by Leon Perlman, Head: Digital Financial Services Observatory, Columbia Institute for Tele-information, Columbia University, New York. (Primary Author)
Michael M. Wechsler, Associate Research Scholar, Digital Financial Services Observatory, Columbia Institute for Tele-information, Columbia University, New York. (Author of Annex C "Regulatory Approaches in Various Regions" and provided research and writing for this paper.)
Regulation of the Financial Components of the Crypto-Economy
The emergence into the public discourse in 2009 of the novel peer-to-peer Bitcoin crypto-currency phenomenon caught many regulators unawares. We now know that Bitcoin and its underlying ‘blockchain’ technology represented a transformational vanguard of a new ‘trustless’ method of sharing data and processes and contracting in a decentralized, traceable and secure manner and, in many cases, without the need for intermediaries. The family of blockchains and its analogues are now known as distributed ledger technologies (DLTs).
Whatever their form or function, ‘crypto’-derived and focused products and services based on DLT are here to stay. They are transformational not just of their utilitarian function in making data transfer and storage more efficient, but notably we argue also in their potential to democratize access to financial products and services, a change not seen the dawn of the commercial Internet in the 1990s. There are still many hurdles and risks to overcome though before they become mainstream, not least of which is regulatory certainty.
The ‘crypto-economy’, as we dub it, has many avenues for transformation by DLTs. This may be through DLT’s novel utilitarian function of new data sharing and storage techniques that are secure, tamper-evident and distributed. Or the introduction of new financial products and trading techniques through the production and use of new ‘crypto-assets’ that feature at their core malleable crypto ‘tokens’ used as ‘programmable money.’ The financial sector in particular is seeing the release of these new asset classes that democratize access to financial products through tokenization, catalyzing and enabling fractional ownership of legacy and new crypto-inspired asset classes. Some of these crypto-assets have attached profit or governance rights, others providing some consumption value. They may also act as payment tool as a crypto-currency, enabling the buying and selling of goods and services. The crypto-economy may also support capital raising through a now controversial method called an Initial Coin Offering.
Overall, there is currently a bifurcation of interest in DLTs, between retail (individual consumers) and enterprises. The former are more engaged in trading of crypto-assets. Indeed there are few live mass consumer applications of DLT other than this direct trading. The focus by the latter is mostly on the utilitarian aspects of DLTs, as reliable, traceable and secure data processes and access. A number of DLTs are being developed by sector consortia of banks and other financial institutions, or shipping companies, or food supply networks. There is likely to be a convergence of the retail and enterprise focus areas over the next few years as the industry matures.
The technologies, products, services and even the participants and actors providing services are novel and will not only change business practices but also test the perimeters of current sets of regulations and the remits and capacity of regulators and authorities that may found remit over them. These effects may be magnified by the innate fluidity of crypto-assets, where the programmable ‘tokens’ underpinning them can rapidly morph from one type to another. And similarly, what is decentralized at one moment may become semi-centralized in another. This fluidity creates challenges in regulatory planning and oversight. Given their mandates of consumer protection, regulators have focused their initial regulatory responses on the retail components, particularly on crypto-currency trading and ICOs.
While the crypto-economy, as measured by capitalization compared to the real (legacy) economy, does not as yet raise any systemic concerns, the emergence of institutional investors will alter that calculus and accelerate we argue the need for regulatory planning or action. A general problem though is whether ‘old’ laws and regulations not specifically referencing DLT technologies, their development, use and application can be used for these new technology shifts and crypto-asset classes. Answering this is the primary goal and contribution of this paper.
In doing so we describe in some detail: the technical components of emerging distributed ledger technologies, their strengths and weaknesses; their potential business application and risks of crypto-assets used in a nascent crypto-economy; and the open legal, regulatory and policy dilemma this all presents to regulators, authorities and lawmakers, as well as to provide some suggested solutions. And similarly, for this crypto-economy to evolve from a current, relatively small pool of participants and traders, systems need to be hardened and operational and market integrity risk profiles decreased so as to attract institutional investors that can bring trillions of dollars for use in creating and trading tokenized assets.
This paper also contributes with a novel systemized taxonomy for classification of the various financial components of the crypto-economy, particularly crypto-assets and their token components. It describes their provenance, use and risks in a technical, business and legal sense. We show how the ecosystem has developed and how it can be used in the broader economy, where the weak points are, what the initial regulatory and policy responses have been, and what stylized legal and regulatory responses may be appropriate to bring certainty and order, close gaps, and remove arbitrage where and if needed. In later sections, we show how regulators in some countries have approached this.
The issues are complex, potentially disruptive and definitely transformative. In this being a challenge to regulators and policy makers, we argue that there is a familiar lens: the transformative impact of the introduction of the commercial Internet in the 1990s and the tension it ventilated between innovation and regulation.
We suggest for use by regulators boilerplate methodologies, challenges and strategies for approaching their task of understanding the components, actors, and risks in the crypto-economy, and suggest stylized solutions where they can be applied. We stylize the regulatory approaches as being: no action; forbearance; restrictive; bring into scope; bespoke; and a hybrid approach. We suggest that a hybrid of ‘bringing into scope’ and a new crypto-asset regulatory framework is a desirable approach given the nascent and fluid nature of DLT and crypto-assets. A novel model crypto-asset regulatory framework is again presented, modified following its use in an earlier study by the author.
We note too that a functional regulatory approach versus an institutional approach is preferred, given that many of the new models are organized into a decentralized, rather than in a readily identifiable (legacy) entity-based manner. Principles-based regulation, we argue, has a perimeter of utility and effectiveness and in many cases that approach may need to be adapted to the new actors and asset classes, governance structures, and to the overall impact of these technologies. Thereto, the effect of DLTs on legal and policy concepts of inter alia payment finality; on laws of evidence; contract law; laws of negotiable instruments; and on data protection is also discussed.
A balance of strict, normative regulation versus effective, but nurturing regulation may be needed. This we note to be the regulator’s dilemma