A Middle-Ground for Cryptocurrency Regulation: Using Delaware's Incentive-Driven Private-Ordering Model.

Author:Davidson, Elizabeth
  1. Introduction 790 II. Background 792 A. Cryptocurrency Emerges as an Alternative 792 B. The Necessity, Still, for Regulation 794 C. Present Manifestations of Regulation 796 i. Regulation of Cryptocurrency Funding by the Securities and Exchange 797 Commission 798 ii. Commodities Per the Commodities Futures Trading Commission 798 iii. Treasury Part I: Fintech Charter 799 with the Office of the Comptroller 800 of the Currency 801 iv. Treasury Part II: Financial Crimes 802 Enforcement Network 803 v. New York's State-Sponsored Regulation: The BitLicense 804 vi. Uniform Regulation of Virtual 805 Currency Businesses Act 806 vii. The Sandbox as a Place to Play 807 D. Private Ordering as a Regulatory 808 Middle-Ground 808 i. Private Ordering in the Financial 809 Sector: Traditional Financial 811 Innovation as a Cautionary Tale 812 ii. Private Ordering in Corporate Law 812 iii. Private Ordering Already Present 813 Within the Cryptocurrency Space 814 III. Analysis 816 A. Similarities Between the Financial 817 Sector and the Cryptocurrency Space 818 i. Similar Features 818 ii. Similar Policy Dialog 819 iii. Analogous Principals and Agents 821 B. Private Ordering Lessons in the 821 Financial Sector Pre-2008 822 i. Unchecked Private Ordering 822 ii. LIBOR 822 iii. Fitch, Moody's, and Standard & Poor's 823 iv. Hypothetically Applied to the 823 Cryptocurrency Space 823 v. The Sandbox Alone is Insufficient 824 C. A Better Option: Private Ordering 825 as Seen in Corporate Law 825 i. Chipotle's Reputational Divesture 825 ii. Applied to Lessig's Contribution 825 IV. Recommendation A. Private Ordering Fits the Mold for Cryptocurrency Regulation i. Decentralized Regulation for a Decentralized System ii. Technological Agility Stems from the Private Sector iii. No Clear Jurisdiction B. Specifications i. The Shape of the Regulating Institutions ii. A Centralized Facilitator iii. Scope of the Regulation C. Practical Ideas i. Programming Auditors ii. Insurance V. Conclusion I. INTRODUCTION

    Proposals for domestic regulation of cryptocurrency have been numerous. (1) From these proposals questions emerge: should prudential agencies such as the Office of the Comptroller of the Currency (OCC) establish jurisdiction? Or should states adopt a uniform act, much like the Uniform Commercial Code (UCC)? (2) Or else, have states' customized regulations that are already in effect, such as New York's BitLicenses, worked? (3)

    Then what is the ideal silhouette for cryptocurrency regulation? Where "emerging technologies ... place great strain on extant regulatory systems," (4) this Note outlines the current regulatory landscape for the cryptocurrency space and recommends, based on a preferred structure of private ordering, the necessity for incentive-driven regulation. In filling the gaps where legislation has not empowered regulators, insiders are partial to a low regulatory ceiling; (5) yet, classically, regulators err on the side of more stringent standards. (6) The cryptocurrency space is no exception to the unnecessary "assumption that the [regulatory] choice ... is between bottom-up solutions and top-down prescriptions, regulation versus deregulation, the administrative state versus the private market actor." (7)

    Technology law scholar Lawrence Lessig has instead taught a nuanced understanding of regulation, claiming that governments self-evidently possess the ability to prudently regulate through mechanisms beyond ex post legal enforcement measures. (8) Reasonably presuming the ability for the government to be thoughtful, and not merely reactive, this

    Note discusses a framework just one conceptual step beyond Lessig's regulatory architecture insights. (9)

    Therefore, a Delaware-inspired private ordering model would provide a sustainable and alternative system that incentivizes technologists to privately reinforce policy interests. Corporate law concepts applied to the cryptocurrency space could mitigate against the threat of insider positions to the detriment of the consumer. Private actors enforce policy goals, filling the regulatory gaps to aid in advancing innovation while also strengthening public confidence. (10) This kind of "soft law" (11) enables the government to facilitate correct incentives with a thoughtful regulatory architecture. (12) Yet, the past is often a map to the future. Therefore, success in shaping an effective cryptocurrency regulation template depends on a clear perspective of the history of financial regulation. (13)

    The 2008 crisis is a useful guide, and accordingly this Note will shed light on lessons to be learned from the obstructive incentive structures of the financial regulatory scheme pre-2008. The Financial Crisis Inquiry Commission has concluded that the "crisis was avoidable," because insiders "ignored warnings and failed to question, understand, and manage evolving risks." (14) The traditional financial system maintained faulty mechanisms of insider control, for example, a trust in self-interested banks to dictate the London Interbank Offered Rate (LIBOR). (15) Thus, as exhibited with the crisis, private actors unremittingly find ways through financial innovations, regulatory arbitrage, or otherwise, to circumvent rule-based regulation. (16) Computer scientists are arguably even more astute at avoiding stifling regulation than the insiders of traditional high finance. (17)

    It is generally not "a good idea to permit judges to have a material interest in the cases they hear, to let students grade their own exams, or to allow referees to place bets on the sporting events they officiate," (18) so how then is insider self-regulation in finance much different? Those involved with shaping the regulatory schema should not hide from, but rather magnify, potential conflicts of interests that occur with self-regulation. (19) Private ordering is not self-regulation (20) and, as seen in the Delaware corporate law courts, has the potential to provide robust private measures to achieve policy goals. (21) Thus, this Note does not claim to "offer a fully elaborated and adoption-ready blueprint for regulatory action." (22)

    Nonetheless, private ordering is ideal in this space because it is consistent with cryptocurrency's decentralization attribute, reduction of transaction costs, and ubiquity.


    A. Cryptocurrency Emerges as an Alternative

    Cryptocurrencies, as popularly known today, (23) gained traction during the 2008 financial crisis. (24) An unknown group or individual by the pseudonym "Satoshi Nakamoto" published Bitcoin: A Peer-to-Peer Electronic Cash System. (25) The white paper offered a solution to prevent market vulnerabilities which caused the banking blunder. (26) As Nakamoto saw it, insider bank personnel had excessive control over the custody and accounting of funds. (27) Where personnel are driven by natural human desires, (28) a trustbased financial system is inevitably poised for problems--self-interest finds its way through cracks of even the most robust internal risk and compliance measures. (29) As a way to combat the insider problem, the Bitcoin proposal outlined a trust-less system, so rather optical transparency becomes the de facto regulator. (30) Nakamoto's solution is thus

    "electronic cash [that] would allow online payments to be sent directly from one party to another without going through a financial institution." (31)

    The first widely used cryptocurrency, Bitcoin, is "a digital token--with no physical backing--that can be sent electronically from one user to another, anywhere in the world." (32) Bitcoin's publicly available accounting system displays the transaction, embodying a communal electronic payment system. (33) Compared to the centralized banking, this alternative eliminates transaction costs and, in combating the propensity for insider to inappropriately take advantage of their accessibility, increases transparency. (34) A number of cryptocurrencies are now available, such as Ripple, Litecoin, and Dash. (35) The relevance of this emerging financial innovation is clear: Bitcoin itself has soared in price since its inception, at one point with total market capitalization of over $100 billion dollars. (36)

    Transactions are displayed on the digital "blockchain," which works like a publicly viewable ledger. (37) Bitcoin and other cryptocurrencies run by "blockchain" enabling technology. (38) Here, all payments are made online, where anyone can access and view anonymous transactions after a group of transactions has been made. (39) Thus, unlike private traditional banking transactions, all users on the network may access an immutable digital copy of the ledger. (40) The technological beauty starts with the fact that every new transaction is grouped with other transactions. (41) The groups are called "blocks." (42) Once the computer program protocol creates a group of the transactions as block it is then added to the ledger and the block contains a timestamp and a link. (43) In grouping these blocks, the correct fit of the mathematical puzzle prevents illegal alteration retroactively, after the formation of a block. (44) The transparency of this entire process structure thus makes the blockchain resistant to transaction modification. (45)

    B. The Necessity, Still, for Regulation

    Thus, cryptocurrencies limit human error within capital transactions, providing a value proposition unlike traditional banking--yet, as with every solution, Bitcoin does not exist without its own set of problems. (46) These problems include, but are not limited to hacks, illegal use, bugs, and a blockchain-specific problem called the "fifty-one percentage attack." (47)

    The popularity of Bitcoin makes it a "massive target" for hackers. (48) Even businesses supporting cryptocurrencies are subject to attacks: the DAO, a $150 million blockchainbased venture capital fund lost much of its value due to a hacking incident. (49) Additionally, criminals use cryptocurrencies to facilitate drug trade...

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