Chapter 21

• Jurisdiction: United States

Chapter 21 Regulating Fintech: Cryptocurrencies and Digital Assets¹

The modern world of cryptocurrencies and digital assets had its beginning with the fall of Lehman Brothers during the 2008 financial crisis. One enterprising person (the word "person" is used advisedly because we don't really know whether it was one or more than one person or even an entity, not a person) who called "himself" Satoshi Nakamoto, invented something called "Bitcoin."² The ostensible concern was that the existing global financial system was failing and that something was needed to replace it. Whether Lehman was failing in fact, the events of 2008 were sufficient to prompt a serious look at the errors of the system and to propose an alternative. So-called fiat currency was in jeopardy.

Nakamoto's idea was to create an alternate financial system that did not rely on governments. One component of his idea was to create a network of computers that would remember financial transactions and to create a new currency called "Bitcoin." In preexisting financial systems, currencies either had intrinsic value, such as those built on gold and silver, or government backing, such as the American dollar. Nakamoto's Bitcoin would be neither of those.

However, pre-existing systems also enabled the growth of capital and technological innovation. The practice of buying stocks on margin was at first an engine of growth in the securities market and then fuel for the Crash of 1929 and the resulting Depression. The ensuing Securities Act of 1933 required comprehensive disclosures by companies wishing to sell their securities to investors and to update the disclosures periodically. As we saw in Chapter 2, the definition of "securities" the sale of which would require that disclosure has been somewhat difficult to apply and, as we will see, is now at the heart of the dispute over whether cryptocurrencies and digital assets are "securities" the sale of which would be governed by the federal securities laws.

Fintech is as much a creature of the explosion of the world of personal computers beginning in the late 1980s as it is a creature of the 2008 financial collapse. Computers became inexpensive, ubiquitous, and, most important, easy to use. Electronic exchanges replaced traditional stock markets and information was exchanged at lightening speeds. Michael Lewis's Flash Boys³ is but one of many chronicles of the change. Another consequence of the computer revolution was the rise of securitization, in which assets were pooled and prospective cash flows could be estimated by computers, and lenders could buy interests in the pools at whatever level of risk they deemed appropriate for their needs, thereby displacing investment advisers. Similarly, credit default swaps—basically insurance offered to creditors based on the perceived risk of default by borrowers—used computers to determine the risk, and electronic trading systems were developed to facilitate trading of over-the-counter derivatives based on the swaps. The oversight of the Commodities Futures Trading Commission (CFTC) had been significantly reduced, but the 2008 financial crisis led to a renewed effort toward more robust government intervention.⁴ Swaps, in particular, were subjected to more oversight.

Fintech thus came at a most auspicious time. The overseers were busy regulating swaps and securitizations, and they missed the birth and significance of fintech. The emergence of the internet allowed the creation of far more data and the creation of networked communities. New sources of data were available; automation and machine learning enabled much faster transactions; artificial intelligence more and more mimicked human features of logic and deduction. This led to the use of artificial intelligence in creating blockchain operating systems, and cryptocurrencies can be preprogrammed to specify the conditions under which payments should take place.

Fintech is based largely on small start-ups that have more expertise in technology than they do in finance. Using cryptocurrencies and blockchains, incumbent financial institutions can settle payments for customer accounts faster and less expensively. But, because fintech firms are young and untested, they present unique challenges for agencies such as the SEC, which regulates the registration of securities and the CFTC, which regulates currency derivatives. The SEC, for example—at least prior to the new Ripple litigation—has been unable to decide whether cryptocurrencies and digital assets were securities that it could regulate. We will discuss this further below.

What Types of Regulation Are Available to Federal Regulators?

Before that question is answered, it is worth considering the types of regulation that might fulfill the regulators' charge of protecting investors. That is not an easy question to answer; in fact, it is not even clear that persons who buy cryptocurrencies and digital assets are even "investors" in the traditional sense. In the typical "investment contract" the "investor" contributes money to a common enterprise in the expectation of profit derived from the entrepreneurial or managerial efforts of others. Why should they need the protection of the federal government, and if they do, what type of protection would that be?

One way regulators can decide what types of regulation are appropriate is the creation of pilot programs and regulatory "sandboxes" in which regulations can be tested. But such pilot programs are difficult to create and assess. Georgetown University Law Professor Chris Brummer uses the SEC's 2016 pilot program on "tick sizes" (the price increments at which stocks are bought and sold) as an example of the difficulty of creating and evaluating pilot programs.

What, Exactly, Is Fintech?

Brummer has concluded that fintech is a term of art that describes "a confluence of technologies applied in financial markets to facilitate lending, payment, investments and capital markets operations." That may appear to be a disappointing definition—perhaps of necessity—because it does not really define those technologies and without such a definition, it is nearly impossible to ascertain whether and, if so, what type of regulation is called for. But it is the best definition that we have at the moment. Some technological innovations, such as "crowdfunding," are relatively easy to identify and to regulate for the protection of users and investors. But others, such as decentralized autonomous organizations, are more difficult to regulate.

What, Exactly, Are "Cryptocurrencies and Blockchains"?

Similarly, some innovations, such as "digital assets," are nearly impossible to define, much less regulate. Brummer's definition of "cryptography," for example, "refers to algorithmic techniques used to protect information by encrypting it in formats accessible to individuals only if they possess a special key." A simpler way to describe that may be "you cannot see what is in my wallet unless you say the secret word." I would define a cryptocurrency as an intangible digital "something" that is encrypted and that can be used a medium of exchange that is separate from any other typical financial institution or entity. One of the claimed advantages of cryptocurrencies and other digital assets is that they claim independence from banks and regulatory agencies. Cryptocurrencies are traded over a network that uses peer-to-peer technology in order to eliminate any outside interference or regulation.

One way to understand these innovations is to understand how networks work. In general, networks share information between and among parties that have no relationship with each other. A principal problem with networks is the issue of "trust." How do parties with no relationship establish trust? Normally, a third-party intermediary who acts as a trusted...