The future of stablecoin issuance appears to lie in becoming more like a bank

Well to be precise, the future of “payment stablecoins” seems to lie in some form of bank like regulation. That is one of the main conclusions to be drawn from reading the “Report on Stablecoins” published by the President’s Working Group on Financial Markets (PWG).

One of the keys to reading this report is to recognise that its recommendation are focussed solely on “payment stablecoins” which it defines as “… those stablecoins that are designed to maintain a stable value relative to a fiat currency and, therefore, have the potential to be used as a widespread means of payment.”

Some of the critiques I have seen from the crypto community argue that the report’s recommendations fail to appreciate the way in which stablecoin arrangements are designed to be self policing and cite the fact that the arrangements have to date withstood significant episodes of volatility without holders losing faith. Market discipline, they argue, makes regulation redundant and an impediment to experimentation and innovation.

The regulation kills innovation argument is a good one but what I think it misses is that the evidence in support of a market discipline solution is drawn from the existing uses and users of stablecoins which are for the most part confined to engaged and relatively knowledgeable participants. This group of financial pioneers have made a conscious decision to step outside the boundaries of the regulated financial system (with the protections that it offers) and can take the outcomes (positive and negative) without having systemic prudential impacts.

The PWG Report looks past the existing applications to a world in which stablecoins represent a material alternative to the existing bank based payment system. In this future state of the world, world stablecoins are being used by ordinary people and the question then becomes why this type of money is any different to private bank created money once it becomes widely accepted and the financial system starts to depend on it to facilitate economic activity.

The guiding principle is (not surprisingly) that similar types of economic activity should be subject to equivalent forms of regulation. Regulatory arbitrage rarely (if ever) ends up well. This is a sound basis for approaching the stablecoin question but it is not obvious to me that bank regulation is the right answer. To understand why, I recommend you read this briefing note published by Davis Polk (a US law firm), in particular the section titled “A puzzling omission” which explores the question why the Report appears to prohibit stablecoin issuers from structuring themselves as 100% reserve banks (aka “narrow banks”).

4. A puzzling omission.

By recommending that Congress require all stablecoin issuers to be IDIs, the Report would effectively require all stablecoin issuers to engage in fractional reserve banking and effectively prohibit them from being structured as 100% reserve banks (i.e., narrow banks9) that limit their activities to the issuance of stablecoins fully backed by a 100% reserve of cash or cash equivalents.10

The reason is that IDIs are subject to minimum leverage capital ratios that were calibrated for banks that engage in fractional reserve banking and invest the vast portion of the funds they raise through deposit-taking in commercial loans or other illiquid assets that are riskier but generate higher returns than cash or cash equivalents. Minimum leverage ratios treat cash and cash equivalents as if they had the same risk and return profile as commercial loans, commercial paper and long-term corporate debt, even though they do not. Unless Congress recalibrated the minimum leverage capital ratios to reflect the lower risk and return profile of IDIs that limit their assets to cash and cash equivalents, the minimum leverage capital ratios would make the 100% reserve model for stablecoin issuance uneconomic and therefore effectively prohibited.11 It is puzzling why the PWG, FDIC and OCC would recommend a regulatory framework that would effectively require stablecoin issuers to invest in riskier assets and rely on FDIC insurance rather than permitting stablecoins backed by a 100% cash and cash equivalent reserve.

This omission is puzzling for another reason. There has long been a debate whether deposit insurance schemes or a regime that required demand deposits to be 100% backed by cash or cash equivalents would be more effective in preventing runs or contagion. Indeed, the Roosevelt Administration, Senator Carter Glass, a number of economists and most well-capitalized banks were initially opposed to the proposal to create a federal deposit insurance scheme in 1933.12 Among the arguments against deposit insurance are that the benefits of deposit insurance in the form of reduced run and contagion risk are outweighed by the adverse effects in the form of reduced market discipline resulting from the reduced incentive of depositors to monitor the financial health of their banks. This reduced monitoring gives weaker banks more room to engage in risky activities the costs of which are borne by the stronger and more responsible banks in the form of excessive deposit insurance premiums or by taxpayers in the form of government bailouts.

In a competing proposal that has come to be known as the Chicago Plan, a group of economists led by economists at the University of Chicago argued in favor of a legal regime that required all demand deposits to be 100% backed by a reserve of cash or cash equivalents.13 Proponents of the Chicago Plan argued that it would be more effective in stemming runs and contagion than the proposed federal deposit insurance scheme, without undermining market discipline or creating moral hazard. The Chicago Plan would have been analogous to the original National Bank Act that required all paper currency issued by national banks to be fully backed 100% by U.S. Treasury securities. The Chicago Plan was ultimately rejected in favor of the federal deposit insurance scheme that was enacted in 1933 not because it would have been less effective than deposit insurance in stemming runs and contagion, but because it was viewed as too radical. Policymakers feared that by prohibiting banks from using deposits to fund commercial loans and invest in other debt instruments, the Chicago Plan would have resulted in a further contraction in the already severely contracted supply of credit that was fueling the great contraction in economic output that later became known as the Great Depression.

It is understandable why the Report does not recommend prohibiting IDIs from issuing, transferring or buying and selling stablecoins that represent insured deposit liabilities. What is puzzling in light of this history, however, is why the Report would effectively prohibit stablecoin issuers from structuring themselves as 100% reserve (i.e., narrow) banks that limit their activities to the issuance, transfer and buying and selling stablecoins fully backed by a 100% reserve of cash or cash equivalents.

“U.S. regulators speak on stableman and crypto regulation” Davis Polk Client Update, 12 November 2021

I am open to the possibility that the conventional bank regulation solution was unintended and that a narrow bank option might still be on the table. In that regard, I note that Circle has been pursuing the 100% reserve bank option for some time already so it would have been reasonable to expect that the PWG Report to discuss why this was not an option if they were ruling it out. The value of the Davis Polk note is that it neatly explains why being required to operate under bank regulation (the Leverage Ratio in particular) will be problematic for the stablecoin business model. This will be especially useful for those in the stablecoin community who may believe that fractional reserve banking is a free option to increase the riskiness of the assets that back the stablecoin liabilities.

But, as always, I may be missing something…

Tony – From the Outside

Self regulation in DeFi

This article in Wired offers a useful summary of how some motivated individuals are attempting to use the transparency of the system to control bad actors.

It is short and worth reading in conjunction with this paper titled “Statement on DeFi Risks, Regulations, and Opportunities Commissioner Caroline A. Crenshaw that sets out a US regulator’s perspective on the question of how DeFi should be regulated. This extract from the paper covers the main thrust of her argument in favours of formal regulation

While DeFi has produced impressive alternative methods of composing, recording, and processing transactions, it has not rewritten all of economics or human nature. Certain truths apply with as much force in DeFi as they do in traditional finance:

– Unless required, there will be projects that do not invest in compliance or adequate internal controls;

– when the potential financial rewards are great enough, some individuals will victimize others, and the likelihood of this occurring tends to increase as the likelihood of getting caught and severity of potential sanctions decrease; and

– absent mandatory disclosure requirements,[10] information asymmetries will likely advantage rich investors and insiders at the expense of the smallest investors and those with the least access to information.

Accordingly, DeFi participants’ current “buyer beware” approach is not an adequate foundation on which to build reimagined financial markets. Without a common set of conduct expectations, and a functional system to enforce those principles, markets tend toward corruption, marked by fraud, self-dealing, cartel-like activity, and information asymmetries. Over time that reduces investor confidence and investor participation.

Conversely, well-regulated markets tend to flourish

“Statement of DeFi Risks, Regulations and Opportunities” by Commissioner Caroline A Crenshaw, The International Journal of Blockchain Law, Vol. 1, Nov. 2021.

Tony – From the Outside

Finance cartels face digital currency shake-up | Financial Times

Cross border payment is one of the areas of conventional banking where challengers believe that crypto/DLT solutions can shake up the existing order. There is little doubt that the cross border payment status quo has lots of room for improvement but Gillian Tett (Financial Times) offers a nice summary of central bank projects that are potentially introducing other vectors of innovation and competition.

— Read on www.ft.com/content/4ab25f71-78ff-40a2-b47c-e04075ea81b4

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

DeFI primer

Lately, this blog has pivoted from something I know reasonably well (bank capital adequacy) to things that I don’t – cryptoassets, stablecoins, central bank digital currencies and DeFi. My last post looked at a paper by Nic Cater and Linda Jeng titled “DeFi Protocol Risks: the Paradox of DeFI”. This week I want to flag another useful paper (well at least from my newbie perspective) written by Fabian Schär that was published in the St Louis Fed Review (Second quarter 2021).

I have to confess that I am not yet fully convinced that the DeFI applications developed to date do much more than offer novel ways of trading risk in new forms of securities or crypto assets. That does not mean that the technology will not someday add value to the financial system that will be increasingly called onto support an increasingly digital economy and ultimately the Metaverse.

Schär’s exploration of the risks of DeFI (Section 3) covers very similar ground to the Carter and Jeng paper I flagged above. What I did find useful was Section 2 that lays out the building blocks that DeFi is based on.

The DeFi Stack

Schär concludes …

DeFi has unleashed a wave of innovation. On the one hand, developers are using smart contracts and the decentralized settlement layer to create trustless versions of traditional financial instruments. On the other hand, they are creating entirely new financial instruments that could not be realized without the underlying public blockchain. Atomic swaps, autonomous liquidity pools, decentralized stablecoins, and flash loans are just a few of many examples that show the great potential of this ecosystem.

While this technology has great potential, there are certain risks involved. Smart contracts can have security issues that may allow for unintended usage, and scalability issues limit the number of users. Moreover, the term “decentralized” is deceptive in some cases. Many protocols and applications use external data sources and special admin keys to manage the system, conduct smart contract upgrades, or even perform emergency shutdowns. While this does not necessarily constitute a problem, users should be aware that, in many cases, there is much trust involved. However, if these issues can be solved, DeFi may lead to a paradigm shift in the financial industry and potentially contribute toward a more robust, open, and transparent financial infrastructure.

As noted above, I am not sure that all of the innovations generated by DeFi to date are going to make the world (or at least the financial system) a better place. That said, I am a traditional banker so what would I know. I remain open to the idea (indeed optimistic) that the technologies, applications and concepts being developed under the DeFi framework have the potential to deliver some value. The extent of improvement in conventional banking and finance is sometimes under appreciated but there is still plenty of room for improvement.

Shär’s paper is relatively short (roughly 20 pages) and worth a read if you are new to the topic like me and interested in this area of finance. It also has an extensive list of references that are worth reviewing for leads in areas worth exploring in more depth.

Tony – From the Outside

Progress in fast payment systems

As we contemplate new forms of money (both Central Bank Digital Currencies and new forms of private money like stablecoins), JP Koning makes the case that the modern payment systems available in the conventional financial system have improved more than is often appreciated …

The speeding up of modern payments is a great success story. Let me tell you a bit about it.To begin with, central banks and other public clearinghouses have spent the last 15-or-so years blanketing the globe with real-time retail payments systems. Europe has TIPS, UK has Faster Payments, India has IMPS, Sweden has BiR, Singapore FAST. There must be at least thirty or forty of these real-time retail payments system by now. 

The speed of these new platforms get passed on to the public by banks and fintechs, which are themselves connected to these core systems.

That is not to say they are perfect but it is helpful to properly understand what has been done already in order to better understand what the new forms truely offer.

You can read his post here ..

http://jpkoning.blogspot.com/2021/07/those-70s-ach-payments.html

Tony – From the Outside

Taming wildcat stablecoins …

… is the title of an interesting paper by Gary Gorton and Jeffrey Zhang which argues that:

  • Cryptocurrency, or stablecoins to be more precise, can be viewed as the latest variation in a long history of privately produced money
  • The experience of the United States during the Free Banking Era of the 19th century suggests that ” … privately produced monies are not an effective medium of exchange because they are not always accepted at par and are subject to bank runs”
  • Stablecoins are not as yet a systemic issue but could be, so policymakers need to adjust the regulatory framework now to be ready as these new forms of private money grow and and potentially evolve into something that can’t be ignored
  • Policy responses include regulating stablecoin issuers as banks and issuing a central bank digital currency
So what?

I am not convinced that a central bank digital currency is the solution. I can see a case for greater regulation of stablecoins but you need to be clear about exactly what type of stablecoin requires a policy response. Gorton and Zhang distinguish three categories …

The first includes cryptocurrencies that are not backed by anything, like Bitcoin. We call these “fiat cryptocurrencies.” Their defining feature is that they have no intrinsic value. Second, there are specialized “utility coins,” like the JPMorgan coin that is limited to internal use with large clients. Finally, there are “stablecoins,” which aspire to be used as a form of private money and so are allegedly backed one-for-one with government fiat currency (e.g., U.S. dollars)

I am yet to see a completely satisfactory taxonomy of stablecoins but at a minimum I would break the third category down further to distinguish the ways in which the peg is maintained. The (relatively few?) stablecoins that actually hold high quality USD assets on a 1:1 basis are different from those which hold material amounts of commercial paper in their reserve asset pool and different again from those which employ algorithmic protocols to maintain the peg.

However, you do not necessarily have to agree with their taxonomy, assessments or policy suggestions to get value from the paper – three things I found useful and interesting:

  1. The “no-questions-asked ” principle for anything that functions or aims to function as money
  2. Some technical insights into the economic and legal properties of stablecoins and stablecoin issuers
  3. Lessons to be learned from history, in particular the Free Banking Era of the 19th century
The “no-questions-asked” principle.

Money is conventionally defined in terms of three properties; a store of value, a unit of account and a medium of exchange. Gorton and Zhang argue that “The property that’s most obvious, yet not explicitly presented, is that money also must satisfy the no-questions-asked (“NQA”) principle, which requires the money be accepted in a transaction without due diligence on its value“. They freely admit that they have borrowed this idea from Bengt Holmstrom though I think he actually uses the term “information insensitive” as opposed to the more colloquial NQA principle.

Previous posts on this blog have looked at both Holmstrom’s paper and other work that Gorton has co-authored on the optimal level of information that different types of bank stakeholders require. If I understood Holmstrom correctly, he seemed to extend his thesis on the value of being able to trade on an “information insensitive” basis to argue that “opacity” in the debt market is something to be embraced rather than eliminated. I struggle with embracing opacity in this way but that in no way diminishes the validity of the distinction he draws between the relative value of information in debt and equity markets and its impact on liquidity.

Gorton and Zhang emphasise the importance of deposit insurance in underwriting confidence in and the liquidity of bank deposits as the primary form of private money. I think that is true in the sense that most bank deposit holders do not understand the mechanics of the preferred claim they have on the assets of the bank they have lent to but it seems to me that over-collateralisation is equally as important in underwriting the economics of bank deposits.

If I have not lost you at this point, you can explore this question further via this link to a post I did titled “Bank deposits – turning unsecured loans to highly leveraged companies into (mostly) risk free assets – an Australian perspective“. From my perspective, the idea that any form of money has to be designed to be “information insensitive” or NQA rings very true.

Insights drawn from a technical analysis of stablecoins and stablecoin issuers.

The paper delves in a reasonable amount of detail into the technicalities of whether stablecoins are economically or legally equivalent to demand deposits and the related question of whether stablecoin issuers might be considered to be banks. The distinction between the economic and the legal status is I think especially useful for understanding how banking regulators might engage with the stablecoin challenge.

The over arching point is that stablecoins that look and function like bank demand deposits should face equivalent levels of regulation. That does not necessarily mean exactly the same set of rules but something functionally equivalent.

One practical outcome of this analysis that I had not considered previously is that they deem Tether to be based on an “equity contract” relationship with its users whereas the other stablecoins they analyse are “debt contracts” (see below). The link between Tether and a money market fund and the risk of “breaking the buck” has been widely canvassed but I had not previously seen the issue framed in these legal terms.

This technical analysis is summarised in two tables (Table 2: Stablecoins and their Contracts as of June 30, 2021 and Table 3: Stablecoins, Redemptions, and Fiat Money as of June 30. 2021) that offer a useful reference point for understanding the mechanics and details of some of the major stablecoins issued to date. In addition, the appendix to the paper offers links to the sources used in the tables.

Lessons to be learned from history

It may have been repeated to the point of cliche but the idea that “those who cannot remember the past are condemned to repeat it” (George Santayana generally gets the credit for this but variations are attributed to Edmund Burke and Sir Winston Churchill) resonates strongly with me. The general argument proposed by Gorton and Zhang is that lots of the ideas being tried out in stablecoin design and DeFi are variations on general principles that were similarly employed in the lightly regulated Free Banking Era but found wanting.

Even if you disagree with the conclusions they draw, the general principle of using economic history to explore what can be learned and what mistakes to avoid remains a useful discipline for any practitioner of the dark arts of banking and money creation.

Summing up in the authors’ own words

The paper is long (41 pages excluding the Appendix) but I will wrap up this post with an extract that gives you the essence of their argument in their own words.

Tony – From the Outside

Conclusion 

The more things change, the more they stay the same. It is still the case that regulation is being outpaced by innovation—thereby creating an uneven playing field—as it is easier and cheaper for more technologically advanced firms to offer similar products and services. 

In this case, it is also true that the problems associated with privately produced money are the same as they were one hundred and fifty years ago. We stress three points from our review of history. First, the use of private bank notes was a failure because they did not satisfy the NQA principle. Second, the U.S. government took control of the monetary system under the National Bank Act and subsequent legislation in order to eliminate the private bank note system in favor of a uniform currency—namely, national bank notes. Third, runs on demand deposits only ended with deposit insurance in 1934. 

Currently, it does not appear that stablecoins are used as money. But, as stablecoins evolve further, the stablecoin world will look increasingly like an unregulated version of the Free Banking Era—a world of wildcat banking. During the Free Banking Era, private bank monies circulated at time-varying discounts based on geography and the perceived risk of the issuing bank. Stablecoin prices are independent of geography but not independent of the perceived risk of their backing assets. If they succeed in differentiating themselves from fiat cryptocurrencies and become used as money, then they will likely trade at time-varying discounts as well. Policymakers have a couple of ways to address this development, and they better get going. 

Grant Williams explores the two sides of Tether

Grant Williams offers a deep dive into the questions that have dogged Tether via a podcast discussion with two Tether sceptics. In addition (though I am not sure how long this link will be active) he is also offering access to the June edition of his newsletter which includes a detailed account of the case against Tether.

William’s perspective is explicitly Tether sceptical. However, he also includes a long Twitter thread from Jim Bianco attempting (in Bianco’s words) “to pushback on the FUD about USDT”. I am not sure Williams adds anything new to the sceptical view but it is useful to see the counter-narrative offered by Bianco covered in the newsletter. That said, my read of Bianco’s contribution is that it is more a defence of the general promise of a decentralised DeFi system, than it is a defence of Tether itself.

The Tether part of the newsletter is a long read at 25 pages (there is always the podcast if you prefer) but it does offer a comprehensive account of the sceptical position on Tether and a flavour of the counter argument.

Tony – From the Outside

Stablecoin backing

… is a hot topic full of claims, counter claims and clarifications. Tether’s USDT token has been getting the bulk of the attention to date but questions are now being asked about Circle’s USDC token (a cryptographic stored value token or stablecoin that allows users to trade crypto assets).

My understanding is that USDC is one of the better (in relative terms) stable coins regarding backing and disclosure but this analysis from Amy Castor argues that is still not especially good and may be getting worse. The Financial Times makes a similar argument.

The broad problem they outline

  • Stablecoins generally start out with a promise that each coin is backed 1:1 with fiat currency (typically USD) or fully reserved
  • Ideally those fiat currency reserves are held on deposit in a bank on a custodial basis
  • Over time that simple promise becomes more nuanced with qualifications that dilute the fiat currency component and introduce concepts like “approved investments”
  • The location of the deposit may also become ambiguous
  • Not always clear if the backing itself has evolved or the disclosure evolves in response to questioning

USDT has been the most high profile example of asset backing being understood to be USD cash but evolving into something USD based but not always 100% cash or necessarily liquid. The two sources cited above suggest that USDC backing may also be less than 100% USD.

Amy Castor points to the change in USDC disclosure between February and March 2021 as evidence of an apparent change in (or clarification of?) the composition of the reserve backing.

Source: Amy Castor, “What’s backing Circle’s 25B USDC? We may never know”

As always I may be missing something, and maybe this is just my traditional banking bias, but Amy poses what seem to me to be pretty reasonable questions like “what are those approved investments? Who approves them? What percentage of assets are in that category?” that Circle is yet to answer.

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