taken action in connection with ICOs, but those were primarily textbook examples of fraud (guaranteed returns, founders absconding with proceeds, etc.) Those earlier enforcement actions effectively said "A con doesn't become legal simply because you slapped the label ICO on it."

This gave ICO advocates hope that "legitimate" ICOs would escape regulatory scrutiny. Outright fraud is more morally repulsive than technical violations of securities law, and the SEC's initial responses to ICOs focused on the outright scams. The November enforcement actions, however, demonstrate that the SEC takes security laws quite seriously. ICO proponents had framed them as a technical breakthrough that would permit projects to raise capital in a low-friction way. In light of the SEC's decision, it's perhaps better to primarily view them as a (failed) regulatory innovation that lowered friction by simply ignoring the relevant laws.

This is a common theme for applications of cryptocurrency. Enthusisasts talk about blockchain as a technical breakthrough that allows for a pseudonymous, decentralized, and censorship-resisitant currency. And as a software engineer who has worked with Bitcoin, I appreciate aesthetically how elegantly Bitcoin's protocol leads to those properties. But technical sophistication doesn't lead to billions of dollars of market cap. In the Bitcoin case, that value followed from properties that facilitated skirting regulations or outright breaking the law. After all, the first "killer" use for Bitcoin was anonymously buying hard drugs from strangers on the internet. That use case alone was enough to drive Bitcoin to several billion dollars in value.

Similarly, Bitcoin enthusiasts continue to tout how it allows anyone to anonymously and frictionlessly send money to anyone in the world. And indeed, banks haven't built consumer-facing ways to easily send money to people in other countries. But moving money across borders isn't a technical problem. Certainly Chase has no problem doing so when I use my ATM card in Tokyo. The bigger hurdle is compliance with regulations and specifically anti-money laundering (AML) laws. Indeed, while it remains technically trivial to send Bitcoin in any country, it's become steadily harder to convert bitcoin to currency in countries that enforce typical banking regulations.

The association of cryptocurrency with illegal activity isn't a reason to outright dismiss the technology. Many of the most popular tech companies today started off by facilitating illegal activity. Uber and Airbnb are obvious examples, and Youtube was a mess of pirated content in its early days.

But companies that overtly break the law are in a precarious position. The success stories are the companies that meet authorities in the middle. Uber's overwhelming popularity with riders and drivers undermined support for burdensome taxi regulations, and most cities and states changed their laws correspondingly. In exchange, Uber began complying with the more modest regulations that cities passed.

It's hard to see a similar scenario playing out for cryptocurrency. I don't have strong opinions on whether or not security laws should be relaxed, but the poor track record of ICOs hasn't made a compelling case for it. (Note that adverse selection is a factor here; many ICOs seem to have attracted the same crowd that ran the penny stock scams of yesterday.) With most tokens trading below issue price, I doubt there's a groundswell of support for changing securities laws to legalize unregistered ICOs.

Similarly, while anti-money laundering laws can seem heavy handed, they serve more compelling purposes than your average taxi regulations c.a. 2008. Countries created AML laws with the intention of fighting some combination of drug trafficking, terrorism funding, and organized crime. Politically speaking, that gives regulators little incentive to meet cryptocurrency companies in the middle.

The genuine technological breakthroughs behind Bitcoin and Ethereum led to widespread opportunities to push against a range of financial regulations. Similarly, the ubiquity of smartphones gave Uber the technological leverage to undermine antiquated taxi regulation (and to capture tremendous value in the process.) Unlike Uber, though, cryptocurrency enthusiasts have found regulators to be largely uncompromising. At this point, if the larger blockchain project is to make lasting impact on the world, it will have to do so through applications other than cryptocurrency.