Bloomberg: For cryptocurrencies, regulatory arbitrage is a feature, not a bug

Original article: https://www.bloomberg.com/opinion/articles/2022-07-26/crypto-breaks-the-rules-and-that-s-the-point#xj4y7vzkg

By Tyler Cowen

One of the most common criticisms of cryptocurrencies is that they are simply a way to get around financial rules and regulations. This criticism is not entirely wrong — but with cryptocurrencies, as with many other innovations, regulatory arbitrage is a feature, not a flaw.

Many times, regulatory arbitrage is most successful when the innovation improves upon an old approach in some way. The message of this arbitrage is that the old regulations need to change.

Consider a concrete example. Many cryptocurrency institutions issue tokens, and for many regulators, tokens have the attributes of securities and should therefore be regulated. But they are not, at least not uniformly. So if you issue a crypto token but don’t need it to be registered as a security or go through the process of satisfying securities laws, then you’re engaging in regulatory arbitrage.

It is worth thinking about why some regulations should change in this new context. In the previous crypto world, issuing securities involved a lot of institutional preparation, investment and legal planning, not even including any regulatory constraints that needed to be met. It is often easier and faster to issue crypto tokens, and fairly immature institutions are already doing this. Software and blockchain do many things that once required offices, people, and a lot of actual administration.

There may be software that automatically issues encrypted tokens based on smart contracts specifying issuance conditions. That possibility just shows how much things have changed.

Standard U.S. regulatory practice typically focuses on regulating host country companies and intermediaries, rather than software. However, once the blockchain begins to verify, store and communicate information, it will be very difficult for regulators to step in and make meaningful changes. As such, the old governance model no longer applies to a significant part of the crypto experience.

The low cost of issuing tokens means that issuing intermediaries can be fairly thinly capitalized. Often, they either don't have the ability or the incentive to meet many of the regulations. Additionally, an institution can fully participate in the crypto space without being based in the US or associated with any particular nation-state.

You can lash out at these characteristics of the market. In any case, they would imply a very different set of regulatory constraints. They also mean that certain kinds of securities (if that's the right name) can be issued much cheaper than before.

Given this reality, shouldn't there be substantive changes in regulation? This may include some areas that are more heavily regulated, but overall regulation may become more permissive. Regulators will have to learn to adapt to a decentralized market structure that is cheaper and harder to control. Common wisdom is that when software can replace major capital investments, regulation should change, even if observers disagree on how.

Unfortunately, the regulatory process is static and often slow to change. Regulators often cling to the status quo until it is no longer tenable. One of the benefits of regulatory arbitrage is that it forces them to act and brings about a new balance.

Even if you think current regulations are appropriate, you should acknowledge that they are also a product of earlier regulatory arbitrage events: Junk bonds helped bypass some equity regulations in the 1980s, for example. Regulatory arbitrage has long been a means of keeping regulation at least somewhat up to date.

Back to the example at hand: indeed, many crypto token schemes are marketed under false pretenses, or are part of a “pump and dump” strategy. These negative aspects of the token phenomenon shouldn’t make us lose sight of their possible benefits as a new method of raising capital or leveraging the market to value projects. Many valuable innovations — such as railroads and the Internet — were also plagued by investor fraud in their early days.

To be clear, this argument is not to say that regulatory arbitrage is always good. It can lead to regulatory overreaction or, conversely, to regulatory gaps that persist for too long and lead to 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 is good about encryption. It has many benefits, some of which I would be happy to cite, but one of the benefits that is certainly underappreciated is that it is a form of regulatory arbitrage.