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Amid the ongoing volatility of cryptocurrency prices, questions have inevitably arisen about the extent to which users can trust that these currencies will constitute relatively stable stores for their valuable assets and that transactions will be comparatively free from malfeasant manipulation. With abundant evidence of price instability and technical complexity obscuring understanding of how transactions take place for the vast majority of users, it is unsurprising that calls have been made for sovereign governments to regulate the operators and traders of cryptocurrencies in the same manner that they regulate central banks, retail and investment banks, and stock exchanges.
Fiat currencies are not perfect
It bears remembering that the institutional arrangements under which fiat currencies are created and traded are far from perfect. Regulations seldom come with guarantees of improved performance. While good regulations are welcomed, bad regulations at best do no harm.
Furthermore, external regulations imposed by sovereign governments constitute only one of the forces disciplining these markets. As has been amply evidenced in studies of the emergence of early share markets in the 18th century and in the management of bank-issued currencies from the 19th century, self-governance has frequently proved more effective at both identifying and correcting for imperfections than state intervention. Self-governance tools include internal rules applied by the market operators and the discipline exerted by those choosing (voluntarily) to trade on them.
Self-regulation as a credible first recourse
So long as alternatives exist, strong incentives are provided for those issuing currencies and operating the exchanges to address activities that decrease trust and therefore the attractiveness of their platforms to users. Users also have strong incentives to invest in information identifying those currencies and exchanges with stronger (more trustworthy) and weaker (less trustworthy) activities and governance arrangements. To the extent that there may be insufficient investment in the acquisition of this information, we have observed the emergence of specialist agencies (e.g., investment analysts) undertaking the requisite investigations, thereby contributing to more informed actors and more efficient markets than would otherwise be the case. Indeed, the public good role of analyzing and publishing the results widely represents one of the most important — but largely unrecognized — activities of regulatory agencies.
It raises the question: In the world of cryptocurrencies, who is undertaking the essential analysis role?
Blockchain transparency aids self-regulation
Despite the newness of cryptocurrencies and their limited impact in world financial markets (the top 100 cryptocurrencies account for $265 billion by market capitalization, of which bitcoin accounts for nearly 43 percent), a body of analysis is already emerging from both financial analysis companies and academic institutions. A distinct advantage of analyzing cryptocurrencies over fiat currencies is the transparency of the transactions, which are contained in the widely distributed blockchain ledger. Consequently, it is feasible to trace all transactions into and out of publicly identified addresses. In fiat currency, this would be the equivalent of being able to trace every transaction involving every coin or banknote issued and every dollar of debt raised under fractional reserve arrangements. While the identity of the transactors is unknown, all the flows are transparent to any observer without the need for disclosure regulations.
For example, John Griffin and Amin Shams of the University of Texas at Austin have traced all transactions undertaken in bitcoin and Tether for March 1, 2017 to March 31, 2018. While it is not possible to ascertain the identity of individual transactors, the authors have used known addresses of major cryptocurrency exchanges to identify that the vast majority of transactions in this period were not between individuals paying for goods and services, but rather to and from currency exchanges. While flows of bitcoin are comparatively evenly distributed across a large number of exchanges, Tether flows are disproportionately directed via one exchange, Bitfinex, which appears to be itself dealing with a limited number of exchanges that also exhibit unusually large bilateral flows. Furthermore, they find evidence of unusual trading between Tether and bitcoin that suggests the use of Tether to manipulate the price of bitcoin when its value relative to the US dollar is falling.
Given the extent to which such information has been both identified and made publicly available, if it does indeed cause trust in specific cryptocurrencies and exchanges to fall, one could expect self-governance arrangements to respond to the information. Credible exchanges, having every incentive to signal their activities to current and potential customers, will seek to quarantine themselves from tainted exchanges and currencies. The tainted currencies and exchanges will lose support and must either desist from the undesired activities or exit the market. If self-governance has been effective, then the same analysis run in a subsequent period will provide confirmation. Thus, incentives exist for ongoing monitoring.
Implications for policy and regulation
Lessons from the history of regulation suggest that rather than responding to populist calls to regulate cryptocurrencies and exchanges, policymakers and regulators might be better served by investing in more research into their operation and delaying intervention until evidence is provided of self-governance mechanisms’ failure to respond appropriately. Furthermore, those calling for action are beholden to acknowledge that the search for more information is a responsible action within the wider processes of regulatory governance. There are far more subtle tools in a regulator’s tool kit than explicit intervention alone.
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