We've seen a range of regulatory attacks against crypto in the past few weeks. Most recently, the U.S. Securities and Exchange Commission (SEC) went after the trading platform Kraken. Although Kraken decided to settle, and they did not agree to any wrongdoing, the regulatory action still cost them substantial time and money -- roughly $30 million in the settlement alone.

Core to the SEC's offense was that Kraken is a centralized custodian with staking products that function as investment contracts. Many legal scholars view their interpretation as fundamentally incorrect -- that lending and staking are qualitatively different because the former has counterpart risk and the latter does not -- but that has not stopped the SEC from going after many crypto companies and to legislate through regulatory action.

But setting aside the important differences between staking and lending, there is an even more important question about the degree of centralization in a platform. Put simply, one of the criteria for defining a security -- even according to the most stringent definition taken by the current SEC with the Howey Test -- is that there is "common enterprise." That's clearly the case with centralized crypto, but what about with decentralized finance and decentralized exchanges?

Recent advances in cryptography are making it possible for DeFi to comply with KYC/AML regulation without having to give away the identities of its users. These methods -- often referred to as zero knowledge proofs -- involve the presentation of extremely computationally intensive problems that a user can present a solution to only if they are the entity they are claiming to be. (Think of the most complicated puzzle and being asked to show the solution; you don't need to give away any of the secret steps, but just show that you have the answer, recognizing that there is no way to get the answer unless you really did the work to put all the pieces together and are telling the truth.)

If DeFi can comply with KYC/AML regulations, then they are in a qualitatively different class than their centralized counterparts when it comes to facing regulatory risk as a security.

Some people might argue that the rise of DeFi simply reflects regulatory arbitrage -- people trying to escape regulation. But my recent research in the Journal of Corporate Finance presents the results of an event study where we look at trading activity before/after a regulatory action taken by three U.S. federal agencies among decentralized and centralized exchanges; we do not find any systematic difference in trading with DEXs. In this sense, greater regulatory flexibility is a byproduct of DeFi's many benefits at empowering users.

Nonetheless, centralized platforms still have an important role to play in helping onboard new users. We'll need to figure out a middle ground because the current regulatory environment -- at least in the U.S. -- is unsustainable for innovation and economic freedom.

https://www.sciencedirect.com/science/article/abs/pii/S092911992300007X

Digital assets have surged in their market capitalization over the past few years - so much so that they cannot be ignored or dismissed as a side interest. Policymakers are now grappling with how to handle the regulation of digital assets, which is particularly challenging given that they are inherently international and tend to prioritize decentralized governance (at least for DeFi) over centralization.

To be sure, every asset fluctuates in value and the negative aspects of crypto we've seen in recent months has nothing to do with distributed ledger technologies (DLTs) and everything to do with the inherent problem in the human heart that causes people to make bad decisions. Such issues are questions of governance, not DLT as a technology, and predictable and reasonable regulatory frameworks can reduce the frequency and severity of the incidents - but only if they are designed right.

Impose licensing requirements on centralized cryptocurrency exchanges and other digital currency services that behave like banks.

Trading cryptocurrencies does not mean that a company should be exempt from financial regulation. If they serve as a custodian of consumers’ assets, and it lends those deposits to others, the company operates as a bank and should be subject to similar regulations that banks are subject to based on their size and asset class.

And yet, many companies in this space have sought regulatory arbitrage operating outside of the U.S. because of regulatory ambiguity and the opportunity to arbitrage on it. That’s exactly what happened with FTX, but what’s worse is that then-CEO Sam Bankman-Fried did so in plain sight and conversation directly with regulators that were supposed to be watchdogs.

Adherence to regulatory requirements could start with capital requirements of the form laid out in the recent current and expected credit loss framework that requires that banks use “reasonable and supportable” forecasts to derive the amount of capital reserves they need to hold out in case of adverse economic events. Or it could involve basic cybersecurity and financial security regulatory requirements, like SOC 2 compliance. Each country may have its own standards.

Provide regulatory clarity about the specifics of legal web3 behavior.

There is no single source that specifies the legal requirements for web3 builders and the guidance is more ambiguous in some countries than others. For example, the U.S. Department of Justice has referred to tokens as commodities in its enforcement actions, whereas the Securities and Exchange Commission (SEC) has called them securities and enforced them as such. The community needs guideposts for legal activity and creating them will promote not only more innovation since more companies will build within the U.S. regulatory sandbox, but also more consumer protection since enforcement will have more legal precedent and the bright line for legal activity will be clearer.

Harmonize international standards.

Some international heterogeneity is good and right - indeed, sovereign countries should make their own decisions on governance. But sadly, many entrepreneurs and companies have chosen to locate outside the U.S. for business and residence because of ambiguous and overly rigid standards. One solution is for countries to produce an equivalent of the OECD published international guidelines around the ethical use of artificial intelligence, and the U.S. could help lead.

Another suggestion is to learn from Switzerland’s regulatory sandbox approach, which not only provides much more clarity on the distinction between security tokens and their counterparts, but also safety in piloting a token as long as the amount raised and transacted upon is below 1 million Swiss francs.

Foster dialogue with researchers and industry practitioners.

It's important for regulators to stay informed about the latest developments and trends. But, regulation and even the hiring process in federal governments does not yet move fast enough to accommodate these trends. One interim solution is for regulatory bodies to participate in the web3 community and promote dialogue with researchers and practitioners. For example, the U.S. Commodity Futures Trading Commission (CFTC) could regularly hold public meetings with industry leaders, academics and other experts to converge on policy solutions.

Every asset is priced according to its fundamental value and expectations of future performance. These two factors are influenced by two dimensions of risk - idiosyncratic (i.e., pertaining to the specific asset in question) and macro (i.e., a more economy-wide phenomenon). Macro risk, such as the threat of over-regulation and/or declines in consumer demand, tends to get the most attention, but it is actually less threatening in some ways.

Right now, many eyes are on the U.S. Securities and Exchange Commission (SEC) and how they are going to deal with Ripple, among other companies pioneering digital assets or providing a means of exchange (e.g., Kraken). That macro risk creates a ripple effect throughout the economy, particularly in the market for digital assets. For example, if XRP gets labeled as a security, then other tokens could be subject to substantial regulatory action as securities too, suffering fines and having to incur new compliance costs.

While that macro risk is important, it is easy to focus on it over the idiosyncratic factors that matter more for a given token. Regulatory clarity will become - we just do not know when - and there will be some degree of convergence across countries because of the mobile nature of capital. If one country over-regulates digital assets, then capital will migrate out and that will cause a re-evaluation. But if a digital asset fails for idiosyncratic reasons (e.g., terrible management or failure to solve a consumer demand), then that is a nail in its coffin for good.

The temptation is to focus on the highly salient macro risk, but a good rule of thumb is to pay close attention to the idiosyncratic factors - that's what really distinguishes one project from another - regardless of the type of asset.

In the mean time, let's see how regulatory bodies continue to form judgments and how companies react!

These days, it seems like everyone and their pet is a "web3 expert." What does it mean to be an expert and how do you identify what to listen to, and what to disregard?

Having taught and studied the economics of blockchain and digital currencies at the University of Nicosia, I’ve found that students often have some beliefs about what tokens are and how business and token economies work. Anytime there is a new technology that enters the landscape, people rush over to capitalize upon the momentum. But to actually speak and build credible in the area of tokenomics, people must be well-versed in the fundamentals of microeconomics and macroeconomics.

Many self-professed “experts” provide advice that sounds fine and even sensible in theory, but that fails in practice. In sum, what matter when designing tokenomic incentives are the answers to the following questions:

Is the economic strategy repeatable? (That is, you don't want to just implement a strategy that coincidentally worked once -- you want to understand why and how a strategy worked so you can learn from it and do it more at scale.)

Is there a way of diagnosing when and how to deploy the strategy for your token and the estimated value of doing so? (That is, you need to understand the specific costs and benefits around a strategy so that you can weigh the tradeoffs to different approaches.)

Is there research that validates the strategy so you can talk about it more credibly? (That is, if you're trying to build support for a strategy that sounds good, but doesn't have any research and evidence to substantiate it, you're going to have a tough time building a coalition!)

A good example of a myth in tokenomics is that deflationary coins are always better. ( “Deflationary” just means an ever decreasing supply of tokens, which in theory increases the purchasing power and value of each remaining token. “Inflationary” means the opposite: an ever increasing supply which, in theory, reduces the value of each token.)

In reality, whether the token is inflationary or deflationary is a second-order question -- that is, it just doesn't matter as much as some people think. In fact, the price of a token can always adjust to meet supply, and each token can be arbitrarily fractionalized, so a fixed supply is a moot point if the token does not provide value to end-users!

When you hear advice about what to invest in or how to launch a project, don't forget to ask these important questions!

Airdrops refer to the transfer of tokens from one digital wallet to another.

While airdrops are new with digital assets, they build on a long-held strategy in marketing of rewarding early and loyal users, or simply other users who have met certain eligibility criteria. Airdrops allow companies to communicate and gift items directly to people on their digital wallets.

The technological capabilities, coupled with the social phenomenon of tokens, can expand the tools that brands have to engage existing and prospective consumers, namely that they can tailor rewards and incentives to them based on observed behavior on the blockchain. There are several types:

Vanilla - eligibility criteria are minor or non-existent and the aim is to reach as many people as possible

Holder - eligibility criteria are based on users who have held a token for a specified time period, often rewarding those who were early supporters

Past value - eligibility criteria are based on users who had contributed value to the community in the past

Future value - eligibility criteria are conditional such that recipients contribute to the future value of the project

To understand the efficacy of airdrops, I undertook research with three collaborators and recently published the results in a leading academic journal, the Journal of Corporate Finance. We gathered data from CoinGecko on all the leading centralized and decentralized exchanges, or CEXs and DEXs for short, and came to an important finding: while CEXs have many more transactions overall, DEXs have exhibited much faster growth even after controlling for confounding factors across exchanges. In short, there has been a surge in DEX activity.

But what can explain the rise of DEXs and might airdrops and the user of governance tokens distributed to community members matter? Using a sample of 51 exchanges over time, we found that airdrops are positively associated with growth in market capitalization and volume, but these benefits are concentrated among DEXs and exchanges that offer governance tokens. In fact, DEXs that conduct an airdrop exhibit a 13.1 percentage point rise in their growth rate of their token's market capitalization. We also find some evidence that DEXs who airdrop governance tokens experience higher volume growth than those who do not.

The benefits are concentrated among airdrops over governance tokens: these exchanges exhibit a 14.9pp higher growth rate in market capitalization and a 25.4pp higher growth rate in volume. We also ruled out concerns that our results are simply driven by short-term social media behavior where airdrop recipients are required to retweet and pump a project - also known as "airdrop bounties."

While our results are not causal, they are robust. Time will tell whether they remain!

See the published and working paper version of the article below!

https://www.sciencedirect.com/science/article/abs/pii/S092911992300007X

https://papers.ssrn.com/abstract=3915140