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I sense a growing middle-of-the-road regulatory consensus on crypto currencies. It splits the difference between “crypto is a Ponzi scheme to defraud investors and enable criminals,” on the one hand, and “crypto solves ancient financial problems and will usher in an era of prosperity and freedom,” on the other. It envisions a future in which domesticated crypto plays nicely within the traditional financial regulatory system.
Last week, four senior International Monetary Fund executives published an outline for international regulation of crypto on IMF Blog that does a good job of summarizing this view. It proposes four principles for crypto regulation: one good, one bad and two ugly.
(1) The defense against the substitution of sovereign currencies is the maintenance of robust, trusted, and credible domestic institutions.
The good — a refreshing blast of sensible fair play. When competition threatens, up your game. Keep your market share by giving customers a better product, not by whining to regulators to hobble your competitors. Satoshi Nakamoto created Bitcoin in response to the 2008 financial crisis, when traditional financial institutions seemed in danger of collapse and financial regulation seemed to be part of the problem rather than part of the solution. Confidence in sovereign credit, central bank competence and respect for rule of law was low.
Crypto gained where sovereign-managed fiat currencies were mismanaged, and financial repression was severe. Commercial successes were areas where traditional financial institutions charged outrageous fees and offered abysmal customer service. Crypto reversed Gresham’s Law — good money drove out bad.
(2) To protect national sovereignty, it is important not to grant crypto assets official currency or legal tender status. Doing so…could generate fiscal risks for government finances, and could threaten financial stability or rapid inflation.
Bad — a direct violation of (1). It’s not sovereignty the authors want to protect, it’s government revenues.
Ever since money was invented, governments have generated large profits from seigniorage. In the old days, this was maximized by debasing the coinage, cutting down the precious metal content of coins while insisting citizens accept them at the old values. The fiat currency system introduced by the 1971 Nixon Shock made this even easier. The government creates money at near-zero cost, spends it for real goods and services, and only a fraction of that money comes back to the government as taxes or fees. Seigniorage can also be generated by the central bank holding non-government interest-paying assets, funded by zero-interest accounting entries, on its balance sheet and other indirect means.
Governments protect their seigniorage with a favorable legal and tax status for currencies issued by sovereigns versus other assets. If these advantages are extended to cryptocurrencies, government revenues will suffer.
If crypto is better than government currencies, it’s better to replace lost seigniorage revenue with taxes rather than protect an inefficient monopoly that harms consumers — don’t outlaw email and instant messaging to protect the post office.
(3) To address the volatility of capital flows associated with crypto, policymakers should integrate them within existing regimes and rules that manage capital flows.
Ugly — managing capital flows (typically either forbidding foreigners from buying domestic assets, or preventing foreigners from taking assets out of the country) is a euphemism for financial repression. For example, the movie The Good, the Bad and the Ugly is a Spaghetti Western. When the movie was made in 1966, Italy “managed” capital flows by refusing to let people take lira out of the country. Foreign companies with lira profits could not repatriate them. The solution was to use the lira to finance American movies made in Italy that had worldwide appeal. Foreign companies repatriated their lira profits in the form of global movie ticket sales.
Had crypto been around in 1966, there would have been no need to make the movies. Foreign companies could have sold their goods in Italy for GBUcoin (good-bad-ugly coin), and moved their profits out with little hassle. Italy could try to control purchase and sale of GBUcoin, but since crypto allows pseudonymous global peer-to-peer transactions, enforcement would be difficult.
Managing capital flows is terrible economics and there’s no way to enforce capital flow management rules on crypto without destroying its advantages.
(4) Finally, tax policies should ensure unambiguous treatment of crypto assets, and administrators should strengthen compliance efforts.
Ugly — you can’t straitjacket innovation with predefined treatments. Long before there was crypto, tax collectors struggled with theoretical differences between casual human exchanges — gifts, you-grill-the-meat-and-I’ll-make-the-salad, hitchhiking, pick-up basketball games, etc. — and taxable events. In practice, if currency is involved it’s usually taxable, if not, it might be taxable in theory but in most cases the authorities won’t try to collect (not legal advice, there are many exceptions!).
Many crypto projects cannot possibly fit into the commercial exchange/human exchange dichotomy. Lines are erased among customers, suppliers, employees, and investors. Projects intertwine economic and non-economic human incentives.
In the future, we may be able to observe the crypto ecosystem and figure out good ways to extract government revenue from it. That’s a reasonable goal for a forward-looking regulator. But this principle is ugly because it wants to “ensure” taxes today, and threatens to “strengthen compliance” as if this is a battle against evil tax evaders rather than a genuine exploration of improved human cooperation.
The good news is that (1) has been the main impact of crypto to date — governments and banks have improved their services to compete with crypto. The bad (2), and ugly (3) and (4), won’t go far because they’re too difficult.
The authors of this IMF Blog post have correctly identified the challenges for regulators — protecting government revenue and mitigating disruption from volatile capital flows — they have just suggested impossible solutions.
I am personally optimistic about crypto regulation at the moment. I don’t mean that I or anyone else knows how to do it right. I mean that there seems to be positive communication between innovators and regulators. They may not see eye to eye, but there is more common ground than there was a few years ago, and more willingness to entertain unconventional approaches. With goodwill and luck, we may have a Pax Bitcoinus in our future.
More From Bloomberg Opinion:
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• Matt Levine’s Money Stuff: Ripple Is a Security and It Isn’t
• Some Bad Bored Apes Won’t Undermine the NFT Market: Aaron Brown
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Aaron Brown is a former managing director and head of financial market research at AQR Capital Management. He is author of “The Poker Face of Wall Street.” He is also an active crypto investor, and has venture capital investments and advisory relations with crypto companies.
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