Crypto is Money Without a Purpose
It isn’t a financial service and shouldn’t be regulated as one. Laws on gambling are more relevant.
By Todd H. Baker
Before FTX crashed, crypto lobbyists and many politicians were complaining loudly that crypto trading was being unfairly denied full participation in banking and finance by overly cautious regulators. We should thank our lucky stars that somebody showed good sense.
Granted, crypto trading looks a lot like the forms of finance we’re all familiar with. It’s made up of things called “exchanges,” “brokers,” “lenders,” “deposits” and “hedge funds.” The financial press breathlessly reports their every move. Crypto also carries the special mystique of the blockchain, which has let traders treat critics as anti-innovation Luddites.
Yet in the most crucial respect, the crypto marketplace isn’t at all like traditional finance. Finance and financial services exist for a purpose that crypto trading lacks. As a Nobel Prize-winning economist Robert Shiller once wrote, “Finance is not about making money per se . . .it exists to support other goals—those of society.”
Finance helps businesses, people and governments raise, save, transmit and deploy money for socially and economically useful ends. Banks allow savings to be pooled and turned into loans for fruit orchards, solar farms, automobiles, small businesses, and houses. The securities market supports the needs of larger businesses and the government in raising capital and helps make the banking process more efficient by distributing risk broadly. Insurance and derivatives markets help manage risk. Participants in finance seek to maximize profit, of course—but in the context of a larger social and economic purpose.
Contrast that with the purposelessness of the crypto trading system. Crypto trading is a game that uses finance as its subject matter. It emulates finance the same way the board games Risk and Monopoly emulate war and real-estate investing. But it is a fiendishly complex and dangerous game born in the age of big data. The “finance” that crypto gambling emulates is the type that society wants less of: highly levered and opaque. It uses all the weapons of modern financial engineering and all the tricks of trading culture to boost returns. It’s the kind of finance that creates crises.
Crypto trading is also gambling. Gamblers bring money—fiat currency—into a casino or online gambling game, wager on outcomes, and convert the winnings or losses back into money. The closed-loop crypto trading system operates in the same way. Crypto trading can’t serve the productive purpose that defines finance. It performs no intermediation function to help expand the economy or improve society. Crypto trading is, as “Seinfeld’s” George Costanza might have said, finance about nothing.
If crypto trading were to be integrated into traditional finance, the risk of systemic contagion would be real. Crypto coins would become part of investment, pension, and retirement portfolios, which are critical pieces of people’s financial support structure. Unexpected connections and hidden leverage would re-create the types of systemic vulnerabilities that led to the 2008 financial crisis. All this would be exacerbated by the “stateless” status of so much of crypto trading and the inability of the current regulatory structure to deal with offshore and virtual crypto trading providers.
Most important, crypto trading would inevitably come to benefit, like other parts of the traditional financial system, from the Federal Reserve’s ever-expanding role as lender of last resort.
None of this sounds like good policy. Instead, crypto trading should be separated as completely as possible from the traditional financial system. Banks, brokerages, investment advisers, money managers, and retirement funds—any entity or affiliate that is part of the regulated financial infrastructure—should be prohibited from participating in, supporting, or adding leverage to crypto trading in any way. This will probably slow, or even reverse, growth in crypto trading. Given the many downsides of gambling, this is a good thing.
No crossover means no crossover. While individuals should be allowed to play in both areas, institutions must choose to be all in with either traditional finance or crypto trading. We can't have distressed crypto-trading firms or enablers causing real-world crises by liquidating assets held in banks and brokerages to cover losses. Nor can we have affiliated entities operating on both sides of the divide, as there is a long history suggesting that risks can’t be effectively segregated in commonly controlled enterprises.
When you have a hammer, everything looks like a nail. That’s why everyone in Washington seems to think that federal financial-services regulators are the natural overseers of crypto trading. This is wrong. Crypto trading should be regulated for what it is—a form of gambling that emulates finance—and not what its advocates tell you it is.
That means the separated crypto-trading system should be excluded from financial-services regulation by the Securities and Exchange Commission, the Commodity Futures Trading Commission, banking agencies, and the Consumer Financial Protection Bureau. Consumers won’t go unprotected. State laws specifically regulating crypto activities, such as New York’s bit license law, will still apply, as will state fraud and consumer protection laws. The Federal Trade Commission’s jurisdiction over any unfair and deceptive advertising or other practice crypto traders and their enablers engage in won’t be affected. Where these laws prove inadequate, state legislatures and Congress can add targeted consumer protections specific to crypto trading. Expanding the reach of state gambling laws to cover crypto trading is also a possibility.
The best part of separating crypto trading from traditional financial services? There will be no need for the Fed to act as a lender of last resort for crypto markets. With no connection between the crypto trading system and the real financial system, there will be no contagion and no systemic risk to deal with. The Fed’s reaction to the next crypto crash will be a big yawn. That’s good when the alternative is metastasized crypto trading causing the next financial crisis.
Mr. Baker is a senior fellow at Columbia University’s Richman Center for Business, Law and Public Policy.
This article originally appeared in The Wall Street Journal on December 20, 2022. Click here to read the original article.