Bitcoin And Digital Asset Regulation: What To Expect

Summary

• In this article, we take a no-nonsense high-level look at cryptocurrency regulations. We explore the attitudes of key policymakers.
• The view that cryptocurrencies could be a threat to U.S. dollar hegemony is simply outdated given the current policy trajectory. Regulations will strengthen the ecosystem and boost investor confidence.
• Introduction of a CBDC/digital dollar would fashion cryptocurrencies into a vehicle of dollarization, fostering greater economic and financial integration with trading partners.
• Bitcoin and other cryptocurrencies are a far greater threat to disfavored and unstable regional currencies than they are to the U.S. dollar, which given thoughtful regulation and integration, they will likely strengthen.

Gary Gensler discussing financial stability with then chairman Federal Reserve Ben Bernanke. The two men came from opposite sides of the spectrum. Bernanke, a lifetime of public service in education and government, before moving to the private sector as hedge fund advisor. Gensler, a multitalented Goldman Sachs veteran who found a higher calling in government.

Chip Somodevilla/Getty Images News

Introduction

Call them cryptocurrencies, call them crypto, call them tokens, call them digital assets, call them DAOs, call them Web3 or Web 3.0... But whatever you call them... regulation is on the horizon. Despite the fact that the Federal Reserve has been working with MIT on the prospect of a cryptocurrency version of the U.S. dollar, publishing a preliminary report recently, the market seemed blindsided by the announcement that the Biden administration will be taking executive action on regulation.

I think we're entering an era where there's going to be a competition of monies. Because of the printing of fiat money and the depreciated value, there will be a competition of monies, and bitcoin is part of that competition.

But there'll be many monies. Not just crypto monies. There will be central bank crypto monies. But there will be different kinds of monies.

-Ray Dalio, Founder of Bridgewater Associates (12/25/2021)

In this article, we will take a broad look at the current state of cryptocurrency regulations, the attitudes of different regulators, and offer reasonable expectations.

Cryptocurrencies form the basis of a new internet layer that, with sufficient R&D and regulatory guidance, will unleash a new era built from the ground up on internet infrastructure. Bitcoin (BTC-USD) has invented a new store-of-value, disrupting a market that gold has dominated since the Age of Discovery. Future projects may allow securities to be issued and custodied directly on the blockchain, tradable peer-to-peer without the need for a centralized exchange, with rules enforceable by code. As discussed in a previous article, we are seeing the emergence of models that challenge the concept of a joint-stock corporation entirely.

Regulators face the challenge of shielding valuable innovation from hot speculative money capable of creating structural chaos. They must shepherd the disruption of incumbent exchanges that would like to limit blockchain innovation to cost-cutting measures in back office functions. Furthermore, they are racing to stop international cryptocurrency domains from repeating the pattern of regulatory capture and arbitrage that has enabled 'multinational' corporations to become tolerably unaccountable, somewhat ungovernable, stateless entities.

Meet the Regulators

At this point, it seems safe to assume that if regulators intended to 'ban' crypto, they would have attempted it a long time ago. An attempt to do so would not have only been misguided, but unlikely to succeed, given that cryptocurrencies are inherently peer-to-peer technologies (China's bitcoin ban has largely failed). Cryptocurrencies are seen by regulators as highly innovative but also highly disruptive, and there is a lot of debate about the appropriate level of regulation.

Much of the debate centers around who should write and enforce such regulations. The IMF once envisioned a world that sounds a lot like what crypto projects are building today. The current IMF director has called for El Salvador (which proved bitcoin can scale to being an everyday usable currency) to abandon bitcoin. The FDIC has said it is exploring how banks could custody crypto assets. Industry groups have formed, and may lobby for self-regulation. The FSB has made cryptocurrencies a top priority. Should there be ISO standards one day, as there is with SWIFT? The CFTC declared bitcoin a commodity, then told Congress not to be 'hasty' with regulations. The former SEC chairman declared that bitcoin is not a security. The current chairman has said that cryptocurrencies that raise money through ICOs are securities.

The World Economic Forum is one of many organizations working towards multilateral cooperation on cryptocurrencies. It has created the "Global Future Council on Cryptocurrencies".

The Future of Financial Infrastructure; World Economic Forum

Today, regulation is sparse and disorganized, with many different institutions vying for control. This state of affairs could be reaching its apex. As Bloomberg recently reported, the Biden administration is planning to launch a "government-wide strategy for digital assets" that will call for various agencies to write proposals. This portends a comprehensive regulatory agenda that will guide the future of cryptocurrencies, and is certainly anything but a ban on bitcoin, or cryptocurrencies in general.

In our view, there are three key institutions to watch: the Securities and Exchange Commission (SEC), the Department of the Treasury (USDT), and the Federal Reserve.

Defining the Boundaries; Charting the Future

We anticipate that the SEC, led by Chairman Gary Gensler, will be the spearhead of this initiative. Gensler had a distinguished career at Goldman Sachs (GS) before serving as Chairman of the CFTC from 2009 to 2015, where he brought reform to financial derivatives markets. He later studied and taught cryptocurrencies at MIT.

Gensler will likely have the difficult job of reigning in unreasonably speculative and often fraudulent activity that undermines confidence in legitimate projects. The IRS recently stated that NFTs alone are rife with 'mountains' of fraud.

Public confidence can only be built on consumer & investor protection

(A quote from a 2018 keynote presentation on crypto finance given by Gensler to the OECD)

An 'NFT' image that looks like it was drawn in Microsoft Paint, yet costs hundreds of thousands of dollars, might be the pinnacle of postmodern art. A developer that attracts investor enthusiasm, only to run off with their capital, is engaged in fraud. How do you discern between a DAO that attracts users with powerful network effects and a Ponzi scheme? Thoughtful regulations are going to be difficult to write. Gensler's acumen on crypto is impressive and he seems up to the task.

While, in our analysis, the SEC is likely to take the lead in the utilitarian role of developing regulatory frameworks, the work of the USDT could be more strategic. The Secretary of the Treasury is a cabinet-level position held by former Chair of the Federal Reserve Janet Yellen. This is a key role in any administration, facilitating policies of the executive branch.

Deputy Treasury Secretary Wally Adeyemo has been tasked as the lead on cryptocurrency policy. Adeyemo's work has been focused on the development of anti-money laundering standards and combating other misuses of cryptocurrency technology. He has also stated that U.S. sanctions will still be effective in the age of crypto, and furthermore, that "the dollar will remain the dominant currency in the world."

This information is critical in the context of the final key player, the Federal Reserve. While the defining policy of the last generation has been QE, the defining policy of the next generation will be the possible (and in our view, extremely likely) issuance of a central bank digital currency (CBDC--also known as a 'digital dollar') by the Federal Reserve.

While the general population transacts digitally every day, these dollar-denominated transactions are in the form of commercial bank money that is created by commercial banks. A CBDC would allow the general population to hold accounts directly at the central bank (similar to how the cash they hold in hand is a central bank liability), giving them direct and digital access to central bank money.

The Federal Reserve has signaled that it would favor an approach that allows intermediaries to create a layer of financial products on top of this system, including managing accounts and payments. This is because the Federal Reserve Act does not authorize direct accounts for individuals.

A CBDC would be the safest digital asset available to the general public, with no associated credit or liquidity risk.

-Money and Payments: The U.S. Dollar in the Age of Digital Transformation (Federal Reserve report on a potential CBDC)

In its preliminary report on a CBDC, the Federal Reserve notes that it is soliciting policy recommendations and "does intend to proceed with the issuance of a CBDC without clear support from the executive branch and from Congress, ideally in the form of a specific authorizing law." For this reason, we speculate that the USDT will play a key role in propounding CBDC policy.

It is worth noting that Yellen wrote her doctoral dissertation under James Tobin, who proposed giving the public access to accounts at Federal Reserve banks. This would be the most radical change in monetary policy since ending the gold standard. It could allow for programmable taxes or benefits, direct-to-consumer monetary policy, among many other financial innovations.

Our hunch is that congress will largely focus on bitcoin, particularly bitcoin mining. Bitcoin is the only cryptocurrency that has matured into a robust industry, even with its notorious volatility. Some companies operating this infrastructure, such as industry leader Core Scientific (CORZ), have taken a responsible approach that is net carbon-neutral. It may not be the most neoclassical form of profit maximization, but Core Scientific was still able to mine over 1,000 bitcoin last month, growing revenue 350% YoY.

Some smaller industry players, such as Stronghold Digital Mining (SDIG), have outright purchased coal plants. Others have operations in politically-sensitive areas such as Russia and Kazakhstan. Firms that engage in this type of behavior are increasingly the target of lawmaker scrutiny.

Crypto Statecraft

We now turn to the broader implications of crypto regulation. In the early days of the World Wide Web (or "Web 1.0"), the U.S. played an instrumental role in promoting open global standards. In the latest evolution of the internet, the protocols that we call "cryptocurrencies" today will become the 'financial plumbing' of tomorrow.

The U.S. is blessed with the largest, most sophisticated, and most innovative capital markets in the world. We actually represent 38% of the world's capital market, and that's when we're only about 23% of the world's economy. They're competitive. They're efficient. They're transparent. But I think we can't take our remarkable capital markets for granted.

New technologies continue to change the face of finance, for investors and businesses, and more retail investors than ever are accessing our markets. Other countries are also developing deep, competitive capital markets as well.

-Gary Gensler, Chairman of the SEC (9/14/2021)

Governments have realized this. The U.S. has warmly welcomed bitcoin infrastructure fleeing crackdowns in China, with the Governor of Texas touting that their rapid on/off capability stabilizes the grid. China is now rethinking this stance, embracing NFTs and allowing certain regions to experiment with blockchain technology. A former U.K. Treasury official has warned that the U.K. is falling 'shockingly' behind.

One area that I hope nation-states start paying greater attention to is the rise in cryptocurrency, because what looks like a very investing and somewhat exotic effort to literally mine new coins in order to trade with them, has the potential for undermining currencies, for undermining the role of the dollar as the reserve currency. For destabilizing nations, perhaps starting with small ones but going much larger.

...

It appears as though China is going to prevent outside technology payment systems like the cryptocurrency development from playing a big role inside China, because I think they recognize given their nationalism, perhaps earlier than other nations like the U.S., Europe, and elsewhere, that this could be a direct threat to sovereignty.

So while we are talking about making decisions, and trying to be strategic, and making alliances, there is a whole new layer of activity that could be extremely destabilizing. And in the wrong hands and in alliances with the wrong people, could be a direct threat to many nation-states and certainly to the global currency markets.

-Hillary Clinton, Bloomberg New Economy Forum (11/19/2021)

Given the power of the Fed and the status of the U.S. dollar, a CBDC will likely wrangle cryptocurrency markets into USD allegiance. In the process, a CBDC might replace stablecoins (which are tokenized commercial paper hedge funds) or strengthen them with alternative models. This will be decided by technical factors related to how the Fed's CBDC database is designed, and what sort of interoperability is allowed. This will strengthen confidence and perhaps lower volatility in the broader cryptocurrency ecosystem.

The long-term answer, however, is to rid the world of unwanted currencies. Having a national money is not only becoming less and less useful as the world becomes more and more interconnected economically and financially, but is becoming more and more destabilizing. Collapsed currencies leave poverty, fear, anger, and insecurity in their wake. National monies have become the Achille's Heel of globalization.

-Benn Steil & Robert E. Litan, Financial Statecraft (2006)

Through integration with bitcoin and other cryptocurrencies, a dollar CBDC would also promote U.S. dollar hegemony. There are many places in the world where the dollar is desired over a national currency. This includes El Salvador, a dollarized economy that recently made bitcoin legal tender.

Policymakers have long-sought to assist countries looking to dollarize their economies. A U.S. dollar CBDC would enhance access and promote this goal. Programmable money, in the form of smart contracts, private cryptocurrencies, and beyond, will create greater cooperation between trading partners.

Some will argue that lack of a national currency is a threat to sovereignty. This is misguided in two ways. The sovereignty of their currencies is already asymmetrically threatened by stateless and global cryptocurrencies. Russia weighed a ban on bitcoin because an invasion of Ukraine might create a run on the ruble, but these innovations have become too powerful to walk away from. Furthermore, very few countries have truly 'sovereign' monetary policy because their own central banks are beholden to the policy decisions of a few eminent central banks, such as the Federal Reserve, Bank of Japan, and European Central Bank. Their local decisions are largely unavailing, though the notion of a national currency may be comforting.

We have suggested in the past that equity in the Federal Reserve may be an untapped resource, and that tokenizing it and/or creating a new class of Fed equity could be a path towards a CBDC. With the power of smart contracts, it could possibly be fashioned into a new policy tool. We propose that bitcoin should be added to the Federal Reserve balance sheet as a symbolic gesture, an acknowledgment of the powerful ecosystem that the community has built.

Conclusions

Many questions remain as we enter a phase of policy proposals and debate. How interoperable will a CBDC be with private cryptocurrencies? Will a CBDC account act as ID verification in the crypto ecosystem? Will smaller cryptocurrency projects leapfrog bitcoin with more powerful primary layers? Will bitcoin act as a treasury asset to the next-generation financial ecosystem? Or will bitcoin become far more than digital gold, fortified by secondary protocol layers that prehend competing innovations?

These questions, and many more, will define a new form of digital-native financial and economic infrastructure. One thing is certain: Cryptocurrencies are here to stay.

Disclosure: I/we have a beneficial long position in the shares of CORZ either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.