The Crypto Puzzle
One of the central predictions of the law and finance literature is that strong investor protection laws will promote the development of strong markets. This prediction rests on the observation that strong laws impose higher costs on sellers of lower quality financial assets, thereby generating a separating equilibrium that helps sellers of higher quality assets overcome potential adverse selection problems. We would thus expect to observe a positive (negative) correlation between higher levels of investor protection and the price of high (low) quality assets.
Against this backdrop, something very strange happened on June 14th, 2018. Speaking at a conference in San Francisco, William Hinman, the Director of Corporate Finance at the US Securities & Exchange Commission (SEC), acknowledged the possibility that some tokens issued as part of an initial coin offering (ICO) may not qualify as ‘securities’ under the test first articulated in SEC v. Howey (see his remarks here). Director Hinman’s remarks were notable for two reasons. First, while Hinman’s views did not necessarily reflect those of the SEC, his remarks were potentially at odds with the agency’s previous statements on this issue (see for example Chairman Clayton’s remarks in December 2017). Second, and more importantly, Hinman’s remarks were greeted by a significant increase in the price of the two most widely traded cryptocurrencies: Bitcoin (5%) and Ether (15%). This increase was also reflected in the global market capitalization of the 1,629 cryptocurrencies covered by CoinMarketCap (see chart here).
This presents us with something of a puzzle. Why would the possibility that some cryptocurrencies might not attract the full force of US securities laws precipitate an increase in their market price? There are at least three potential explanations. The first is that this price increase was simply unrelated to Director Hinman’s remarks. Indeed, the market prices of cryptocurrencies such as Bitcoin and Ether are extremely volatile—even on days when federal regulators don’t suggest a potentially significant change in government policy. Ultimately, however, while correlation certainty does not equal causation, the unbridled glee within Cryptoland on June 14th (see Financial Times) suggests that the two may not be entirely unrelated.
The second potential explanation is that the price increase reflected the market’s collective view that the compliance and other costs of imposing US securities laws on the ICO market exceeded the expected benefits from enhanced market transparency and investor protection. While this explanation is certainly plausible, it also raises the uncomfortable question of whether the expected benefits of stronger investor protection are the same for all market participants.
This takes us to the final—and most troubling—potential explanation: that the demand for cryptocurrencies includes a critical mass of market participants that would not benefit from the stronger legal protections, enhanced transparency, and regulatory scrutiny that comes with the application of federal securities laws. This list would include the sponsors and issuers of dodgy ICOs, those engaged in market manipulation, and those using cryptocurrencies as a medium of exchange in the context of criminal enterprises. Viewed from this perspective, the crypto puzzle is not really a puzzle at all. After all, it is the cattle rustlers, horse thieves, and snake oil salesmen who stand the most to gain from living in the wild, wild west.
Dan Awrey is a Professor of Financial Regulation at the University of Oxford.