Regulation is one side of the (crypto)coin. Understanding it is the other.
Elizabeth Warren has her eye on crypto.
Here is how Warren opened her letter:
I write to request information regarding the Security and Exchange Commission’s (SEC’s) authority to properly regulate cryptocurrency exchanges and to determine if Congress needs to act to ensure that the SEC has the proper authority to close existing gaps in regulation that leave investors and consumers vulnerable to dangers in this highly opaque and volatile market.
Volatile market, indeed. In case you were not keeping tabs, Bitcoin is down roughly 50% from its April 2021 high of $63,000. At the time of press, it was trading at around $34,000.
Why is Bitcoin down? There are various factors. China is clamping down on Bitcoin, forcing miners to close up shop or leave the country to reestablish, which will take some time; Binance, the world’s largest crypto exchange is under scrutiny; and respected economists like Paul Krugman and Nassim Taleb came out and spoke against crypto (more on this below).
Perhaps though, and that may be wishful thinking, more people realize that while cryptocurrency could be the future, it still will be a centralized endeavor, like the digital dollar or Euro. El Salvador, after all, is trying to move away from dollarization and adopt Bitcoin, but that sure seems like a mistake. If Bitcoin doesn’t work in a developing economy, one of its selling points, would it ever work in a developed economy?
Crypto trading is ubiquitous as Warren pointed out:
As demand for cryptocurrencies has grown in recent years, the amount of trading activity on cryptocurrency exchanges has also grown, particularly amongst the largest exchanges. The volume of trading on Coinbase, the largest cryptocurrency exchange in the United States, grew from $30 billion in the first quarter of 2020 to $335 billion in the first quarter of 2021, a more than 10-fold increase.
In our previous issue, we discussed how easy crypto trading has become and how, in the eyes of the trader, it has reached some sort of parity with stocks. There are two main problems with this. First, while there may be parity in terms of perception and access, the parity does not extend to regulation and protection. Warren aptly observed:
The increased use of cryptocurrency exchanges presents unique risks to consumers. Although they describe themselves as cryptocurrency “exchanges,” these platforms lack the same types of basic regulatory protections as traditional national securities exchanges like the New York Stock Exchange or Nasdaq. And even though they share many features of traditional securities exchanges, such as “bring[ing] together buyers and sellers, execut[ing] trades, and display[ing] prices,” cryptocurrency exchanges may be able to escape federal regulation if the digital asset being traded does not qualify as a security under federal law.
That’s a problem and we applaud Senator Warren for asking the SEC to focus on this issue. That said, in our opinion, there is an even bigger problem, one which Senator Warren does not mention. What is Bitcoin in the first place?
Paul Krugman is a renowned economist and a distinguished professor at the City University of New York's Graduate Center. In 2008, he was the sole recipient of the Nobel Memorial Prize in Economic Sciences for his work on international trade theory. A few weeks ago, he published an opinion piece on crypto in the New York Times, noting that, twelve years after its introduction, “cryptocurrencies play almost no role in normal economic activity.”
The piece attracted a lot of comments, 1494 and counting. The first commenter asked an interesting question:
First, how da heck is bitcoin legal? Can anyone start their own currency? Could we use a particular kind of sea shell, limited in quantity and hard to find? Could I start my own tomorrow afternoon (I expect to have some time on my hands then.)
This is how Krugman responded:
I think we'll be cracking down on the illegal stuff. As for the rest, well, yes, anyone can create something, call it an asset, and if people buy it, then I guess it is an asset. Dogecoin was literally started as a joke, and still it trades for high prices. The only sad thing is that the name turns out to be about canines, not the rulers of the Venetian Republic.
Judging by that answer, it seems like Krugman is skeptical about Bitcoin being an asset. In the opinion itself, he adopts a similar tone:
Why are people willing to pay large sums for assets that don’t seem to do anything? The answer, obviously, is that the prices of these assets keep going up, so that early investors made a lot of money, and their success keeps drawing in new investors.
While Krugman uses strong words, we still think this is a lost opportunity to set the record straight. What does an asset that doesn’t “seem to do anything” mean? If Krugman truly feels that Bitcoin is not an asset, we think it would have been more powerful to say that.
Krugman lands another punch in the next paragraph:
This may sound to you like a speculative bubble, or maybe a Ponzi scheme — and speculative bubbles are, in effect, natural Ponzi schemes. But could a Ponzi scheme really go on for this long? Actually, yes: Bernie Madoff ran his scam for almost two decades, and might have gone even longer if the financial crisis hadn’t intervened.
After not going after Bitcoin enough, we feel that the above quote from Krugman went just a little too far. There is absolutely no question that Bitcoin is a speculative endeavor, but not every speculative market is a Ponzi scheme. What people bought from Madoff was pure air; they thought Bernie Madoff was managing their investment portfolios, but he was just paying old accounts with new money. There was no underlying financial asset or business, or a promising currency or collectibles. That’s a Ponzi scheme. If you buy a Top Shot moment, you either derive utility from it and/or you are speculating that somebody will take it off your hands for a higher price (earlier this year, we covered NFTs on our March 19, March 25, and May 28 issues). If your objective is purely the latter, i.e. speculative gain, you are in the domain of the Greater Fool Theory. The difference between the Greater Fool Theory and Ponzi schemes is subtle, but it is important to distinguish them.
Nassim Taleb, of the Fooled by Randomness fame, also took a strong position against crypto. Here is his recent CNBC appearance.
Taleb is right on all of this, other than the Ponzi comment. Bitcoin is absolutely a speculative tool powered by the Greater Fool Theory, meanwhile trying to create a distraction from criticism by hiding behind the promise of the currency of the future, which he exposes wonderfully. But if we believe that there is still a possibility of Bitcoin becoming a currency, or, alternatively, people view it as some sort of digital collectible, well, then that disqualifies it from being a Ponzi scheme. Now, that doesn’t mean much and it doesn’t make us a Bitcoin fan as there are still genuine questions surrounding its actual purpose and whether it is beneficial for society.
If you feel like we are being picky here, we are. That’s because we feel the only way to fully clear up the confusion is to have airtight definitions about investing, speculation, gaming, gambling, assets, currencies, Ponzi schemes, etc. We feel like we are still dancing around the real problem which prevents us from the most effective solution.
Now, consider a scenario where all the crypto regulation starts to happen and they are brought to the standards surrounding equities. That would certainly improve what we have today. At least, scams like this are probably less likely to happen.
That said, even with better regulation, we would still not have complete parity between stock and cryptocurrencies, for a simple reason. A stock is a financial asset and Bitcoin is not. If you own stock, you own a piece of a business, you can value the piece that you own and make a decision accordingly. You can exit the position by selling to a counterparty, but that is NOT the only way you can achieve a return. You can sit back and collect dividends (if the company has chosen to distribute dividends), or you can have stock buybacks, or the company can get acquired. This is the whole point of owning a bona fide financial asset; selling to a counterparty might be a way to realize returns, but it is not the only way; as you can just receive cash flows directly.
With Bitcoin, your only exit is finding somebody who will pay a higher price. That’s called the Greater Fool Theory. Now, if you want to participate in a market like this, assuming it is legal, that’s one choice. But all the regulation in the world would not change the fact that, as currently designed, Bitcoin is not a financial asset. You can speculate on it, but you cannot invest in it.
In her letter, Elizabeth Warren posed this question to the SEC:
How do the characteristics of assets traded on cryptocurrency exchanges differ from those of assets traded on traditional securities exchanges? Do these characteristics warrant additional investor and consumer protections for cryptocurrency exchanges relative to those provided for traditional exchanges?
The question, while important, elevates Bitcoin to something that it is not. Presumably, there might be some crypto designs where it actually becomes an asset, but Bitcoin, for one, is not a financial asset like stocks are. Aswath Damodaran has been making that point for a while now, but it seems to get lost in the cacophony of opinions. Here’s the deal: if you cannot invest in Bitcoin, “investors” must know that they are not investing; they are just speculating. Now, assuming Congress wants to allow speculation in things that masquerade as assets, that’s a choice that people have. It is critical, however, that they understand what they are doing.
That is a tall order, however, when the pro-crypto faction continues to frame the issue as a rebellion against the establishment, literally costing people their lives. Robinhood, tallied $87.6 million in revenues from crypto trading in one quarter, $30 million of which was from Dogecoin alone.
Crypto trading is not investing, but Robinhood seems to be having decent success at framing it as an old guard vs. new guard problem. This is dangerous. We are not saying the entirety of Wall Street is innocent because there are a lot of things that need to be fixed. Having said that, throwing out the fundamental principles of finance and investing in favor of open speculation in things with unclear societal purpose is akin to throwing the baby out with the bathwater. We very much doubt that Robinhood cares about democratizing finance as much as they care about filling their own pockets. There’s nothing wrong with wanting to make money, of course, that’s the primary (but not only) purpose of a business. That said, it is clear that if your revenues are materially impacted by crypto trading, you are not going to be the one that is banging the drum saying that crypto trading is pure speculation.
Here is the punchline. Regulatory protections, which Senator Warren focuses on, are surely important, but it’s only one side of the coin. The other side is financial literacy, and more specifically, knowing what you are buying. Thus, to the extent regulation gives people more confidence without them truly understanding what it is that they are buying, that may just fall short of solving the problem. In fact, we are a bit concerned that it may make matters worse.
That’s why we are really bullish on SportsCore®, our financial education initiative where our mission is to teach finance through sports.