Yet again, we see rumblings of banning crypto, with a peeved RBI, and an unsure finance ministry seeking global validation to embark on such a step. Both have their reasons, and feelings. Unfortunately, policy making doesn’t happen on an island, it’s influenced by apprehension, cognitive bias, leanings of society, and mostly, doses of over confidence, or measures of under comprehension.

Meanwhile, as I was completing writing this piece over the weekend today, it was perplexing to see another heavy-handed attempt at enforcement by the SEC in the US. In the Coinbase front-running case, where the SEC has seemingly taken the opportunity of penalizing insider trading by a few individuals at Coinbase to also implicate nine crypto companies of violating securities laws.

Whether it is to optimistically claim them as the future “currency of the internet” or anxiously dismiss them as dangerously volatile and speculative, the ubiquity of cryptocurrency conversations is unmissable. Regardless of which side of the debate one supports, the innovation already has billions of dollars backing it, and is worth more than a trillion – which is a prominent reason why it has come under the radar of financial institutions and regulators across the globe. Moreover (and admittedly), things change quickly in the world of crypto – while the November of last year witnessed crypto prices at dizzying heights, events such as the spectacular implosion of the TerraUSD stablecoin, followed by lending & opaque investing contagion, leading to several crypto behemoths going under - starting with Three Arrows Capital which at one time managed an estimated $10bn in assets, and then multiple counter-parties like Celcius ($5.67bn), Voyager Digital ($5.8bn), Genesis ($20.7bn)- all this within the last two months has reignited the desire to re-look at a new crypto regulation in an attempt to tame its wildly swinging oscillations.

Regulation: Good Intent, but Bad Outcome Looking at the analogy of fintech in the recent past. The ability of fintech to address real problems increased the rapid adoption of emerging fintech solutions amongst institutions (b2b) and consumers alike (b2c). This invited risks, and regulators started to respond. This response came in three phases: initial encouragement of fintech growth with limited regulatory intervention, this was followed by analyzing the risk of fintech to consumers, investors, financial service firms, and how this tied to impacting financial stability, and finally developing a framework to install effective guardrails. During the process, however, if the approach had been leaning towards obsessive security & protection, then the outcome could’ve been unfavorable for innovation, progression of fintech, and uniform financial access.

Accredited investors - value transfer: Case in point is how one of the more sophisticatedly regulated financial markets, i.e., the US, has handled regulation from a protection lens: by narrowly restricting various emerging & high return asset classes to accredited investors. Yes, it does protect, but it transfers most of the value accretion (which mostly happens in many of these closed asset classes) only to a narrow segment. The rich get richer. The accredited segment is on the right side of information asymmetry to front run market opportunities. Retail investors have to settle for the remnants.

There have been several interventions to try and discourage some of the asymmetry, by allowing more investors to access private companies via SEC’s amendments to accredited investor definition in Aug 2020. Protection or security as singular lenses can be good intent but bad outcomes. To further illustrate this point, one only has to recall the recent SEC regulation which requires information about issuers to be current and publicly available for broker-dealers to quote their securities in the OTC market. While this move limits instances of fraud and manipulation, it also makes it challenging for retail investors to virtually make any profit from OTC securities from businesses that fail to regularly update their financials.

India & crypto - sentiment not rationality: Closer to home, the sentiment towards virtual currencies is palpable: an effective concoction of confusion and fear of the unknown. Both ingredients that can significantly hinder not only innovation but even adoption of newer financial paradigms. The RBI has been seeking to ban cryptocurrencies altogether, and has been issuing “cautionary” public notices dissuading investments in digital currencies claiming that it is “associated with potential economic, financial, operational, legal, customer protection and security related risks.” So, let’s try and understand some of the motivations of the government:

1. Security / money laundering: A prominent argument, authorities claiming that the foundation of cryptocurrencies in anonymity and decentralization makes it a great channel for money laundering & for criminal & terrorist activities financing. However, crypto provides a completely transparent ledger with traceability embedded in the underlying blockchain metadata. This can provide a great technology for anonymity for good actors, as well as visibility & an audit trail for bad actors.

2. Investor protection: Another worry hassling regulators is when emerging exchanges claim digital currencies to be a safe and high-return investment that misguides the regular investor. With the absence of stringent regulation, there is little to no investor protection in the DeFi space. And this is a valid concern especially in the light of crypto scams ranging from pump-and-dump schemes, fake celebrity endorsements, phishing scams, and more. Where money is involved, scams will follow and so putting up effective guardrails with appropriate regulation can support legitimate players while also creating a level-playing field for genuine players in the crypto sphere.

3. Monetary stability: Regulators apprehend the emergence of digital assets threatens financial stability by diminishing the value of government-controlled money. However, crypto has several use cases, and a system of payments is only one utility, and even in that case, even massively adopted crypto currencies used for payment facilitation still won’t replace fiat money. Both can and will coexist. Crypto can bring more efficiency into mentary markets, the pathway won’t be smooth or predictable, but that’s no reason to ban it, but to provide enabling & evolving regulation.

Detangling DeFi vs CeFi: The one aspect pertaining to protection that may not be fully appreciated is in the application layer of blockchain and is about the structure of the asset management entity. Every crypto fund, lender that has been severely impacted in the recent contagion has been a centralized entity. Whereas the DeFi or decentralized finance entities (projects or protocols or asset managers), which are non-custodial, and on-chain in their structure - all such platforms have remained secure and their investors haven’t had to face the consequence of the asset manager becoming insolvent. Web3 technology in fact is about DeFi, whereas the actions of ‘bad actor’ (not always bad intentioned, but just structurally poor) centralized entities have colored the entire crypto spectrum as over-leveraged & high risk. This nuance is important to understand for regulators. The principles of decentralizing finance can actually help take forward some of the government’s larger objectives in both financial services and inclusion. Putting a plug on crypto and DeFi will not.

The RBI Governor’s earlier comment on the digital currency – claiming how its value is lower than even tulips (referring to the Dutch “tulipmania” of the 1600s), asking investors in the country to “invest at their own risk,” and even stating that cryptocurrencies threaten macroeconomic and financial stability – the negative sentiment towards a revolutionary and emerging asset class becomes apparent. The RBI needs a crash course in token economics and why a decentralized system underpinned by blockchain technology and a tokenized economy can actually help complement some of the regulator’s longer term objectives around risk concentration and transparency in financial markets.

Functionality in token economics: Does that mean crypto is a low risk asset class and fraud is in the margins? No. There is a lot of scammy stuff in crypto and there are several bad actors. It’s an emergent asset class, just a decade old, and bad actors will be weeded out by market cycles. And regulation can in fact help isolate them. Crypto is also not a low risk asset class, it is new and it is risky. Crypto tokens that have utility in the network, from securing networks, to conferring economic & access rights, to governance enablement, such functional tokens will define the future of crypto economics. The use case for Web3 is immense via this mechanism. Purely speculative tokens that have no utility will die a market led death.

To conclude, while the need for regulation of this emerging asset class cannot be argued, it is important that regulators focus on developing a framework that not only protects, but also creates an ecosystem for Web3 innovation, decentralized finance, and digital assets. Having a balanced policy will also help India’s emerging middle and mass affluent classes to participate in the innovation and value creation in this new tokenized economy. Because, the higher end of the spectrum will anyways have access through complex structures, and the rich will continue to get richer. With an enabling regulation framework that understands Web3 technology & principles, and regulation that should be evolutionary in approach when handling a foundational technology, not only can larger market communities participate in the value creation, but also India can emerge as one of the epi-centers of Web3 innovation. We have the talent, we have the entrepreneurs, let’s not kill it - either outright, or by suffocation.