One of the most common criticisms of cryptocurrencies is that they are just a way to circumvent financial rules and regulations. This criticism is not entirely wrong, but with crypto, as with many other innovations, regulatory arbitrage is a feature, not a bug. Very often, regulatory arbitrage is most effective when innovation improves some aspect of old methods. Refereeing sends the message that old regulations need to change.
Let’s take a concrete example. Many cryptocurrency institutions issue tokens that many regulators believe have the properties of securities and should be regulated as such. But that’s not the case, at least not uniformly. So, if you issue a crypto token, but you are not required to register it as a security and go through the securities law compliance process, you are engaging in regulatory arbitrage.
It is worth thinking about why certain regulations should change in this new context. In the pre-crypto world, issuing a security involved a multitude of institutional preparations, investments and legal planning, even outside of the regulatory constraints that had to be respected. Issuing crypto tokens is generally easier and faster, and quite immature institutions have done it. Software and blockchains do much of the work that once required offices, staff, and a lot of hands-on management.
There could be software that automatically issues cryptographic tokens, based on smart contracts specifying the conditions of issuance. This very possibility is a sign of how much things have changed.
Standard U.S. regulatory practice generally focuses on regulating hospitality companies and intermediaries, rather than software. Yet once a blockchain verifies, stores and communicates information, it is difficult for regulators to step in and make a meaningful difference. Thus, the old regulatory model no longer applies to a significant part of the crypto experience.
And the lower costs of issuing tokens mean that issuing intermediaries can be quite thinly capitalized. They are often unable or unincentivized to comply with many regulations. Additionally, an institution can fully participate in the crypto space without being based in the United States or tied to a specific nation-state.
You can denounce these characteristics of the market. Either way, it will involve a radically different set of regulatory constraints. This also means that certain types of securities (if they should be called that) can be issued at much lower prices than before.
Faced with this reality, shouldn’t the regulations be modified – and substantially? This may include some areas where regulation is even stricter, although overall regulation will likely become more relaxed. Regulators will have to learn to live with a more decentralized market structure, less costly and more difficult to control. It stands to reason that when software can replace major capital investments, regulations must change, even if observers disagree on how to do it.
Unfortunately, the regulatory process is static and its evolution is generally slow. Regulatory agencies often stick with the status quo until it is no longer tenable. One of the advantages of regulatory arbitrage is that it forces their hand and creates a new balance.
Even if you think current regulations are appropriate, you must recognize that they are also the product of previous episodes of regulatory arbitrage: in the 1980s, for example, junk bonds helped circumvent some regulations on actions. Regulatory arbitrage has long been a way to keep regulations at least somewhat up to date.
To return to the example above: it is true that many crypto token schemes are marketed under false pretenses or are part of a “pump and dump” strategy. These negative aspects of the symbolic phenomenon should not make us forget their possible advantages as a new method of fundraising or using markets to promote projects. Many valuable innovations – I think of railroads and the Internet – were also prey to investor fraud early on.
To be clear, the argument is not that regulatory arbitrage is always a good thing. This can lead to regulatory overreaction or, conversely, regulatory failures that persist for too long and enable persistent fraud or systemic risk. The argument is that, fundamentally, regulatory arbitrage is part of a process that leads to lower costs, greater innovation and better rules.
People often ask me what cryptography is for. It’s good for many things, and I’m happy to name a few, but surely one of its most underrated benefits is that it is a form of regulatory arbitrage.
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