4 Questions On Crypto Regulation

It is not the job of regulators to ensure that users make profits.
It is not the job of regulators to prevent people from making losses.
It is not the job of regulators to prevent people from doing stupid things, argues Ajay Shah.

Answering four questions leads to the optimal financial regulatory design when faced with any new situation.

When we apply them into the ownership and use of cryptocurrency, there are some concerns about consumer protection, and there is a reasonably simple strategy which can be applied when Indian financial service providers engage with Indian residents.

For many people, financial regulation is what today's financial regulators do, it is what satisfies powerful political lobbies, or interference, into the things that one does not like.

Financial regulation should not be such casual use of State violence.

There is a structured and disciplined approach through which we can analyse a situation, and discover the useful role (if any) for financial regulation. This runs through asking four questions.

Systemic risk

Does a financial firm or market present a problem to the soundness of the overall financial system in the event of a default?

If so, there can be market failure in the form of a negative externality imposed upon innocent bystanders. This can be a reason for the government to get involved, either through rules that reduce the failure probability, or rules that make resolution more orderly.

In the case of cryptocurrency, the magnitudes involved in India are as yet tiny and there is no hint of systemic risk.

When any one player gets to a balance sheet of perhaps Rs 3 trillion, or 1 per cent of gross domestic product, this can become a consideration.

Resolution

Does a financial firm present significant difficulties for resolution through the route of Insolvency and Bankruptcy Code (IBC)?

As an example, it makes sense to resolve defaulted financial firms who do not have retail depositors, such as DHFL, through the IBC process of handing power to the committee of creditors. But when faced with retail depositors of a bank, we require the specialised Financial Resolution Corporation.

When we get to Indian financial service providers which accept cryptocurrency deposits in ways that are akin to a bank, this could require coverage in the Financial Resolution Corporation. But the simple process of owning and trading cryptocurrency does not induce questions about resolution.

Prudential regulation

If an organisation like a bank promises assured returns, or an insurance company makes promises about payouts in the future, then unsophisticated consumers worry about the extent to which these promises will be upheld.

To reduce the risk faced by such consumers, governments can engage in 'prudential regulation', to bring failure probabilities down to low values.

These concerns do not arise when dealing with the process of buying or owning or transferring cryptocurrency assets.

Consumer protection

Financial firms often treat consumers unfairly. This leads to consumer retreat from formal finance, in favour of informal finance or gold or overseas assets.

Regulators intervene in the working of the financial system in order to improve the fairplay as seen by consumers.

With thousands of cryptocurrency assets, including some scamsters, there seems to be a problem in terms of unsophisticated consumers making mistakes and then retreating from cryptocurrencies as a class. This would be an excessive retreat from an entire sector in response to some bad apples.

Indian regulators can help matters through a reasonably simple strategy, akin to that used with money management.

In money management, unsophisticated users must go to highly regulated mutual funds, but once a customer is above a certain minimum ticket size (e.g. Rs 500,000) they are presumed to have knowledge or the means to acquire the requisite knowledge, and they are able to go to hedge-fund style assets.

This approach can be useful in the world of cryptocurrency.

Indian regulators could force Indian financial firms offering cryptocurrency trading to have a 'market lot' of at least Rs 500,000. This would ensure that unsophisticated users, the proverbial 'dentists and grandmothers', would not come into this field.

Access to the field would be for sophisticated participants.

Making losses is normal in finance.

When anyone buys a share on the stock market, there is a precisely 50 per cent chance of the share price going down the next day.

Derivatives trading is a precisely zero-sum activity: For each rupee gained by someone, there is a rupee lost by someone else. If the price at first listing of half of initial public offerings (IPOs) is not below the IPO price, the IPO market is not being fair to the founders.

Making losses is not a market failure. Eliminating almost all risk requires buying US government bonds.

It is not the job of regulators to ensure that users make profits. It is not the job of regulators to prevent people from making losses. It is not the job of regulators to prevent people from doing stupid things.

To be free is to have the freedom to do stupid things.

The task of financial-economic policy is limited to addressing market failure, ie, the four problems of systemic risk, resolution, prudential regulation, and consumer protection.

There is a large distinction between financial regulation (the use of state power to force people to behave in certain ways) versus financial advice (your views of what is optimal for me).

We may think it is not useful for a certain person to own cryptocurrency assets. This is the zone of advice.

I have never owned cryptocurrency and I am sceptical about the present state of cryptocurrency. But I am sceptical about many investment alternatives such as real estate or gold.

My opinions about good or bad asset allocation strategies are just opinions.

Financial regulation is not a matter of opinion; it is the sombre business of wielding State violence to mitigate market failure in finance -- to organise State intervention on the problems of systemic risk, resolution, prudential regulation, and consumer protection.

Every step in this field, each interference in the natural state of freedom, must be backed by sound logic, evidence, and justification for the use of State power in the public domain.

Ajay Shah is a researcher at Pune International Centre.

Feature Presentation: Ashish Narsale/Rediff.com