The Regulator’s Dilemma

China, ICOs, and the future of cryptocurrency regulation

On September 4th, the People’s Bank of China (PBOC), the Chinese central bank, announced their intention to ban cryptocurrency ICOs (Initial Coin Offerings) and launch inspections into over 60-related exchanges/organizations. Soon after, leading Chinese crypto-exchanges OKCoin, Huboi, and BTCChina announced they would halt trading services to Chinese customers. The surprise announcement shook the crypto markets, but it is not the first time that the Chinese have made an effort to crack down. In December 2013, the Chinese government banned usage of Bitcoin by Chinese banks, and this past January, they stated their intention to increase regulation of Chinese cryptocurrency exchanges and require further information disclosure from users.

Now the Chinese government has turned its attention to Ethereum, and its rampaging token sale/initial coin offering (ICO) market. While the Chinese have put themselves out front, they aren’t the only ones paying attention. In recent weeks, the US Security and Exchange Commission (SEC) issued its own guidance on ICOs, suggesting that some (but not all) token sales may be subject to securities law.

Despite this new flurry of activity, I suspect that as with previous efforts, state actors will ultimately fail to restrain the rampant expansion of the crypto-economy. I believe this is because government actors face a unique set of barriers and incentives that make restricting the cryptocurrency ecosystem functionally impossible and economically perilous.

An ICO Primer

Before we go further, let’s take a step back and review the ICO landscape. In recent months, the ICO funding market has become red hot — by some estimates surpassing early stage Venture Capital funding over the summer. The ICO fundraising model is straightforward in principle: a new project announces their intention to build a new product or platform, and the team then sells the public (or select investors) digital coins or “tokens” meant to be utilized in the new platform. Investors and future users purchase these tokens ostensibly to gain access to the new platform, but in practice often because they hope the tokens will appreciate in value. The ease of creating, selling, and storing these tokens in exchange for BTC or ETH to a global audience has made it a popular funding route for new crypto-ventures. Typically, ICO projects will release a whitepaper with a product roadmap and technical vision — but they rarely have an actual working product ready to release.

The recipe for a liquidity rampage is clear. While the global cryptocurrency market cap has grown from $15 billion to over $150 billion since the start of 2017, crypto holders still have few avenues to spend or reinvest their coins. At the same time, in contrast to traditional financing, ICOs can (in theory) be launched by anyone, anywhere, with some basic crypto coding knowledge. Finally, while traditional private financing rounds would weed out a number of projects and be restricted to a limited, wealthy, and (theoretically) more educated audience, most ICOs are open to the masses — anyone with cryptocurrency can participate by sending coins to the ICO’s creator’s crypto wallet. The result is that nearly $1.8 billion in cryptocurrency has now flowed in to ICO projects — many of which still have little to show beyond an idea, team, and whitepaper.

The rise of ICOs presents several problems for regulators around the world. The same advantages that offer massive liquidity to ICO fundraisers creates major risks for consumers and big headaches for regulators. While startups seeking traditional venture funding undergo due diligence as a prerequisite to raising a round, the public can buy ICO tokens without any diligence whatsoever. Private fundraising limits investors, but anyone with a few satoshis and an internet connection can participate in most ICOs. Most problematically, some ICO tokens may not pass the Howey Test, meaning they are subject to securities regulations in jurisdictions like the US.

While leaders of the most high-profile projects in the ecosystem have made an effort to communicate with regulators and self-police, there is a long-tail of sketchy and predatory projects that have been willing to flaunt the law. As with any gold rush, some nefarious actors smell the hype and have moved in, hoping to defraud investors with false promises.

Wack-A-Coin

That brings us back to China. What is interesting about the Chinese action on crypto is there are several plausible explanations. Perhaps the Chinese state is fearful that crypto poses a threat to its consumers or state control over currency and financial markets, and hopes this action will block further advancement of the technology. Alternately, the Chinese may see the writing on the wall, and hope to merely slow Ethereum adoption, so that Chinese entrepreneurs can produce their own state-sanctioned crypto markets. This would fit prior patterns, where China initially moved to block adoption of new Western-controlled technology platforms like Facebook, Twitter, and Google, making room for companies like Baidu (Google), Sina Weibo (Twitter), and Ren Ren (Facebook) to grab Chinese users. This has concentrated economic returns in the country and provided an easier access point for Chinese regulators.

Whatever their motives, the challenge for the Chinese and other regulators will be to find a balance between stopping bad actors and halting innovation. This is easier said than done.

In the past, technology platforms were vulnerable to disruption through attacks on business operators and centralized servers. This has been the Chinese playbook in the past — but with crypto it becomes a game of whack-a-mole. While China can shut down individual Bitcoin exchanges, they can’t shut down the Bitcoin network itself (or other blockchain-based cryptocurrencies) without seizing control of Bitcoin nodes and miners distributed widely across the world. The devil you know is often better than the one you don’t — and China may soon learn that cooperation with high-profile exchanges and support for new crypto-based services, rather than opposition, is the only way to avoid driving users underground — much like we saw in the early days of Bitcoin.

The Regulator’s Dilemma

The durability of crypto-protocols means regulatory decisions may hinge more on economic incentives than brute force. I believe that would-be regulators face a Prisoner’s Dilemma. Each state has an incentive to try to restrict or control cryptocurrency within their jurisdiction, much like China, but doing so risks driving development of global networks to more friendly, safe-haven jurisdictions like Japan or the Crypto Valley in Switzerland. Even if states are able to collectively organize and try institute a global ban, the resiliency of the blockchain makes it likely that crypto-commerce would continue, but shift away from more centralized state-supported services to dark markets.

The Regulator's Dilemma (1)

The beauty of the cryptocurrency ecosystem is that its decentralized nature makes it possible for it to withstand state aggression, while its network effects provide an incentive for states to participate. The more countries and users adopt a cryptocurrency, the more secure and useful it becomes. Thus, as more states liberalize crypto-regulations, holdout states will face even greater costs to staying on the sidelines. In the short term, I think we will see further efforts to restrict cryptocurrencies, but in the long run this economic pressure will force most states to join in the coming crypto-boom.

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