Crypto needs regulation, but it doesn’t need new rules

Innovation is rarely fluid or predictable. With a digital revolution underway in the financial services industry, a sector of the economy where the thirst for innovation and profit can never be quenched, there is also a serious risk of over-regulation and under-regulation. Policymakers would do well to base their efforts on the main objectives that underpin existing financial regulations: financial stability, deep and efficient funding markets across the debt and equity spectrum, and the prevention of debt and equity. fraud and illicit activities.

The keystone of this approach is to identify the functions that a new product or process performs. We should look beyond the superficial labels and ask ourselves how a token, digital wallet, cryptocurrency or crypto exchange is used and with what existing instrument or process the new technology competes, complements, or aims to replace, then adjust it accordingly.

Crypto entrepreneurs looking for capital have touted Initial Coin Offerings, or ICOs, as an efficient new (read unregulated) way to raise money for businesses. Yet their function was neither new nor unregulated. In function, ICOs were offerings of securities, and in 2017 the SEC rightly stepped in to regulate them in accordance with well-understood and long-standing federal securities laws.

Many new digital technologies are designed to perform other well-understood financial activities, including payments and record keeping. Regulators have overseen these functions for decades and have a deep understanding of their importance and how they work in our financial ecosystem.

Existing regulatory frameworks provide the tools to deal with many of the risks of new technologies without stifling their promises. If the application of these frameworks reveals outdated requirements, such as a mandate to use paper documents or other outdated technology, including for government functions such as mortgage and collateral registration, regulators should delete them. If a coordinated analysis by national and international authorities reveals a regulatory gap, it must be addressed. But we shouldn’t start by assuming that there is a need to reinvent the regulatory regime.

As a historical example, “bearer bonds” are enlightening. These instruments provided for the payment of cash to the cardholder upon presentation to the issuer outside banking and brokerage systems, providing fertile ground for money laundering, tax evasion and corruption. Regulatory coordination between the Treasury, Federal Reserve, SEC, and their international counterparts has largely ended this market without harming the corporate bond market, which has flourished over the past decades. The same approach can be applied to new instruments with similar risks, such as transferring bitcoin using an anonymous wallet.

The efforts of policymakers to address issues concerning the future of money, payments and credit are at various stages of maturity. The Federal Reserve is studying the desirability and feasibility of issuing a digital dollar. A bill pending in Congress would direct the SEC and the Commodity Futures Trading Commission to collaborate on cryptocurrency regulation.

These efforts are not yet sufficiently coordinated or proactive to meet the challenge. Financial regulators and economic decision-makers must define an agreed plan to deal with the digitalization of financial assets and technologies, based on the current regulatory framework. This effort should address at least three pressing issues:

First, which regulators will regulate what types of digital assets and financial technologies? Roles and jurisdictions will overlap, as is currently the case when, for example, securities held in a brokerage account are used to facilitate an international payment where the SEC, Fed, and Treasury have a variety of important interests. But clarity would make markets more efficient while discouraging efforts to circumvent regulation.

Second, what requirements does a digital asset or technology have to meet to legally function in the United States? The foundation of financial regulation is the prevention of fraud, manipulation, money laundering and tax evasion. Here we need to use digitization, including its audit and tracing capabilities, to reduce these risks. We must also keep in mind the default rule of the American system: innovation is welcome in the absence of a legal reason to oppose it.

Third, should the United States issue a digital dollar, or rather facilitate digitization through other means such as stablecoins, digital currencies whose price is tied to a reserve asset, such as fiat currency? The Fed will have a critical input on this issue, but issuing a central bank digital currency could have far-reaching consequences that extend beyond the jurisdiction of the Fed. This would imply the role of commercial banks in the economy and could have consequences in a crisis if the existence of a digital dollar encourages the depletion of other assets. There would also likely be thorny questions about government access to user financial data and the preemption of financial innovation in the private sector.

A rapid and coordinated approach to regulatory clarity that builds on our existing knowledge base will enable responsible innovation and ensure that the U.S. financial system continues to play its leadership role in capital formation, lending. and maintaining the stability upon which the economy depends.

Mr. Clayton was President of the SEC 2017-2020. Mr. McIntosh served as Undersecretary of the Treasury in 2019-21 and led the Financial Stability Board’s multilateral deliberations on the regulation of digital assets.