REGULATING CRYPTO, ON AND OFF THE CHAIN.

• Author: Chason, Eric D.

Table of Contents Introduction 1014 I. Regulatory Models for Crypto 1017 A. Introduction 1017 1. The Modern Regulatory State 1017 2. Neutrality 1018 B. Ancillary Regulation 1020 1. Anti-Money Laundering 1020 2. Tax Compliance 1021 3. Summary 1022 C. Curtailing Fraud and Market Manipulation 1023 D. Information Disclosure 1026 E. Cryptocurrency Design and Quality Standards 1030 F. Mixed Regimes 1032 G. Summary 1033 II. The TerraUSD Debacle 1034 A. Introduction 1034 B. TerraUSD's Rise 1039 C. Comparing the TerraUSD Peg to Other Stablecoins 1040 D. Regulating Algorithmic Stablecoins After Terra's Collapse 1044 III. Applying the Model to Other Cryptoassets 1046 A. MakerDAO's DAI Stablecoin 1046 1. Introduction 1046 2. Information Reporting 1047 3. PWG Report and Minimum Standards 1048 B. Tether's USDT Stablecoin 1050 1. Introduction 1050 2. Information Reporting 1051 3. PWG Report 1052 C. Wrapped Bitcoin 1053 Conclusion 1055 INTRODUCTION

When delivering my remarks at the Law Review's Symposium on Cryptocurrencies in February 2022, I argued for a regulatory structure that acknowledges, and even uses, the peculiarities of the blockchain. Specifically, I argued that regulators should consider the extent to which various cryptocurrencies are inherently transparent. Bitcoin, for example, is so decentralized that it is likely not a "security" for purposes of U.S. securities laws. We would struggle to find a central party with otherwise hidden information that should be disclosed to investors. Moreover, policymakers likely could not effectuate changes to the Bitcoin blockchain directly. For example, policymakers might have concerns over the environmental impact of Bitcoin mining operations. (1) Yet, because Bitcoin is so decentralized, policymakers could not readily mandate changes to Bitcoin's mining protocols in the hopes of lessening the environmental impact.

Thus, policymakers should focus their attention on activities that exist outside of the Bitcoin protocol. Policymakers might be powerless to change the mining protocol, but they could regulate mining operators within their jurisdictions. Similarly, policymakers have regularly focused their attention on market actors in order to curtail fraud and manipulation. In short, policymakers cannot regulate Bitcoin itself, but they can regulate actors who deal with Bitcoin.

In my remarks at the Symposium, I urged policymakers and scholars to consider this distinction as they examine emerging problems in the world of cryptocurrencies. For example, policymakers will inevitably impose some regulatory structure on stablecoins (cryptocurrencies pegged to the U.S. dollar or other sovereign currency). (2) The regulatory approach should, however, depend on how individual projects are organized. The DAI stable-coin relies on smart contracts and the blockchain to maintain a peg between its value and the U.S. dollar. (3) In contrast, the Tether stablecoin (USDT) relies on financial reserves of bank accounts and other high-quality assets. (4) Under my suggestion, USDT should be the subject of greater regulatory scrutiny rather than DAI because Tether's structure is inherently more centralized and less transparent than DAI's.

This Article continues to advocate these points but acknowledges the challenges of later events. In early May 2022, the TerraUSD stablecoin lost its U.S.-dollar peg, sending shockwaves through cryptocurrency markets. (5) From May 1 to May 15, TerraUSD itself was down 82 percent from its previously pegged market price of $1.00. TerraUSD's peg mechanism relies on a related cryptocurrency, Luna, which became functionally worthless. (6) Bitcoin, by far the largest cryptocurrency in terms of market capitalization, did not escape the shockwaves, falling 20 percent over these two weeks. (7)

Many observers drew comparisons between Terra's collapse and prior financial crises and scandals. If the Terra collapse was a "Lehman moment" for cryptocurrencies (or at least stablecoins), (8) then the Dodd-Frank style policy response should soon appear on the horizon. Indeed, some could interpret Terra's fall as vindicating earlier calls for stricter regulation of stablecoins.

Before succumbing again to the crisis/legislation cycle, (9) policymakers should note that Terra's collapse has shown no signs of destabilizing larger financial markets or the economy. Rather than Lehman, the better analogy might turn out to be the dotcom crash of 2000. Unless there is something special about cryptocurrencies and stablecoins, the events of May 2022 could simply be another popped bubble, sorting out winners and losers. Regulators, too, will be moved to take more assertive action in the absence of reform legislation.

This Article attempts to sketch a regulatory approach for crypto that can endure the current turbulence. Most fundamentally, regulators should take a neutral posture toward crypto, letting markets and legislatures decide whether crypto is a good or bad thing. Within this posture of neutrality, regulators should incorporate crypto design into their regulatory systems whenever possible. Many regulatory systems are, however, ancillary to the innovations of cryptocurrencies. Taxing authorities, for example, must find ways to incorporate crypto into systems of taxation, (10) but they generally will not need to think deeply about fundamental issues of crypto design. Similar considerations apply to regulatory systems dealing with fraud and market manipulation.

Mandatory information disclosures (such as those required by securities law) are most affected by crypto design. Many cryptocurrencies are extremely transparent and require little if any additional disclosures. Others, however, are plagued by serious informational asymmetries. Regulators will need to consider these fundamental issues as they decide whether to include individual cryptocurrencies within the definition of a "security."

Finally, regulators should resist calls to impose minimum-product standards on crypto. Even before the collapse of TerraUSD, prominent voices called for stablecoins to be brought within the tightly regulated world of banks and other insured depository institutions. (11) Even if such moves could have protected investors in TerraUSD, protection is not necessarily sound policy. Currently, stablecoins do not function as methods of payments. (12) Moreover, extending banking regulation to stablecoins almost certainly would mean governmental support if not outright deposit insurance. Such a move would also make many stablecoins impractical if not illegal. For now, regulators should let developers and investors continue to take risks in the design of stablecoins rather than imposing rigid regulation.

1. REGULATORY MODELS FOR CRYPTO

   1. Introduction

      1. The Modern Regulatory State

         For many of its proponents, cryptocurrency opened a new horizon of deregulation and laissez-faire economics. (13) In one extreme view, decoupling money from the state would weaken and undermine the state, leading to a golden era of crypto-anarchy. (14) Even within the modern state, cryptocurrency could open illegal activities like drug trafficking and tax evasion. (15) In a more moderate view, cryptocurrencies would simply lead to more private and secure money. (16) Admittedly, I am painting simple figures with very wide strokes. Not all cryptocurrency proponents are libertarians or anarchists; those who are have diverse motives. My goal, simply put, is to identify a perspective that is hostile or skeptical toward most forms of cryptocurrency regulation.

         For such skeptics, the questions raised by this Article are largely beside the point. For example, a recurring question is whether cryptocurrency should be regulated as a security. Libertarians may well answer "No." In reaching this answer, they may not care about the nuances of securities law, the Howey test, (17) and the unique aspects of a particular cryptocurrency. Instead, a libertarian may well claim that securities laws are a form of misguided paternalism that should be minimized or abolished. (18)

         This Article will not engage with this point of view for several reasons. Most importantly, doing so would require us to engage in a much larger discussion about the modern state. Indeed, this discussion would not ultimately even be about cryptocurrency. To be clear, I do not mean to dismiss a libertarian (or even anarchistic) critique of the regulatory state. The goal, at least of this Article, is to determine how cryptocurrency should be treated by the modern regulatory state.

      2. Neutrality

         Arguments against crypto regulation may also be transient. Some readers will recall the internet tax policies of the late 1990s and early 2000s. At the time, policymakers viewed the internet as a fragile bud that needed a few years to mature before it could reasonably be subjected to the full force of the modern regulatory state. This transient approach proved to be persuasive, resulting in dispensations like the Internet Tax Freedom Act. (19)

         Critics of regulation could make similar arguments about crypto today. Like the internet of the late 1990s, crypto has the potential to fundamentally alter the economy in the coming decades. (20) Temporary forbearance from tax and regulation may not, however, be the appropriate response. Such forbearance is, in effect, a subsidy for new market entrants. Arguably, new entrants should be required to compete with established players on similar regulatory footing.

         This Article will assume that the regulatory policy surrounding crypto should be neutral. Crypto should not receive any special breaks absent express legislative directive. Conversely, it should not face any special barriers either. At least for purposes of this Article, the goal should be to impose regulation on a basis comparable to existing products and investments.

         This orientation towards neutrality does answer some questions. For example, libertarians might object to the taxation of...