Four principles for crypto regulation

There was a substantial surge in the market capitalization of cryptocurrencies recently, reaching nearly $3 trillion in 2021 but collapsing to under $1 trillion by the end of 2022. We also witnessed fraudulent behavior by many bad actors, from Terra (Luna) to FTX.

Any asset has fluctuations, and the fraudulent behavior was not due to an inherent flaw in distributed ledger technologies (DLTs) but rather bad governance and an absence of a predictable and reasonable regulatory framework. In fact, nearly all the fraudulent behavior took place offshore, at least in part because most cryptocurrency companies have viewed the U.S. regulatory framework as too confusing or ambiguous to set up shop.

Distributed ledger technologies, often referred to as “web3” (or the new generation of the internet for short), use the blockchain to provide ways for users to access, record and validate activity digitally. Although the process is not always fully decentralized, or “permissionless,” blockchain is an enabling technology for collaboration and economic activity often among many, geographically disparate people. Web3 tools include cryptocurrencies.

The expansion of DLT into all areas of the economy is inevitable because it is simply better at doing the job than existing centralized ledger technologies, including in financial services. But the regulatory environment will influence whether the U.S. can take advantage of the technology to its fullest — or whether we sit idly by as other countries, such as the United Arab Emirates and Singapore, lead the charge in attracting investment, entrepreneurs and technologists.

We believe there are four important issues that must be reflected in regulation.

1. Impose licensing requirements on centralized cryptocurrency exchanges and other digital currency services that behave like banks.

Just because a company trades cryptocurrencies does not mean that it should be exempt from financial regulation. If the company serves as a custodian of consumers’ assets, and it lends those deposits to others, it is effectively operating as a bank and should be subject to similar regulations that banks are subject to based on their size and asset class. Sadly, many companies in this space have sought regulatory arbitrage by operating outside of the U.S. because of regulatory ambiguity and the opportunity to arbitrage on it. That’s exactly what happened with FTX, but what’s worse is that then-CEO Sam Bankman-Fried did so in plain sight and conversation directly with regulators that were supposed to be watchdogs.

What does adherence to regulatory requirements look like? For starters, it could involve capital requirements of the form laid out in the recent current and expected credit loss framework that requires that banks use “reasonable and supportable” forecasts to derive the amount of capital reserves they need to hold out in case of adverse economic events. Or it could involve basic cybersecurity and financial security regulatory requirements, like SOC 2 compliance.

Centralized crypto exchanges need to consider the effect that their failure has on the system, and simply arbitraging and evading regulation that already exists and that they should be under can provide the proper guard rails to mitigate future catastrophic outcomes.

2. Provide regulatory clarity about the specifics of legal web3 behavior.

Sadly, there is no single source that specifies the legal requirements for web3 builders. And, in some cases, the regulatory guidance is conflicting. Most notably, the Department of Justice has referred to tokens as commodities in its enforcement actions, whereas the Securities and Exchange Commission (SEC) has called them securities and enforced them as such. Creating guideposts for legal activity will promote not only greater innovation since more companies will build within the U.S. regulatory sandbox, but also more consumer protection since enforcement will have more legal precedent and the bright line for legal activity will be clearer.

Clear and consistent regulations are essential for companies operating in the cryptocurrency space. Regulators should work to create regulations that are easy for companies to understand and follow and that do not create unnecessary barriers to entry. An example of clear and consistent regulations is the New York State Department of Financial Services issuing a “BitLicense” specifically for companies operating in the cryptocurrency space, which sets clear and consistent requirements for companies to meet to operate in the state.

The U.S. has the luxury of experimenting with different approaches because of the varying state-level capabilities. For example, Wyoming passed legislation that recognizes certain types of cryptocurrencies and blockchain tokens as legal property and created a new type of bank specifically for cryptocurrency companies, which allows them to operate in a more permissive regulatory environment. Similarly, Tennessee passed legislation that recognizes decentralized autonomous organizations (DAOs) – a new form of governance that leverages the use of smart contracts and tokens – as limited liability corporations, which provides additional liability coverage for DAO members.

3. Harmonize international standards.

Because of a rigid and stringent regulatory framework, many web3 entrepreneurs and companies locate outside the U.S. for business and residence. Much like developed countries meet to coordinate economic policy through the G20 annual meetings, and the OECD has published international guidelines around the ethical use of artificial intelligence, U.S. regulatory agencies should cooperate with others to identify a common set of principles and standards.

Although many look to the SEC for guidance, they too can learn a lot from international counterparts. For example, they could work with the European Securities and Markets Authority (ESMA) to share information and coordinate regulatory efforts to combat fraud and protect investors in both regions. Similarly, the U.S. could learn from best practices in other countries, including Switzerland’s regulatory sandbox, which not only provides much more clarity on the distinction between security tokens and their counterparts, but also safety in piloting a token as long as the amount raised and transacted upon is below 1 million Swiss francs.

4. Foster dialogue with researchers and industry practitioners.

The cryptocurrency industry is rapidly evolving, and it’s important for regulators to stay informed about the latest developments and trends. Unfortunately, regulation and even the hiring process in the federal government does not yet move fast enough to accommodate these trends, so it is important for regulatory bodies to participate in the web3 community and promote dialogue with researchers and practitioners. For example, the U.S. Commodity Futures Trading Commission (CFTC) could regularly hold public meetings with industry leaders, academics and other experts to discuss the latest developments and trends in the cryptocurrency space.

Fortunately, there are many platforms for facilitating these dialogues. For example, the Center for Digital Finance and Transformation at Columbia University frequently brings industry practitioners and academics together, and sometimes helps convene and participates with federal and state policymakers. Policymakers, especially in the SEC, CFTC and DOJ, should seek opportunities to work with and delve into details with practitioners and researchers.

These recommendations are certainly not exhaustive, but they reflect a general set of governing principles that would improve U.S. economic and social competitiveness, while simultaneously mitigating against the risk of tail outcomes, like those observed over the past year in the crypto community. Most importantly, we encourage regulators not to take a one-size-fits-all approach to web3 regulation, but to understand the context and allow for experimentation and dialogue.

Christos A. Makridis is a research affiliate at Columbia Business School, Stanford University and the University of Nicosia, and CEO and founder of Dainamic, a startup that aims to democratize access to AI for mid and small sized banks. Jay Jog is co-founder of Sei Labs, the first sector specific L1 blockchain specialized for trading. He was previously an engineering lead at Robinhood.