Decoding Cryptocurrency Regulation

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Scholars present a framework for digital asset regulation to prevent fraudulent and deceptive practices.

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In the blink of an eye, $40 billion in life savings, home down payments, and investment portfolios disappeared in the cryptocurrency collapse of 2022. For policymakers, the crypto market failure underscored serious issues of fraud, deception, and unfair business practices in the digital asset space.

In a recent article, Sarah Hammer, a legal scholar and executive director at The Wharton School of the University of Pennsylvania, and Brett Hemenway Falk, director of the Crypto and Society Lab at the University of Pennsylvania, argue that regulators should adopt new cryptocurrency standards to protect investors from predatory digital currency practices. Hammer and Hemenway Falk recommend a three-prong approach to improve consumer protection while maintaining industry innovation.

Cryptocurrencies are digital assets in which transactions are verified and records maintained by a decentralized system employing a “protocol” that uses cryptography and blockchain technology. These digital asset transactions use peer-to-peer monitoring through blockchain technology’s virtual ledger that records transactions for both physical and digital items. For example, parties can record transactions for gold, real estate, copyrights, and cryptocurrency through blockchain.

When making a transaction, users submit requests to update the blockchain through a “smart contract”—computer code that defines the scope of the digital asset and acts as an intermediary between users. When a user makes a request to update the blockchain, the smart contract records and carries out the instruction on the blockchain.

A stablecoin is a type of digital asset that is designed to maintain a stable value relative to government regulated currency, physical commodities such as precious metal, other cryptocurrencies, and computerized algorithms.

Hammer and Hemenway Falk recommend that regulators create “crypto standards” that govern cryptocurrency development and provide consumer protection rules to counter abuse of digital assets. Currently, independent developers, who make their own rules, code features of crypto trading, such as smart contracts and stablecoin. As a result, Hammer and Hemenway Falk warn that any developer can build a smart contract that refuses service to some users or alters transactions for others at random.

Importantly, Hammer and Falk note that although crypto standards offer many benefits, standards alone are not sufficient to address all of the practices discussed in their article. They therefore propose a second pillar of cryptocurrency regulation: an additional national overlay of very strong investor or consumer protections as absolutely necessary to address activities in this space.

To ensure compliance with securities regulation, the U.S. Congress authorized the Financial Industry Regulatory Authority, a nongovernmental body made up of various groups within The New York Stock Exchange and The Association of Securities Dealers, to provide exams for over 624,000 brokers and dealers. To sell securities, brokers must pass these exams. Hammer and Hemenway Falk argue that a nongovernmental agency, similar to the Financial Industry Regulatory Authority, could require licensing for digital asset development as well.

Hammer and Hemenway Falk also point to the Hypertext Transfer Protocol, which allows server communication between machines running different software and hardware, as an example of industry self-regulation. Despite offering different operating systems, industry leaders collaborated to standardize many images displayed on computers.

Hammer and Hemenway Falk note that blockchain networks such as Ethereum have started implementing similar self-governance standards for smart contract functionality. Crypto community members propose rules governing digital assets. Other community members then select and finalize these rules. Developers who choose to follow adopted regulations are allowed some discretion as to how they implement certain functionalities.

Hammer and Hemenway Falk argue that crypto standards offer many public policy benefits. Adopting a standardized computer code, for example, would lower entry costs for new developers and reduce costs for current operators. Without such a code, new developers would have to develop custom implementations, costing additional time and money.

They argue that regulators should ensure crypto issuers are honest, fair, and professional in the way they manage potential conflicts of interest, and that developers use a standard system through which customer complaints are fielded.

Hammer and Hemenway Falk also suggest that regulators should require public disclosure of various policies, processes, and procedures of issuers. They also support publishing procedures governing transaction manipulation and the disclosure of customer asset treatment in the case of bankruptcy or financial instability. They argue that treatment plans should mirror existing consumer protection rules.

To increase transparency to the public, agencies should require that issuers of crypto describe the technology that powers their digital assets to users and update those users on any changes to the source code, Hammer and Hemenway Falk argue.

They acknowledge, however, that U.S. policymakers would face significant challenges in setting crypto standards.

For example, cryptocurrency lacks a single, central regulatory body, a dynamic that Hammer and Hemenway Falk argue complicates efforts to regulate or enact new legislation. Although transactions are public, the individuals making them remain anonymous, prohibiting effective policing of bad behavior on crypto platforms.

In addition, Hammer and Hemenway Falk note that there is a lack of clarity in the law as to whether a cryptocurrency may be considered a security or a commodity. Furthermore, Congress has yet to decide if either the Securities Exchange Commission or the Commodity Futures Trading Commission has jurisdiction over legal issues related to crypto. Hammer and Hemenway Falk maintain that U.S. regulators must answer key jurisdictional questions to make further progress on regulation.

Beyond U.S. policymaking, Hammer and Hemenway Falk conclude that international standards governing digital assets are essential to establish international consistency and collaboration. Although Hammer and Hemenway Falk admit that international regulation is difficult to enforce, they insist that the collective process of establishing standards could inspire nations to adopt regulations that combat fraudulent and deceptive practices in the digital asset space.