Should central banks regulate Crypto-currencies?

The cryptocurrency industry has grown at a staggeringly fast rate. Bitcoin’s value has increased by 925% since 2019, as of 25/02/22 (Coinmarketcap, 2022). This essay will analyse the costs and benefits of regulating cryptocurrencies and any potential unintended consequences of regulation to determine whether regulation of cryptocurrency markets is warranted.

Firstly, cryptocurrencies could pose a systemic risk to the economy. For finance, systemic risk can be defined as the risk that an event will trigger a loss of economic value and increased uncertainty about the financial system to the degree that it could have significant adverse effects on the real economy (Dwyer, 2009). Cryptocurrencies pose a systemic risk primarily because of opaque and potentially unbacked stablecoins (Coffeezilla, 2021). If stablecoins, like Tether, are unbacked, a fall in confidence could cause a ‘bank run’-like scenario, where providers cannot meet their short-term liabilities due to insufficient liquidity. Research from León et al (2011) suggests that opaqueness transforms risk into uncertainty, which can, in turn, lead to instability. Therefore, if an exogenous shock causes a crash in the cryptocurrency market, the endogenous systemic risks would exacerbate it. Due to increasing interdependence between cryptocurrencies and legacy finance, like Standard Chartered’s $380m investment into cryptocurrencies (Business Insider, 2022), a cryptocurrency crash could cause a cascading failure throughout financial markets, with consequences similar to the 2008 global financial crisis. If systemic risks materialise into an economy-wide recession, its impacts would be a negative externality, as the consequences of cryptocurrency transactions would impact third parties. Therefore, it can be argued that the Bank of England should internalise the externality by intervention.

Although stress on public finances may increase with regulation, the industry could benefit from increased confidence in the long run. An example of a regulation that could be implemented is that it could become a requirement for stablecoin providers to conduct weekly attestations and quarterly audits via third parties to ensure that liquid assets fully back them. In addition, the FCA, Britain’s financial regulator, operated at a £12.9m surplus from fees for the 2019-2020 financial year (FCA, 2020). Whilst this doesn’t mean that regulation isn’t a drag on growth, it indicates that regulation mightn't burden public finances. However, government failure may occur as the wrong regulations could harm the economy. For example, the notion is that as long as the components of the financial market are safe, the system itself will be safe. This assumption carries the danger of regulators falling victim to the ‘fallacy of composition’ that Milton Friedman foreshadowed in 1980 (Dwyer, 2009). Furthermore, regulation could cause a business exodus from the UK. This would impact living standards as the unemployment rate rises. Hence, regulation may result in a worse outcome presently. Although, in future, systemic risks could outweigh the consequences of regulation

Another argument favouring regulation is that the government has a moral obligation to protect its citizens. Blockchain is new, and imperfect information has encouraged scammers. An example of such a scam was ‘Bitconnect’, which defrauded $2b from victims (WSJ, 2021). Authorities protect investors in traditional finance, so cryptocurrency policy shouldn’t differ. However, it is desirable for individuals to have responsibility for their investments. Using public funds to protect people disincentivises the utmost care required when investing. Investors taking more responsibility increases allocative efficiency as funds are more likely to be invested in projects with long-run potential. Although, investors will always have bounded rationality as they possess imperfect information. A superior solution to regulation could be ‘nudge policies,' such as providing information on the risks of investing. One type of policy that central banks could introduce is to mandate that every cryptocurrency must obtain its approval before investors can purchase it in the UK to prevent fraudulent currencies from being sold to unsuspecting investors. However, blockchain technology poses a significant challenge to regulators. Due to cryptocurrency's decentralised nature, this rule enforcement would be impossible without an unacceptable cost to the taxpayer and encroachment on civil liberties. Despite its disregard for human rights, China’s failure to enforce its cryptocurrency ban illustrates the difficulties of applying such a rule. In addition, we must also consider the risk of investor protection regulations failing due to regulatory capture. People who have worked in an industry typically have the best knowledge of the industry. They are uniquely capable of combatting the asymmetric information problem that authorities face. However, there is a risk of managers influencing regulators they used to work with to weaken rules that could affect their firm, leading to ineffective regulation (Hardy, 2006).

An argument against regulation is that it can stifle innovation. The progression of money has stagnated since the abandonment of the gold standard in the 1970s. This stagnation results from the central bank's currency issuance monopoly. Cryptocurrencies present an opportunity to expand the functionality of money. Research indicates that regulation discourages innovation (Aghion, Bergeaud and Van Reenen, 2019). This conclusion suggests that if regulations were implemented, investment expenditure would fall, which is a critical component of aggregate demand (AD=C+I+G+(X-M)) and a determinant of the productive capacity of the economy. In the long run, a decrease in the economy's productive capacity results in falling living standards, ceteris paribus. Potential consequences of regulation are shown in figure 1:

Regulation increases barriers to entry. Thus, incumbent currencies could gain monopoly power if regulators become overbearing. This may limit cryptocurrency's progression, as the incentive to improve is minimal without competition. Although, as long as at least two currencies exist, the market could become an oligopoly with an efficient outcome because currencies will have an incentive to ‘undercut’ each other. This, quite abstractly, would be in terms of utility rather than price. As a result, the long-run equilibrium for the cryptocurrency industry would likely be at a ‘Nash equilibrium,' which would be similar to the conditions of a market with more competitors. As collusion could occur, this isn’t a given. Because barriers to entry wouldn’t be extremely high, incumbent currencies would still have an incentive, albeit a weak one, to innovate to discourage new entrants into the market. Nevertheless, more competition would be preferable, which regulation could discourage. A common criticism of cryptocurrency is that, according to Gresham’s law, bad money will drive out good money (Friedman, M and Friedman, R, 1980). However, Gresham’s law will only apply to different kinds of money between which there is a fixed exchange rate (Hayek, 1976). An example of cryptocurrency innovation is the relatively new “Solana”, which can process over 2000 transactions per second (Solana, 2021), compared to Ethereum’s 30 (Decrypt, 2021). Such innovation mustn’t be stifled by regulation.

Lastly, regulating cryptocurrencies would do little to reduce crime on the ‘dark web’, as regulation of public blockchains could push criminals into private ones. As most blockchains are public, authorities have exceptional capabilities to track wallets associated with crime. There is no way of linking a wallet to its owner. Still, once a cryptocurrency is withdrawn to exchanges, which require identification, the perpetrators of crime lose their anonymity. This has been a strong crime deterrent. An unintended consequence of regulations is that it incentivises black market development, where criminals can withdraw their ill-gotten gains into fiat currency without scrutiny. Thus, regulation could increase crime rates, as criminals migrate to markets not under government supervision. An example of black market growth despite intervention is the 'war on drugs’, which has been fought since the 1970s, with little progress. Also, it’s worth considering that due to the trade-off between enforcement costs and the costs of crime, the socially efficient level of crime isn’t 0 (Friedman, D, n.d). However, the socially efficient level, when marginal social benefits are equal to marginal social costs, may require some regulation to reach. When calculating the socially efficient level, we must also factor in the opportunity cost of expenditure and committing labour to regulate markets. Taxpayers' money could be better spent on healthcare, and regulators could be more productive in manufacturing. Thus, regulations to reduce crime wouldn’t promote an efficient outcome.

In final analysis, central banks must regulate cryptocurrency markets in moderation. They must abstain from investor protection and crime prevention regulations due to costs to the taxpayer and businesses in the short run, in addition to unintended consequences, such as black market growth, in the long run. However, a robust body of theoretical analysis and empirical evidence indicates that regulations that diminish systemic risk would benefit the economy substantially. Managing systemic risk in cryptocurrency markets wouldn’t hinder most currencies in any meaningful way because stablecoin providers constitute the most significant risk as a result of their lacking transparency. International cooperation is required to limit systemic risk adequately. However, this doesn’t justify inaction by authorities as they can manage some risk unilaterally. Thus, with proper regulation, the economy can be protected from another great depression without impeding freedom and innovation.

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References:

Aghion, Bergeaud and Van Reenen (2019). The Impact of Regulation on Innovation, p.19. Available at: https://scholar.harvard.edu/files/aghion/files/impact_of_regulation_on_innovation.pdf

Business Insider (2022). These 13 banks have invested the most in crypto and blockchain to date.[online]. Available at: https://markets.businessinsider.com/news/currencies/13-top-banks-investing-cryptocurrency-blockchain-technology-funding-blockdata-bitcoin-2021-8?op=1

Coffeezilla (2022). Video recording: Exposing Tether - Bitcoin’s Biggest Secret. [online]. Available at: https://www.youtube.com/watch?v=-whuXHSL1Pg

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Friedman, M and Friedman, R(1980). Free to Choose: a personal statement. 1990 edition. USA, Harvest publishing.

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Hayek (1976). Denationalisation of Money: An Analysis of the Theory and Practice of Concurrent Currencies. Available at: https://iea.org.uk/wp-content/uploads/2016/07/Denationalisation%20of%20Money.pdf

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Leon , Machado , Cepeda , Sarmiento (2011). Too-connected-to-fail Institutions and Payments System’s Stability: Assessing Challenges for Financial Authorities. Available at: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2101221

Wall Street Journal (2021). SEC Sues BitConnect and Founder, Alleging Massive Cryptocurrency Scam of World-Wide Investors. [online]. Available at: https://www.wsj.com/articles/sec-sues-bitconnect-and-founder-alleging-massive-cryptocurrency-scam-of-world-wide-investors-11630535853