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.

blockpolitik

In 2017, the cryptocurrency ecosystem catapulted further than ever into the mainstream. A mixture of curiosity, admiration, and fear has forced the elites in the finance and technology world to recognize the vast potential of decentralized technology like Bitcoin and Ethereum to reshape our world.

And yet, even amid a media frenzy and torrent of capital inflow, the decentralized technology movement has yet to penetrate another crucial group of power players: those in politics.

While organizations like the Coin Center are doing great work in education and advocacy, and some tech-savvy lawmakers are beginning to organize, crypto-politics is still seen by many as a niche area.

This will not be a permanent state. Like the rise of the internet and mobile technology, the proliferation of decentralized software will continue to supplant old products, businesses, and communities until one day we find ourselves in a new world entirely. Anticipating and accepting that these advancements are inevitable is a prerequisite for formulating a believable vision for the future of society.

Some of this thinking is already being done — but because the philosophical underpinnings of the cryptocurrency movement lie with libertarian-minded cyber-punks, it has largely been a collection of techno-utopians, anarcho-capitalists, and Republicans who have been articulating their vision.

This leaves an enormous vacuum in crypto-political thought on the Left. While many in the anarcho-capitalism camp believe that the development of non-state currencies and “unstoppable” decentralized applications represent an existential threat not only to the efficacy but the entire existence of governance, I disagree. I believe we can accept the inevitability of decentralized technology without giving up on the fundamental liberal belief: we are bound to one another not only by smart contracts, but by a social contract. As such, I believe that this technology was not meant to just destroy our legacy economic, social, and political institutions, but rather to give us a framework from which we can build these institutions anew.

While I am optimistic about the future, I also take issue with some aspects of the techno-utopian crowd. There is a view among some that governance is, essentially, just another system to be engineered — and thus the creation of new digital governance models is better left in the hands of a software engineer than a political scientist. What they fail to see is that even a decentralized, digital society will require both social and computer engineering. And I think we will need both. After all, one of the most brilliant innovations in decentralized governance came from a group of lawyers, farmers, and businessmen 200 years before the computer even existed. Why should it only be developers and the technically-literate who should participate in debates around digital constitutions? Governance stems from values and human judgements — these choices are not a fixed problem to be solved, but a philosophical one.

In the days to come, I look forward to exploring these issues from a fresh perspective. I won’t pretend to have all the answers, but I do hope to start the debate. After all, what is the future, if not what we create of it?