Crypto Policy 101

I taught a class on how to regulate crypto!

Last fall, I taught PP426: Public Policy for Blockchains and Digital Assets at the London School of Economics. As far as I know, it was the first ever English-language graduate-level course on cryptocurrency regulation; the first class on how the crypto industry is regulated and could be regulated globally. 

We had students from every continent and professional background, from central bankers, civil servants and tax collectors looking to shape crypto policy in their countries to crypto traders and hobbyists wanting to understand their industry more deeply.

There’s so much to say about what we covered and how it went that it’s hard to sum up in a blog post, but here’s my best shot. 

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What is Crypto?

The class started where it had to: with a basic description of what crypto is and what it’s used for. We began by defining public permissionless blockchains (~distributed ledgers that use cryptography) and looking at why they were invented (~to transact without government interference) and where they came from (~the anarcho-capitalist, cyber-libertarian “cypherpunk” movement). We had a few lectures to get technical terms and concepts straight and moved on to evaluate crypto infrastructure and activity.

The main selling point of blockchains is “censorship resistance,” the ability for anyone with an internet connection to transact on the database without any central authority being able to block them. (The police can always show up with a court order and guns, but that’s another story). 

To get censorship resistance, blockchains sacrifice privacy, security and cost. Blockchains are still pseudonymous (not anonymous), so every address and its full transaction history is at risk of being personally identified and exposed to the world (i.e. “doxxed”). Permanent, irrecoverable losses from password mismanagement are still common (private key loss) and smart contract protocols are hacked monthly. And transaction costs are still high(ish), though fees have fallen dramatically on new “layer 2” blockchains (like Arbitrum and Base). 

The ecosystem built on this infrastructure is somewhat novel. Automated market makers enable 24/7 permissionless asset exchange (e.g. trading ETH for USDC) and decentralized lending protocols for 24/7 (over)-collateralized borrowing (i.e. borrowing USDC against ETH). This system is better than traditional finance in many countries for cross border money movement (which relies on slow and expensive correspondent banks), but is otherwise costly and clunky.

In parts of the developing world with sanctions, financial repression or monetary dysfunction like Nigeria, Venezuela, Argentina, Lebanon and Iran, crypto is a useful escape hatch for some. Like cash US dollars, stablecoins and bitcoin have some market share in retail payments, remittances, and international trade, despite the frictions, for lack of better alternatives. 

But in the rest of the world where there’s decent economic management and financial services, crypto hasn’t been particularly positive or useful. It isn’t channeling savings into investments or funding mortgages or business loans or raising productivity in the way other technology has. Instead, it’s rife with various kinds of malfeasance (Ponzis, rug pulls or worse) and is mostly an outlet for unproductive speculation (e.g. memecoins).

The clearest use for crypto is with bitcoin as a “store of value” and hedge against monetary debasement, like gold, but it’s odd. Units of the bitcoin cryptocurrency don’t produce goods or services. They’re just numbers on a database that was invented fifteen years ago by pseudonymous programmers.

Yet tens or hundreds of millions of people believe that these new ledger entries will be very valuable in the future, enough for bitcoin’s market capitalization to exceed a trillion dollars today. As long as enough people keep believing this (and they will, as far as I can tell), the value of bitcoin will hold up and this “use case” will continue to work.

Creating a trillion plus dollars in value from nothing is notable, but as bitcoin appreciates and holders are able to spend more, that’s new demand for goods, services and assets without any extra supply. As a result, to the extent that bitcoiners get rich, they’ll do so by taking purchasing power from the rest of society that doesn’t have coins.

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How Could We Regulate it?

The second half of the class was about crypto regulation and how to think about it systematically. Drawing on work from standard-setters like the Basel Committee and Financial Stability Board is a good start. The idea that substantially equal economic activities and risks should be treated equally, regardless of the underlying technology, is instructive. Having an organized list of objectives that we should care about as policymakers is also helpful. 

Financial stability was the first goal on the list, and for good reason. Nobody wants another stablecoin to de-peg, another exchange to collapse, or worse, a regular bank to flop due to crypto’s volatility. 

Here, we focused on stablecoin regulation, and how the US doesn’t have any even though 99% of stablecoins are in dollars and the largest issuer (Tether) has never been audited and holds 2% of T-bills (100 billion dollars). We contrasted that with the EU’s Markets in Crypto-Assets bill, which set out common sense governance and reserve requirement rules for all stablecoin issuers that want to operate in Europe. 

We also looked at how domestic crypto exchanges and service providers could be regulated to safeguard customer money with basic things like asset segregation and what to do about unregulated offshore competitors (like FTX). We looked at how the Basel Committee is keeping (volatile) crypto assets off bank balance sheets around the world with guidance that all crypto should be matched 1:1 with shareholder equity.  

Consumer and investor protection was the second key policy objective, also for good reason. Nobody wants a financial system full of fraud and scams that fails to channel savings into plausibly productive ventures. 

The key question here is what crypto assets should and shouldn’t count as securities and how to decide quickly and rigorously, since we already have securities regulations and crypto securities shouldn’t have completely separate rules just because they live on different databases. The US, again, has done nothing here, in contrast to Europe and some other jurisdictions. Crypto non-securities (like memecoins and utility tokens) should also be regulated (as should their advertisement), but the question is how and what the tradeoffs are between the different options. 

Limiting illicit finance was another key policy goal, because nobody wants to facilitate money laundering, drug or arms trafficking, and sanctions evasion, etc. 

There are lots of things to worry about here. One is what to do about high-risk offshore crypto exchanges and service providers (like OTC desks) in countries like Russia that have little or no know-your-customer and anti-money-laundering checks and deliberately turn a blind eye to darknet marketplaces, cybercrime, and other illicit activity. Another question is what to do about on-chain tumblers or mixers, like the recently sanctioned Tornado Cash, which are privacy tools or money laundering tools, depending on who you ask. 

We could have also spent a few days on tax compliance and market integrity and what policies might advance these objectives, but there just wasn’t enough time.

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The Class

I was surprised by lots of things throughout the semester. Grasping the distinction between on-chain activity (buying an NFT on the Ethereum blockchain) and off-chain activity (buying Dogecoin on Coinbase) was challenging for students that hadn’t used crypto before.

I was also surprised by just how much easier it is to regulate onshore centralized exchanges and other service providers than to regulate on-chain activity, where authorities only have leverage through freezing stablecoins and at the points where crypto and the traditional financial system touch, the so-called fiat on- and off-ramps. 

Striking the right tone was also surprisingly difficult. On one hand, I had to be genuinely open minded to all of crypto’s potential use cases and be fair about the shortcomings of the existing financial system, of which there are many. On the other hand, I couldn’t minimize the seriousness of the issues that plague this un-censorable, cyber-libertarian ecosystem. 

In any case, everyone always says that the best year to teach a class is the second, because you’re still very excited and motivated, but you can substantially improve by doubling down on what worked, changing what didn’t, and adding new interesting content. I sure hope that turns out to be true, because v2 starts in just five months!