The problem with regulating stablecoin issuers like banks

One of my recent posts discussed the Report on Stablecoins published in November 2021 by the President’s Working Group on Financial Markets (PWG). While I fully supported the principle that similar types of economic activities should be subject to equivalent forms of regulation in order to avoid regulatory arbitrage, I also wrote that it was not obvious to me that bank regulation is the right answer for payment stablecoin issuance.

This speech by Governor Waller of the Fed neatly expresses one of the key problems with the recommendation that stablecoin issuance be restricted to depositary institutions (aka private banks). To be honest I was actually quite surprised the PWG arrived at this recommendation given the obvious implication that it would benefit the bank incumbents and impede innovation in the ways in which US consumers can access money payment services

“However, I disagree with the notion that stablecoin issuance can or should only be conducted by banks, simply because of the nature of the liability. I understand the attraction of forcing a new product into an old, familiar structure. But that approach and mindset would eliminate a key benefit of a stablecoin arrangement—that it serves as a viable competitor to banking organizations in their role as payment providers. The Federal Reserve and the Congress have long recognized the value in a vibrant, diverse payment system, which benefits from private-sector innovation. That innovation can come from outside the banking sector, and we should not be surprised when it crops up in a commercial context, particularly in Silicon Valley. When it does, we should give those innovations the chance to compete with other systems and providers—including banks—on a clear and level playing field”

“Reflections on stablecoins and Payments Innovations”, Governor Christopher J Waller, 17 November 2021

The future of payment stablecoins is, I believe, a regulated one but I suspect that the specific path of regulation proposed by the PWG Report recommendations will (and should) face a lot of pushback given its implications for competition and innovation in the financial payment rails that support economic activity.

I don’t agree with everything that Governor Waller argues in his speech. I am less convinced than he, for example, that anti trust regulation as it stands offers sufficient protection against big tech companies operating in this space using customer data in ways that are not fully aligned with the customers’ interests. That said, his core argument that preserving the capacity for competition and financial innovation in order to keep the incumbents honest and responsive to customer interests is fundamental to the long term health of the financial system rings very true to me.

For anyone interested in the question of why the United States appears to be lagging other countries in developing its payments infrastructure, I can recommend a paper by Catalini and Lilley (2021) that I linked to in this post. This post by JP Koning discussing what other countries (including Australia) have achieved with fast payment system initiatives also gives a useful sense of what is being done to enhance the existing infrastructure when the system is open to change.

Tony – From the Outside

Stablecoin regulation

The question of whether, or alternatively how, stablecoins should be regulated is getting a lot of attention at the moment. My bias (and yes maybe I am just too institutionalised after four decades in banking) is that regulation is probably desirable for anything that functions as a form of money. We can also observe that some stablecoin issuers seem to be engaging pro actively with the question of how best to do this. There is of course a much wider debate about the regulation of digital assets but this post will confine itself to the questions associated with the rise of a new generation of money like digital instruments which are collectively referred to as stablecoins.

My last post linked to a useful summary that Bennett Tomlin published laying out what is currently playing out in the USA on the stablecoin regulation front. Tomlin concluded that the future of stablecoins appeared to lie in some form of bank like regulation. J.P. Koning has also collated a nice summary of the range of regulatory strategies adopted by stablecoin issuers to date.

Dan Awrey proposes another model for stablecoin regulation

Against that background, a paper titled “Bad Money” by Dan Awrey (Law Professor at Cornell Law School) offers another perspective. One of the chief virtues of his paper (refer Section III.B) is that it offers a comprehensive overview of the existing state regulatory framework that governs the operation of many of the stablecoins operating as “Money Service Businesses” (MSB). The way forward is up for debate but I think that Awrey offers a convincing case for why the state based regulatory model is not part of the solution.

This survey of state MSB laws paints a bleak picture. MSBs do not benefit from the robust prudential regulation, deposit guarantee schemes, lender of last resort facilities, or special resolution regimes enjoyed by conventional deposit-taking banks. Nor are they subject to the same type of tight investment restrictions or favorable regulatory or accounting treatment as MMFs. Most importantly, the regulatory frameworks to which these institutions actually are subject are extremely heterogeneous and often fail to provide customers with a fundamentally credible promise to hold, transfer, or return customer funds on demand.

Awrey, Dan, Bad Money (February 5, 202o). 106.1 Cornell Law Review 1 (2020); Cornell Legal Studies Research Paper No 20-38
Awrey also rejects the banking regulation model …

… PayPal, Libra, and the new breed of aspiring monetary institutions simply do not look like banks. MSBs are essentially financial intermediaries: aggregating funds from their customers and then using these funds to make investments. They do not “create” money in the same way that banks do when they extend loans to their customers; nor is there compelling evidence to suggest that their portfolios are concentrated in the type of longer term, risky, and illiquid loans that have historically been the staple of conventional deposit-taking banks

… and looks to Money Market Funds (MMFs) as the right starting point for a MSB regulatory framework that could encompass stablecoins

So what existing financial institutions, if any, do these new monetary institutions actually resemble? The answer is MMFs. While MSBs technically do not qualify as MMFs, they nevertheless share a number of important institutional and functional similarities. As a preliminary matter, both MSBs and MMFs issue monetary liabilities: accepting funds from customers in exchange for a contractual promise to return these funds at a fixed value on demand. Both MSBs and MMFs then use the proceeds raised through the issuance of these monetary liabilities to invest in a range of financial instruments. This combination of monetary and intermediation functions exposes MSBs and MMFs to the same fundamental risk: that any material decrease in the market value of their investment portfolios will expose them to potential liquidity problems, that these liquidity problems will escalate into more fundamental bank-ruptcy problems, and that—faced with bankruptcy—they will be unable to honor their contractual commitments. Finally, in terms of mitigating this risk, neither MSBs nor MMFs have ex ante access to the lender of last resort facilities, deposit guarantee schemes, or special resolution regimes available to conventional deposit-taking banks.

In theory, therefore, the regulatory framework that currently governs MMFs might provide us with some useful insights into how better regulation can transform the monetary liabilities of MSBs into good money.

Awrey’s preferred model is to restructure the OCC to create three distinct categories of financial institution

The first category would remain conventional deposit-taking banks. The second category—let’s call them monetary institutions—would include firms such as PayPal that issued monetary liabilities but did not otherwise “create” money and were prohibited from investing in longer-term, risky, or illiquid loans or other financial instruments. Conversely, the third category—lending institutions—would be permitted to make loans and invest in risky financial instruments but expressly prohibited from financing these investments through the issuance of monetary liabilities

Stablecoins would fall under the second category (Monetary Institutions) in his proposed tripartite licensing regime and the regulations to be applied to them would be based on the regulatory model currently applied to Money Market Funds (MMF).

Awrey, Dan, Bad Money (February 5, 2020). 106.1 Cornell Law Review 1 (2020); Cornell Legal Studies Research Paper No 20-38
What does Awrey’s paper contribute to the stablecoin regulation debate?
  • Awrey frames the case for stablecoin regulation around the experience of the Free Banking Era
  • This is not new in itself (see Gorton for example) but, rather than framing this as a lawless Wild West which is the conventional narrative, Awrey highlights the fact that these so called “free banks” were in fact subject to State government regulations
  • The problem with the Free Banking model, in his analysis, is that differences in the State based regulations created differences in the credit worthiness of the bank notes issued under the different approaches which impacted the value of the notes (this is not the only factor but it is the most relevant one for the purposes of the lessons to be applied to stablecoin regulation)

Finally, the value of bank notes depended on the strength of the regulatory frameworks that governed note issuing banks. Notes issued by banks in New York, or that were members of the Suffolk Banking system, for example, tended to change hands closer to face value than those of banks located in states where the regulatory regimes offered noteholders lower levels of protection against issuer default. Even amongst free banking states, the value of bank notes could differ on the basis of subtle but important differences between the relevant requirements to post government bonds as security against the issuance of notes bank notes.

  • If we want stablecoins to reliably exchange at par value to their underlying fiat currency then he argues we need a national system of regulation applying robust and consistent requirements to all issuers of stablecoin arrangements
  • Awrey then discusses the ways in which regulation currently “enhances the credibility of the monetary liabilities issued by banks and MMFs to set up a discussion of how the credibility of the monetary promises of the new breed of monetary institutions might similarly be enhanced
  • He proposes that the OCC be made accountable for regulating these “monetary institutions” (a term that includes other payment service providers like PayPal) but that the regulations be based on those applied to MMFs other than simply bringing them under the OCC’s existing banking regulations
  • The paper is long (90 pages including appendices) but hopefully the summary above captures the essence of it – for me the key takeaways were to:
    • Firstly to understand the problems with the existing state based MSB regulations that currently seem to be the default regulatory arrangement for a US based stablecoin issuer
    • Secondly the issues he raises (legitimate I think) with pursuing the bank regulation based model that some issuers have turned to
    • Finally, the idea that a MMF based regulatory model is another approach we should be considering
I will wrap up with Awrey’s conclusion …

Money is, always and everywhere, a legal phenomenon. This is not to suggest that money is only a legal phenomenon. Yet it is impossible to deny that the law plays a myriad of important and often poorly understood roles that either enhance or undercut the credibility of the promises that we call money. In the case of banks and MMFs, the law goes to great lengths to transform their monetary liabilities into good money. In the case of proprietary P2P payment platforms, stablecoin issuers, and other aspiring monetary institutions, the anti-quated, fragmented, and heterogenous regulatory frameworks that currently, or might in future, govern them do far, far less to support the credibility of their commitments. This state of affairs—with good money increasingly circulating alongside bad—poses significant dangers for the customers of these new monetary institutions. In time, it may also undermine the in-tegrity and stability of the wider financial system. Together, these dangers provide a compelling rationale for adopting a new approach to the regulation of private money: one that strengthens and harmonizes the regulatory frameworks governing monetary institutions and supports the development of a more level competitive playing field. 

Tony – From the Outside

What stablecoins might become

Bennett Tomlin offers a useful summary here of what is currently playing out in the USA on the regulation of stablecoins. His conclusion is that the future of stablecoins lies in some form of bank like regulation.

It is difficult to say exactly how all of this will play out. My intuition is that a new type of banking charter will be created that will allow stablecoin issuers to access Fed master accounts and there will be an expectation that stablecoins will hold their reserves there. It also seems reasonably likely that the Treasury gets its way and stablecoin issuers will need to register with the Treasury. I expect that securities regulations may be part of the cudgel that will be used to help ensure that the only stablecoins are the “approved” stablecoins.

The end result of this will likely be that any stablecoin issuer that wants to continue operating would need to become a bank and is going to have significantly less flexibility with what they can do with their reserves. Those that choose not to register or are not approved are likely to have difficulty accessing the U.S. banking system. They may have trouble servicing redemptions, and may perhaps even find themselves aggressively pursued by regulators.

https://www.coindesk.com/policy/2021/10/20/what-stablecoins-might-become/

Who knows if the end game is a bank charter but the regulatory solution will undoubtedly shape what stablecoins become. The best solution (I think) will recognise that there is in fact a variety of types of stablecoins offering their users different kinds of promises.

If the answer proposed is a bank charter then it will be interesting to see how bank liquidity requirements might apply to a 100% reserved stablecoin arrangement. The kinds of haircuts that bank liquidity rules apply to liquid assets (other than funds held at a central bank) seem to be completely missing in the approaches currently applied in fiat backed stablecoin arrangements.

Tony – From the Outside

A (the?) main move in finance

Matt Levine’s Money Stuff column (Bloomberg Opinion) had a great piece today which, while nominally focussed on the enduring question of “Looking for Tether’s Money”, is worth reading for the neat summary he offers of how finance turns risky assets into safe assets. The column is behind a paywall but you can access it for free by signing up for his daily newsletter.

This particular piece of the magic of finance is of course achieved by dividing up claims on risky assets into tranches with differing levels of seniority. In Matt’s words…

Most of what happens in finance is some form of this move. And the reason for that is basically that some people want to own safe things, because they have money that they don’t want to lose, and other people want to own risky things, because they have money that they want to turn into more money. If you have something that is moderately risky, someone will buy it, but if you slice it into things that are super safe and things that are super risky, more people might buy them. Financial theory suggests that this is impossible but virtually all of financial practice disagrees. 

Money Stuff, Matt Levine Bloomberg, 7 October 2021

Matt also offers a neat description of how this works in banking

A bank makes a bunch of loans in exchange for senior claims on businesses, houses, etc. Then it pools those loans together on its balance sheet and issues a bunch of different claims on them. The most senior claims, classically, are “bank deposits”; the most junior claims are “equity” or “capital.” Some people want to own a bank; they think that First Bank of X is good at running its business and will grow its assets and improve its margins and its stock will be worth more in the future, so they buy equity (shares of stock) of the bank. Other people, though, just want to keep their money safe; they put their deposits in the First Bank of X because they are confident that a dollar deposited in an account there will always be worth a dollar.

The fundamental reason for this confidence is that bank deposits are senior claims (deposits) on a pool of senior claims (loans) on a diversified set of good assets (businesses, houses). (In modern banking there are other reasons — deposit insurance, etc. — but this is the fundamental reason.) But notice that this is magic: At one end of the process you have risky businesses, at the other end of the process you have perfectly safe dollars. Again, this is due in part to deposit insurance and regulation and lenders of last resort, but it is due mainly to the magic of composing senior claims on senior claims. You use seniority to turn risky things into safe things

He then applies these principles to the alternative financial world that has been created around crypto assets to explore how the same factors drive both the need/demand for stablecoins and the ways in which crypto finance can meet the demand for safe assets (well “safer” at least).

The one part of his explanation I would take issue with is that he could have delved deeper into the question of whether crypto users require stablecoins to exhibit the same level of risk free exchangeability that we expect of bank deposits in the conventional financial world.

Matt writes…

The people who live in Bitcoin world are people like anyone else. Some of them (quite a lot of them by all accounts) want lots of risk: They are there to gamble; their goal is to increase their money as much as possible. Bitcoin is volatile, but levered Bitcoin is even more volatile, and volatility is what they want.

Others want no risk. They want to put their money into a thing worth a dollar, and be sure that no matter what they’ll get their dollar back. But they don’t want to do that in a bank account or whatever, because they want their dollar to live in crypto world. What they want is a “stablecoin”: A thing that lives on the blockchain, is easily exchangeable for Bitcoin (or other crypto assets) using the tools and exchanges and brokerages and processes of crypto world, but is always worth a dollar

The label “stable” is a relative term so it is not obvious to me that people operating in the crypto financial asset world all necessarily want the absolute certainty of a coin that always trade at par value to the underlying fiat currency. Maybe they do but maybe some are happy with something that is stable enough to do the job of allowing them to do the exchanges they want to do in risky crypto assets. Certainly they already face other costs like gas fees when they trade so maybe something that trades within an acceptable range of par value is good enough?

What it comes down to is first defining exactly what kind of promise the stablecoin backer is making before we start down the path of defining exactly how that promise should be regulated. I do think that the future of stablecoins is likely to be more regulated and that is likely to be a net positive outcome. The term “stablecoin” however encompasses a wide variety of structures and intended uses. The right kind of regulation will be designed with these differences in mind. That said, some of the stablecoin issuers have not done themselves any favours in the loose ways in which they have defined their promise.

Matt’s column is well worth reading if you can access it but the brief outline above flags some of the key ideas and the issues that I took away. The ways in which seniority in the loss hierarchy creates safety (or what Gary Gorton refers to as “information insensitivity”) is I think the key insight. I frequently encounter papers and articles discussing the role of bank deposits as the primary form of money in developed economies. These nearly always mention prudential regulation, supervision and deposit insurance but the role of deposit preference is often overlooked. For anyone looking to dig a bit deeper, I did a post here offering an Australian perspective on how this works.

Tony – From the Outside

Reserves of top stablecoins

This graph from an IMF blog neatly summarises the considerable diversity in the asset backing of stablecoins. While the IMF blog highlights the risks associated with stablecoins, I prefer to remain open to the possibility that they represent a new vector of competition that will force traditional banking to lift its game.

That possibility does however (for me at least) require that the banking regulators develop a stablecoin regulatory model that is fit for purpose. I am yet to see any jurisdiction that appears to be offering a good model for how this might be done but welcome any suggestions on what I am not seeing.

In the interim, JP Koning did a good post summarising the regulatory models he saw being pursued by stablecoin issuers.

Tony – From the Outside

Misunderstanding Narratives: The Hero’s Journey – The Big Picture

Joseph Campbell’s “The Hero with a Thousand Faces” is a great book. It offers insights into some deep ideas about how the world does (or should) work that have influenced a wide variety of people including George Lucas and Ray Dalio and was included in Time magazine’s list of the top 100 books.

Barry Ritholz did a short, but insightful, post here where he reminds us that the timeless appeal of the narrative that Campbell explores can also mislead us.

Our narrative bias for compelling stories can prevent us from seeing the forest for trees. Dramatic tales with clearly delineated Good & Evil are more memorable and emotionally resonant than dry data and tedious facts. Try as you might, finding a singular cause of some terrible economic outcome is an exercise in futility. Instead, you will find a long history of political, economic, psychological, and (occasionally) irrational drivers that eventually led to some disaster.

We look for the spark that ignites the room full of hydrogen, instead of 1,000 other factors that created the conditions precedent. You can find example after example of disasters widely thought of as “single event causes;” upon closer examination, they are revealed as the result of far more complex circumstances and countless interactions

https://ritholtz.com/2021/09/misunderstanding-narratives-the-heros-journey/

This for me is an insight that rings very true but is often forgotten to feed our appetite for reducing complex stories to simple morality plays. I like the stories as much as the next person but the downside is that the simple appealing story distracts us from understanding the route causes of why things like the GFC happened and leave us exposed to the risk that they just keep repeating in different forms.

Tony – From the Outside

Bank regulators might be missing something with regard to Bitcoin

The Basel Committee on Banking Supervision (BCBS) released a consultation paper in June 2021 setting out its preliminary thoughts on the prudential treatment of crypto asset exposures in the banking system.

I covered the paper here but the short version is that the BCBS proposes to distinguish between two broad groups: One where the BCBS believes that it can look through the Crypto/DLT packaging and largely apply the existing Basel requirements to the underlying assets (Group 1 crypto assets). And another riskier Group 2 (including Bitcoin) which would be subject to its most conservative treatment (a 1250% risk weight).

At the time I noted that it was not surprising that the BCBS had applied a conservative treatment to the riskier end of the crypto spectrum but focussed on the fact that that bank regulators were seeking to engage with some of the less risky elements.

I concluded with my traditional caveat that I was almost certainly missing something. Caitlin Long (CEO and founder of Avanti Financial Group, Inc) argues that what I missed is the intra-day settlement risk that arises when conventional bank settlement procedures deal with crypto-assets that settle in minutes with irreversibility.

The BCBS could just apply even higher capital requirements but the better option she argues is to create a banking arrangement that is purpose built to deal with and mitigate the risk. I have copied an extract from an opinion piece she wrote that was published in Forbes magazine on 24 June 2021

Thankfully, there is a safe and sound way to integrate bitcoin and other Group 2 cryptoassets into banking systems:

– Conduct all bitcoin activities in a ring-fenced bank that is either stand-alone or is a bankruptcy-remote subsidiary of a traditional (leveraged) bank.

– Use no leverage in the bank. No rehypothecation of bitcoin held in custody. Hypothecation of assets held in custody is fine, but the bank must not permit greater than 1:1 leverage. Remember—bitcoin has no lender of last resort or clearinghouse.

– Take no credit or interest rate risk within the bank. Hold 100% reserves in cash, T-bills or similar short-term, high-quality liquid assets. The bank makes money on fees, which crypto fintechs have successfully done for years due to high transaction volume.

– Pre-fund transactions, so that the bank settles second or simultaneously instead of settling first and thereby avoid “back door” leverage caused by a counterparty failing to deliver.

– Permit no collateral substitution or commingling in prime brokerage.

– Design IT and operational processes for fast settlement with irreversibility, complete with minute-by-minute risk monitoring and reconciliation processes.

https://www.forbes.com/sites/caitlinlong/2021/06/24/bis-proposed-capital-requirements-for-cryptoassets-vital-move-but-theyre-too-low-for-bitcoin/?sh=10d0a9f22546

If you want a deeper dive Avanti lay out their arguments in more detail in a letter submitted to the Federal Reserve responding to a request for comments on draft guidelines proposed to assist Federal Reserve Banks in responding to what the Fed refers to (emphasis added) as “… an increasing number of inquiries and requests for access to accounts and services from novel institutions“.

It is quite possible that I am still missing something here but the broad argument that Avanti lays out seems plausible to me; i.e. it would seem desirable that a bank that seeks to support payments to settle crypto asset trades should employ a payment process that allows instant payments as opposed to end of day settlement.

Some parting observations:

  1. The Fed is moving towards the implementation of an instant payment system so arguments based on problems with 40 year old payment systems such as the Automated Clearing House (ACH) currently used by the USA would be more compelling if they addressed how they compare to the new systems that have been widely deployed and proven in other jurisdiction.
  2. Notwithstanding, there is still a case for allowing room for alternative payment solutions to be developed by novel institutions. In this regard, Aventi has committed to embrace the level of regulation and supervision that is the price of access to an account at the central bank.
  3. Aventi’s regulatory strategy is very different to the decentralised, permission-less philosophy that drives the original members of the crypto asset community. Seeing how these two competing visions of money play out continues to be fascinating.
  4. I still have a lot to learn in this space.

Tony – From the Outside

Regulatory strategies adopted by USD stablecoin issuers (continued)

One of my recent posts flagged some useful work that JP Koning had shared summarising four different regulatory strategies USD stablecoins issuers have adopted.

  1. The New York Department of Financial Services (NYDFS) trust company model [Paxos, Gemini, BUSD]
  2. The Nevada state-chartered trust model [TrueUSD, HUSD]
  3. Multiple money transmitter license model [USDC]
  4. Stay offshore [Tether]

If I read this post from Circle correctly, we can now add a fifth strategy; the Federally-chartered national commercial bank model. For those with a historical bent, this might also be labelled the “narrow bank” model or the “Chicago Plan” model.

Here is a short extract from the Circle post …

Circle intends to become a full-reserve national commercial bank, operating under the supervision and risk management requirements of the Federal Reserve, U.S. Treasury, OCC, and the FDIC. We believe that full-reserve banking, built on digital currency technology, can lead to not just a radically more efficient, but also a safer, more resilient financial system.

We are embarking on this journey alongside the efforts of the top U.S. financial regulators, who through the President’s Working Group on Financial Markets are seeking to better manage the risks and opportunities posed by large-scale private-sector dollar digital currencies.

Tony – From the Outside

The Paradox of DeFi

Nic Carter and Linda Jeng have produced a useful paper titled “DeFi Protocol Risks: the Paradox of DeFi” that explores the risks that DeFi will need to address and navigate if it is to deliver on the promises that they believe it can. There is of course plenty of scepticism about the potential for blockchain and DeFi to change the future of finance (including from me). What makes this paper interesting is that it is written by two people involved in trying to make the systems work as opposed to simply throwing rocks from the sidelines.

Linda Jeng has a regulatory back ground but is currently the Global Head of Policy at Transparent Financial Systems. Nic is a General Partner at a seed-stage venture capital film that invests in blockchain related businesses. The paper they have written will contribute a chapter to a book being edited by Bill Coen (former Secretary General of the Basel Committee on Banking Supervision) and Diane Maurice to be titled “Regtech, Suptech and Beyond: Innovation and Technology in Financial Services” (RiskBooks).

Linda and Nic conceptually bucket DeFi risks into five categories: 

  1. interconnections with the traditional financial system, 
  2. operational risks stemming from underlying blockchains, 
  3. smart contract-based vulnerabilities, 
  4. other governance and regulatory risks, and 
  5. scalability challenges.

… and map out the relationships in this schematic

Conclusion: “No Free Lunch”

The paper concludes around the long standing principle firmly entrenched in the traditional financial world – there is “no free lunch”. Risk can be transformed but it is very hard to eliminate completely. Expressed another way, there is an inherent trade off in any system between efficiency and resilience.

Many of the things that make DeFi low cost and innovative also create operational risk and other challenges. Smart contracts sound cool, but when you frame them as “automated, hard-to-intervene contracts” it is easy to see they can also amplify risks. Scalability is identified as an especially hard problem if you are not willing to compromise on the principles that underpinned the original DeFI vision.

The paper is worth a read but if you are time poor then you can also read a short version via this post on Linda Jeng’s blog. Izabella Kaminska (FT Alphaville) also wrote about the paper here.

Tony – From the Outside

The BIS publishes some research on what drives investment in cryptocurrencies

Came across this paper published by the BIS titled “Distrust or speculation? The socioeconomic drivers of US cryptocurrency investments” authored by Raphael Auer and David Tercero-Lucas. The paper makes clear that its conclusions are not necessarily endorsed by the BIS but it is interesting none the less.

The authors downplay the idea that cryptocurrencies are all about opting out of fiat currencies and cite evidence that investors are treating crypto as just another asset class.

From a policy perspective, the overall takeaway of our analysis is that as the objectives of investors are the same as those for other asset classes, so should be the regulation. Cryptocurrencies are not sought as an alternative to fiat currencies or regulated finance, but instead are a niche digital speculation object.

From this perspective, increased regulation is actually a good thing for crypto

A clarifying regulatory and supervisory framework for cryptocurrency markets may be beneficial for the industry. In fact, regulatory announcements have had a strong impact on cryptocurrency prices and transaction volumes (Auer and Claessens, 2019, 2020), and those pointing to the establishment of specific regulations tailored to cryptocurrencies and initial coin offerings are strongly correlated with relevant market gains.

They go so far as arguing that regulation may actually improve the long term viability of the asset class by addressing the problems associated with the energy consumption of the “proof of work” model.

Better regulation may also be beneficial – quintessential in fact – for the industry when it comes to the basic security model of many cryptocurrencies. This is so as the long-term viability of cryptocurrencies based on proof-of-work is questionable. Auer (2019a) shows that proof-of-work can only achieve payment security (i.e., finality) if the income of miners is high, and it is questionable whether transaction fees will always be high enough to generate an adequate level of income to guarantee save transactions and rule out majority attacks. In the particular for the case of Bitcoin, the security of payments will decrease each time the “block subsidy” declines (Auer, 2020). Potential solutions often involve some degree of institutionalisation, which in the long-run may require regulation or supervision.

I have to confess that I skimmed over the middle section of the paper that documented the modelling the authors used so I can’t attest to the reliability of the research. I read it mostly from the perspective of gaining a perspective on how the regulatory community is thinking about cryptocurrency.

Tony – From the Outside