Bitcoin bonanza must be met with smart, tailored regulation

Bitcoin bonanza must be met with smart, tailored regulation
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The speculative frenzy in so-called cryptocurrencies like Bitcoin brings up important public policy questions. Legitimate institutions such as the CME and CBOE are launching bitcoin financial products.

Entrepreneurs are raising money through Initial Coin Offerings (ICOs) that look like securities offerings. Bitcoin prices gyrate at warp speed. What, if anything, should regulators do about this? 

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First, let’s remember why we regulate financial markets differently from other markets. The people demand strict regulation of financial markets for very good reasons. Free markets work great when people have good information about the price and quality of their choices. 

 

With financial instruments, that is not always the case. It is often difficult for investors to know exactly what they are buying, and issuers don’t necessarily want to divulge all the relevant details. For this reason, regulators force disclosure of important information about financial instruments and their prices.

Consumer protection is a big concern. Money attracts thieves just like garbage attracts flies. Regulators thus have a never-ending task of trying to protect consumers from the manipulators and fraudsters. Brokers thus have a regulatory duty to recommend only investments that are “suitable” for investors. 

Regulators are also concerned about systemic risk. Financial meltdowns have a history of spreading and bringing down the entire economy, causing widespread unemployment and misery. When banks get into trouble, they stop lending, and this exacerbates a contraction of economic activity.  

Bitcoin and innovations such as ICOs are scary in all of these dimensions. The history of markets is the history of bubbles, and they usually end badly. Unsophisticated investors who buy in at the peak of a bubble get burned. Those who borrow to participate in the bubble suffer even more because the borrowing amplifies the losses. 

Those who lend to those who borrow also get burned when the borrowers can’t pay. From a monetary policy perspective, the notion of an unregulated monetary system with no flexibility raises the specter of the periodic financial catastrophes we experienced during the days of the gold standard. 

There are good reasons why the entire world abandoned the gold standard. It just didn’t work for providing long-term economic growth and stability. 

Bitcoin is especially troubling because of its shadowy beginnings. It is not clear who Bitcoin's pseudonymous inventor, “Satoshi Nakamoto,” really is. There are people accused of being Satoshi Nakamoto who deny it, and there are those who claim to be Satoshi Nakamoto but cannot prove it. 

Even worse, the near anonymous nature of Bitcoin transactions has made it the coin of the realm in the underground economy. Ransomware attackers routinely demand payment in Bitcoin before promising to unlock your hard drive.  Drug dealers and human traffickers accept Bitcoin for transactions on the dark web. 

So, what should regulators do? Crypto technology is here to stay. It is not going away. The best way to tame its excesses and provide for consumer protection, law enforcement and economic stability is to permit legitimate licensed financial institutions to offer properly regulated products. 

The upcoming trading of futures on Bitcoin is a case in point. Currently, Bitcoin exchanges are virtually unregulated and subject to all the usual problems that afflict unregulated financial markets, including outright theft, fraud, Ponzi schemes, spoofing, pumping and dumping, wash sales and other manipulations.  

Moving Bitcoin trading onto markets with good surveillance and good audit trails will go a long way to making the trading fair and orderly. Indeed, history shows that the introduction of futures trading generally reduces volatility in the underlying assets, so the introduction of bitcoin futures should help to reduce the volatility of Bitcoin prices.

Bitcoin itself is fundamentally useless until it is used to buy goods and services. This is the Achilles heel of Bitcoin’s pseudo anonymity. The dark uses of Bitcoin and other cyber currencies can be deterred by applying full anti-money laundering (AML) and know-your-customer (KYC) rules at all the entry and exit points to the cryptocurrency world. 

Cyber currency exchanges as well as merchants accepting cyber currencies should be required to report large Bitcoin transactions just as they report large cash transactions. Indeed, one of the purported advantages of cyber currencies is that they are “just like cash" and therefore should be treated as such for the purposes of AML and KYC rules. 

Thus, drug dealers and ransomware attackers who accumulate Bitcoin will run the risk of detection when they try to spend their ill-gotten gains.

Banking regulators should permit financial institutions to hold and lend cyber currencies, but they need to carefully monitor the riskiness of such endeavors. Permitting loans in cyber currencies will make it easier for people to short Bitcoin and thus pop the bubble. 

However, the extreme volatility in this space makes it possible that highly leveraged financial institutions will suffer extreme losses if they are not careful. Thus, regulators need to pay close attention to the safety and soundness of financial institutions transacting in cyber currencies and the soundness of the clearinghouses that back futures trading in cyber currencies.

ICOs are an interesting innovation in corporate finance. They provide instant liquidity for early-stage investments in speculative startup businesses. This also provides instant opportunities for unscrupulous characters to dump worthless investments on gullible investors and ruin capital markets for the legitimate raising of the capital needed to grow the economy. 

We need fully-funded regulators who have the resources and the good judgment to arrest the real crooks while staying out of the way of legitimate capital raising.  

U.S. securities regulation is based on a philosophy of disclosure, not merit regulation. It is not the job of the regulators to determine what are good or bad investments. It is their job to make sure that necessary information is appropriately communicated to investors and to deter and punish the fraudsters.  

Speculating in bitcoin and cyber currencies may be suitable for some investors but not others, and regulators need to make sure that the suitability rules are being followed. 

James J. Angel, Ph.D., CFA is a finance professor at the McDonough School of Business at Georgetown University.