We Can Have Effective Crypto Regulation Without Stifling Innovation. Here's How.

Note: This article originally appeared on fortune.com in August 2022. 

The only constant about the crypto markets over the past few weeks is the speed at which things seem to be getting worse.

Even the most seasoned observers were shocked as Bitcoin lost more than half its value in the space of a few months and the total market cap for cryptocurrencies dropped below the $1 trillion mark after it reached $3 trillion in November.

It’s a chain of events that started with the overnight collapse of algorithmic stablecoin TerraUSD and its companion token Luna. The contagion effects took down Three Arrows Capital, Celsius, and Voyager.

Now, critics are doubling down on their claim that crypto markets are nothing but a “wild west” of costly speculation. The crypto industry and traditional finance await more–and potentially far more aggressive–government regulation.

Only time will tell what that regulation will look like and whether it will be effective. Currently, one thing is clear: The application of traditional regulatory frameworks won’t cut it.

Cryptocurrency is a unique asset class based on a unique technology. For crypto regulation to truly make a difference, it will need to protect investors without stifling financial innovation.

My experience as a regulator for the Treasury, an architect of one of the first crypto compliance functions, and the co-founder of a regtech company has led me to conclude that a strong and comprehensive regulatory framework for cryptocurrency can only be achieved through the prioritization of a few key objectives.‍

Clear, workable definitions

The SEC has made clear its desire to regulate and oversee cryptocurrencies. The recent, near doubling in size of its Cyber Unit (now renamed the “Crypto Assets and Cyber Unit”) shows that it’s ready to dedicate further resources and personnel to bringing crypto fully under its regulatory umbrella. But while increasing personnel will inevitably extend the SEC’s enforcement capabilities, crypto platforms are still waiting for answers to the question of exactly how cryptocurrencies are to be classified, as well as how regulatory authority will be split or shared between the SEC and the Commodity Futures Trading Commission (CFTC).

It will be up to Congress to step in and sort out these questions. However, decisive legislation in the near term doesn’t seem particularly likely, considering that lawmakers only recently began prioritizing crypto hearings.

When lawmakers brought in Crypto CEOs for a meeting last December, a key presentation was a “level-setting” explanation of the blockchain and the basics of web3 by former acting Comptroller of the Currency, Brian Brooks (notably the first agency head with a background in crypto). This was a good first step, but lawmaker education will be key in closing the knowledge gap to create effective regulation.

To date, potential regulators have defined crypto by comparing it to the closest approximation from the world of traditional finance. This “if-it-looks-like-a-duck” approach has resulted in definitions based on what cryptocurrency has in common with traditional finance, rather than what sets it apart.

Crypto regulators will need to create new definitions–ones that speak directly to the technology and processes unique to crypto. This, in turn, will allow regulators to create a regulatory framework specially tailored to the assets it seeks to oversee.

Some of these definitions have been written into the recent Gillibrand-Lummis bill. Should the bill pass, those definitions would become the literal “letter of the law.” But it remains to be seen whether the language and information provided would be sufficient for the agencies tasked with creating and enforcing regulations.

Develop regulations that are strong yet flexible

It’s an old truism that innovation doesn’t happen in a boardroom. Technological innovation often requires an independent streak that doesn’t play nice with the status quo.

The problem, of course, is when that independent streak runs afoul of traditional legal safeguards. But regulation and innovation can work together if we stay flexible and focused on the end consumer. Insofar as a crypto token fits an existing regulatory framework, the regulation should apply.

However, if a token fits in multiple regulatory frameworks depending on how it is used, individual use cases shouldn’t automatically extend the regulatory scope beyond its purview. A good litmus test for regulators is to ask the question: Is this rule protecting the end consumer? Or am I protecting existing businesses at the expense of new product innovation that could improve consumer outcomes or promote competition?

Regulators cannot be expected to see the future more than anyone else. But by being conscious–not just of the limits that are being set, but of the space left for products and processes to grow–they can write strong, comprehensive regulations while still allowing finance and technology to continue to evolve.

Enforce regulations at the speed of technology–and let the technology help you

Future conversations about 2022’s crypto market crash will inevitably focus on how fast things went wrong. It will be front of mind for lawmakers and regulatory agencies as they develop new policies specifically designed to protect consumers and counter extreme market volatility.

As these new laws solidify, it will be crucial that these groups consider an often overlooked policy objective: the development of an enforcement framework that will allow regulators to move as fast as the crypto market itself.

Speed is not traditionally a regulator’s strong suit–and intentionally so. Regulators are, by nature, thoughtful, prudent, and measured. But in contrast to the opacity of the traditional finance industry, crypto-specific regulations have the potential to take advantage of crypto’s own native characteristics, such as its digital-first format and inherent transparency.

This not only means that blockchain-enabled tools can be put to use helping enforce regulations, but future regulations will also stand to gain from the technological advancements that have sprung up as part of the larger crypto ecosystem.

This, like the work of setting clear definitions and writing flexible policy, will require work on the part of both lawmakers and regulatory agencies. But the reward for doing so may be a regulatory enforcement framework that paves the way not just for crypto regulation, but for the next generation of traditional financial market regulation as well.‍

A path forward

The silver lining to periods of crisis and difficulty is that they often spur action from those with the power to enact lasting change.

However, there is always a danger that the desire to “fix what’s broken” will lead to decision-making that is overly conservative and shortsighted, stifling growth in the long term.

Crypto regulation is needed–and the time to write and implement it has clearly arrived. Policymakers would do well to remember that to ignore what makes cryptocurrencies unique and valuable is just as foolish as never regulating them at all.