How Should Financial Regulators Handle the Bitcoin Era?

William Magnuson is an Associate Professor at Texas A&M Law School. This post is based on a recent article by Professor Magnuson, forthcoming in the Stanford Journal of Law, Business & Finance.

Financial regulators in the United States and abroad have recently trained their sights on innovations at the intersection of finance and technology. Cryptocurrencies like Bitcoin and Ethereum have come under fire, as have other fintech firms. But despite a flurry of activity and increasing attention to the issue, regulators have struggled to apply old law to new facts. In a recent article, Financial Regulation in the Bitcoin Era, forthcoming in the Stanford Journal of Law, Business & Finance, I argue that existing models of financial regulation are ill-equipped to handle the problems that will arise in the Bitcoin era, and I propose a set of guiding principles for a more effective financial regulatory regime.

The recent decade has witnessed an extraordinary degree of innovation in the financial sector. Upstart financial technology (or “fintech”) firms have introduced a dizzying area of new financial products and services into the market. Online crowdfunding platforms such as Kickstarter and LendingClub have changed the way that companies and individuals raise capital. Digital robo-advisors have challenged the business models of investment advisors and asset managers alike. And, most emblematically, cryptocurrencies such as Bitcoin have emerged as viable alternatives to traditional national currencies. The new Bitcoin era, defined by the rapid proliferation of fintech firms into an ever broader array of industries, has altered the landscape of finance in fundamental ways.

Financial regulators across the world have recently started to take notice of these changes. Several regulators, such as the Securities Exchange Commission and the Office of the Comptroller in the United States, have issued white papers and sought comments on how, and whether, current regulations should apply to fintech companies. Others have begun to crack down on fintech actors, finding that many of them fail to comply with existing financial rules. Still others have created “regulatory sandboxes” for fintech firms, allowing them to operate under relaxed compliance regimes in order to encourage experimentation and innovation. The diverse array of policy proposals and enforcement initiatives in recent months reflects, among other things, the great difficulty that regulators have had in fashioning appropriate regulatory responses to the rapid rise of the Bitcoin era.

My article aims to fill this gap. It argues that fintech’s unique model of finance raises concerns about the ability of regulators to achieve three essential goals of financial regulation: the efficient allocation of capital, the protection of consumers, and the prevention of systemic risk. Each of these goals is undermined by fintech’s defining features—its reliance on disembodied institutions, complex algorithms, and frequent adaptation to provide an evolving set of financial services to consumers. These features render the conventional tools of financial regulators largely ineffective by increasing the cost of identifying, monitoring and sanctioning market participants. In order to resolve these problems, financial regulation must adopt new tools that are better designed to address the unique structure of fintech markets.

My article makes three contributions to the literature on financial regulation. First, it identifies the key features of fintech firms that distinguish them from traditional financial institutions. Fintech industries tend to be typified by high levels of diffusion, in that market actors are small and dispersed rather than large and concentrated. Fintech industries tend to rely on high levels of automation, in that they rely on algorithms and big data for their essential functions. And fintech industries tend to demonstrate high frequencies of adaptation, in that they undergo significant structural transformations in response to changes in market conditions. Thus, an initial aim of the article is to taxonomize the core features of the Bitcoin era and demonstrate how these features are different in important ways from traditional finance.

Second, my article assesses the consequences of fintech’s structure on the efficacy of current financial regulation. The article argues that fintech’s unique model of finance places pressure on, and indeed undermines, several core purposes of financial regulation. It may reduce the capacity of the financial sector to allocate capital efficiently within the economy. It may increase the likelihood that consumer protections will be weakened or evaded. And it raises a set of systemic risk concerns that are potentially more troubling than the “too big to fail” concerns that have motivated recent financial reform efforts. Thus, an additional aim of the article is to demonstrate the existential difficulties that the Bitcoin era poses for financial regulation.

Third, my article proposes a set of reforms aimed at creating a “law of fintech” that better addresses the particular features and risks of the Bitcoin era. It argues that the law of fintech should focus on three overriding priorities. First, regulators should adopt a set of information forcing rules requiring fintech actors to disseminate accurate and comprehensive information about fintech products. Second, regulators should adopt a set of security forcing rules requiring fintech firms to adopt cybersecurity procedures that match the level of idiosyncratic risk they present to consumers, investors and third parties. And third, regulators should establish a set of tradeoff forcing rules requiring fintech firms and government authorities alike to explicitly acknowledge the policy tradeoffs of their decisions.

The full article is available for download here.

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