By Conner Morris 

Why the Cryptocurrency Market Is Worth Regulating

Currently, the market capitalization of all cryptocurrencies is around $500 billion, after a significant increase to $630 billion in January 2018.[1] While the industry has been growing steadily over the last few years, in 2017 the digital asset industry exploded – the number of cryptocurrencies and digital assets on exchanges rose from 617 to 1,335, a 216% increase, and the total market cap in the industry increased by 3,363%.[2] Furthermore, crypto-companies raised over six billion dollars in 2017 alone through 382 Initial Coin Offerings (ICOs), which is one of the means by which crypto-companies offer their assets for sale.[3]  Because of its vast application and advantages compared to traditional currencies, cryptocurrency is believed by analysts to be in just the beginning of its growth, with some even estimating that the market cap will rise as high as two trillion dollars in the coming years.[4]

Although this industry could be valued in the trillions of dollars and investors have billions of dollars on the line, it has been largely unregulated and therefore open to financial scams.[5]  The U.K. treasury committee recently called the crypto-industry the “Wild West” and stated investors should be prepared to lose all of their money.[6] Unfortunately, the committee does not seem to be wrong. Digital asset analytic firms have found that around 80% of the ICO’s they studied were scams, and over the past two years investors have been defrauded out of nearly $100 million.[7]

The U.K. treasury committee recently called the crypto-industry the “Wild West” and stated investors should be prepared to lose all of their money.

Thus, to protect investors from fraud, manipulation, and the like, it is obvious that this industry needs some form of regulation, but how should it be regulated?

Why the Existing U.S. Government Regulatory Framework Doesn’t Fit

Thus far, the U.S. has regulated the crypto-industry within its current framework of laws, rather than introducing new ones.[8] U.S. regulators have decided that the digital asset field is to be regulated by the U.S. Securities and Exchange Commission (SEC), which is responsible for regulating securities that are traded within the U.S.[9]  Recent statements issued by SEC chairman Jay Clayton, as well as the commissions recent release of their “statement on potentially unlawful online platforms for trading digital assets,” indicate that not only is the SEC leaning towards applying traditional security laws to most cryptocurrencies and the exchanges trading them, but also that they are unwilling to add or update their laws for this new digital asset industry.[10]

This decision to regulate cryptocurrency with security laws is harmful for the industry. First, there is a legal concern because it is hard to see how a cryptocurrency can be defined as a security when it does not seem to meet the four prongs of the “Howey Test”:  (1) an investment of money (2) in a common enterprise (3) with the expectation of profits (4) from the efforts of others, that the Supreme Court announced in 1946 for determining whether an asset is a security.[11]  Simply put, it is difficult to see how a cryptocurrency network meets prongs two and four. Ideally, crypto-companies are decentralized, peer-to-peer networks, where its users have individual goals rather than common goals, and profits are determined by the usefulness of the product, rather than the efforts of others.[12]

Secondly, labeling digital assets sold by crypto-companies as securities would force crypto-companies who want to sell their assets through ICO’s to either register their digital assets or offer their asset in a way in which they are exempt from registration.[13] Both of these options are not ideal as the application of these securities laws to the cryptocurrency market would harm their growth.[14] If a crypto-company wanted to publicly sell their assets and were forced to register these assets as securities, the cost would be extremely high.[15] There are costs associated with the registration process, costs associated with the required disclosure of information, and costs associated with ongoing regulatory exposure.[16] Not only would this make it more difficult for investors to invest in these companies, but it would stifle the “free market” that is key to this industry’s success.[17] An abundance of users and a free network are essential to cryptocurrency markets because not only is the value of the product dependent on how many users there are, but the technology also works in a way in which the more users there are, the more secure the assets are.[18] Additionally, offering these assets in a way in which they would be exempt from security laws would not provide the growth and free market the industry needs, because securities laws restrict the number of active investors with requirements.[19]

An abundance of users and a free network are essential to cryptocurrency markets because not only is the value of the product dependent on how many users there are, but the technology also works in a way in which the more users there are, the more secure the assets are.

Why an Industry Sponsored Self-Regulated System Is Best for the Industry   

While regulating cryptocurrencies with outdated securities regulation does not seem to be the answer, it is clear this industry requires regulation to help it grow further. With the current unregulated system, crypto-currency entrepreneurs are reluctant to get involved due to possible violations of the law, investors are reluctant to invest because of the uncertainty of valuations, and other countries are luring crypto-companies away from the U.S. with laws that enable these companies to grow.[20]

Rather than burden the industry with outdated regulatory costs, the solution which would actually provide the most safeguards while, still allowing the industry to grow, would be an industry sponsored self-regulatory system, like The Virtual Commodity Association (VCA), a self-regulatory agency founded by Cameron and Tyler Winklevoss. In an industry as new and complex as cryptocurrencies, the crypto exchanges themselves have the best ability to monitor their own exchanges, as they best understand the technology and needs within the industry.[21] A self-regulatory agency like the VCA could act as a nonprofit, independent regulatory organization, that would not be a trade organization and could provide regulatory programs that will be compliant with global standards in the industry.[22] Therefore, it would provide the oversight necessary to detect and deter fraudulent behavior, and thus incentivize investment by promoting efficiency and transparency.[23] Furthermore, a system like this could be integrated with the SEC in a way which gives them the regulatory oversight they desire, albeit limited, without burdening the industry with costs that would stifle its growth. A current example of a system that works like this is the National Futures Association, which is a self-regulated organization that aids regulations within the U.S. derivative industry, and helps this industry keep their regulatory costs down.[24] Furthermore, rather than the SEC shifting the costs of their regulatory practices directly onto crypto-companies, the crypto-companies themselves could create the cost effective regulatory framework that they need. For all of these reasons, a self-regulatory system seems to be a promising way to encourage investment while not burdening the industry with costs it cannot afford.

[1] Nate Nead, Cryptocurrency: Growth Trends & Industry Performance, INVESTMENT BANK (Mar. 6, 2018, 4:01 PM), https://investmentbank.com/crypto-growth/.

[2] Id.

[3] Id.

[4] Id.

[5] Aaron Hankin, ‘Wild West’ cryptocurrency market, MARKET WATCH (Sept. 19, 2018, 11:06 AM), https://www.marketwatch.com/story/wild-west-cryptocurrency-market-needs-to-be-regulated-says-uk-treasury-committee-2018-09-19.

[6] Id.

[7] Aaron Hankin, Too many ICOs peddle outright fraud, MARKET WATCH (Aug. 20, 2018, 4:08 PM), https://www.marketwatch.com/story/too-many-icos-peddle-outright-fraud-finra-2018-08-20.

[8] Arjun Kharpal, Cryptocurrencies: Regulating the new economy, CNBC (Aug. 9, 2018, 2:20 AM), https://www.cnbc.com/2018/08/09/cryptocurrencies–regulating-the-new–economy.html.

[9] Id.

[10] See Evelyn Chang, The SEC just made it clearer that securities laws apply to most cryptocurrencies and exchanges trading them, CNBC (Mar. 7, 2018, 6:48 PM), https://www.cnbc.com/2018/03/07/the-sec-made-it-clearer-that-securities-laws-apply-to-cryptocurrencies.html.

[11] Diego Zuluaga, Should Cryptocurrencies Be Regulated like Securities? CATO INSTITUTE (June 25, 2018), https://www.cato.org/publications/cmfa-briefing-paper/should-cryptocurrencies-be-regulated-securities.

[12] See Id.

[13] Id.

[14] Pawel Kuskowski, Why Regulating Cryptocurrencies As Securities Would Stifle Growth, FORBES (Aug. 1, 2018, 6:26 AM), https://www.forbes.com/sites/pawelkuskowski/2018/08/01/why-regulating-cryptocurrencies-as-securities-would-stifle-growth/#f4bf2cb242b0.

[15] Id.

[16] See Id.

[17] See Id.

[18] Id.

[19] See Id.

[20] Stephan J. Obie and Mark Rasmussen, How Regulating Could Help Cryptocurrencies Grow, HARVARD BUSINESS REVIEW (July 17, 2018), https://hbr.org/2018/07/how-regulation-could-help-cryptocurrencies-grow.

[21] Paul Vigna, Winklevoss Effort to Self-Regulate Cryptocurrency Gets Members, WALL STREET JOURNAL  (Aug. 20, 2018 6:31 PM), https://www.wsj.com/articles/winklevoss-effort-to-self-regulate-cryptocurrency-gets-members-1534804308?mod=mktw.

[22] See Cameron Winklevoss, A Proposal for a Self-Regulatory Organization for the U.S Virtual Currency Industry, GEMINI  (Mar. 13, 2018), https://medium.com/gemini/a-proposal-for-a-self-regulatory-organization-for-the-u-s-virtual-currency-industry-79e4d7891cfc.

[23] See Id.

[24] See Id.