How to regulate Cryptocurrencies?

News: Indian regulators can leverage the simple money management approach towards regulating Cryptocurrencies. The task of financial-economic policy is to address market failure, i.e. the four problems of –  systemic risk, resolution, prudential regulation, and consumer protection.

Does cryptocurrency merit financial regulation in India?

The role for financial regulation in any situation can be analysed using four parameters below:

Systemic risk: Does a financial firm or market (Crypto market in this case) present an issue to the soundness of the overall financial system in the event of a default? If so, there can be a market failure. This can be a reason for the government to get involved, either through rules that reduce the failure probability, or rules that make resolution more orderly.

– In the case of cryptocurrency, the magnitudes involved in India are as yet tiny and there is no hint of systemic risk. When any single player gets to a balance sheet of perhaps Rs 3 trillion, or 1% of gross domestic product, this can become a consideration.

Resolution: Does a financial firm present significant difficulties for resolution through the route of Insolvency and Bankruptcy Code (IBC)? For instance: Resolving defaulted financial firms having no retail depositors, such as DHFL, through the IBC process of handing power to the committee of creditors is optimal. But, in case of retail depositors of a bank, a specialised Financial Resolution Corporation is needed.

– The simple process of owning and trading cryptocurrency does not elicit questions about resolution.

Prudential regulation: If an organisation makes promises about future payouts, then unsophisticated consumers worry whether these promises will be fulfilled or not. To reduce this risk, governments can engage in “prudential regulation”, to bring failure probabilities down to low values.

– These concerns do not arise when dealing with the process of buying or owning or transferring cryptocurrency assets.

Consumer protection: Financial firms often treat consumers unfairly, leading to consumer retreat from formal finance, in favour of informal finance or gold or overseas assets. Regulators need to intervene in such cases.

– With thousands of cryptocurrency assets, there is a risk for unsophisticated consumers making mistakes and then retreating from cryptocurrencies as a class. This would be an excessive retreat from an entire sector.

What is the way forward for Indian regulators?

Indian regulators can deploy a reasonably simple strategy, akin to that used with money management.

Money management approach: In money management, unsophisticated users must go to highly regulated mutual funds. Once a customer is above a certain minimum ticket size (e.g. Rs 500,000) they are presumed to have knowledge or the means to acquire the requisite knowledge.

Indian regulators could force Indian financial firms offering cryptocurrency trading to have a “market lot” of at least Rs 500,000. This would ensure that unsophisticated users, would not come into this field. Access to the field would be for sophisticated participants.

It is not the job of regulators to ensure that users make profits. It is not the job of regulators to prevent people from making losses.

A regulator’s job is to ensure that a market failure doesn’t happen.

Source: This post is based on the article “How to regulate Cryptocurrencies?” published in Business Standard on 29th Nov 2021.