Decrypting Crypto: Constructing an Improved Framework for the Regulation of Cryptocurrencies

Abstract

This paper consists of an examination of the fundamental economic and practical characteristics of cryptocurrency, a critical analysis of current US federal regulation, and a detailed proposal of a framework to better regulate crypto. As part of my examination of the fundamental economic and practical characteristics of cryptocurrency, I discuss the origin of cryptocurrency and the blockchain technology that supports its use, distinguishing between the two primary consensus mechanisms of proof-of-work and proof-of-stake. I also outline the various types of cryptocurrencies, breaking down the market of cryptocurrencies into the important types of stablecoins, fiat cryptocurrencies, and memecoins. This examination continues as I analyze the moneyness of cryptocurrency, evaluating its role as a medium of exchange, store of value, and unit of account. I find that stablecoins fulfill all three roles of money much more completely than fiat cryptocurrencies, which bear a stronger resemblance to speculative assets than currency. In order to critically analyze the current US federal regulation of cryptocurrency, I discuss in detail the five topics of investor protection, systemic risk, national security, taxation, and innovation as the key considerations federal regulation ought to address. I then describe and evaluate current crypto regulation across the four most relevant federal regulators—the SEC, FinCEN, the IRS, and the CFTC—identifying many weaknesses and regulatory gaps, including instances of regulatory ambiguity, the lack of adequate investor protection for owners of fiat cryptocurrencies, the existence of unregulated systemic risk to the broader financial system posed by stablecoins, and the absence of adequate off-exchange regulation by US financial crime regulators. To address these shortcomings, among others, I provide a structure for an improved regulatory framework, one based on the division of cryptocurrencies into the categories of (money like) stablecoins and (asset-like) fiat cryptocurrencies. I then outline the details of my regulatory framework, which includes the following key recommendations. For stablecoins, I suggest that the Fed use its authority to implement reserve requirements for systemically important stablecoins, specifically requiring stablecoin issuers to back their coins one-for-one with reserves at the central bank. For fiat cryptocurrencies, I recommend that Congress provide the SEC with expanded jurisdiction to regulate fiat cryptocurrencies by implementing listing standards for exchanges, combatting market manipulation on social media, and promoting sustainability in several key ways. Lastly, I propose several additional regulations that apply to both stablecoins and fiat cryptocurrencies, relating to the key considerations of national security, taxation, and innovation. To conclude, I analyze the political feasibility of my proposed framework, finding that there are many reasons to be hopeful for bipartisan agreement on my proposed regulations. I then briefly discuss opportunities for future research into crypto regulation, including research related to the potential risks and benefits of an international crypto regulatory body or agreement and research related to the regulation of other areas of the digital asset space such as DeFi and NFTs.