Regulating Digital Assets | Jessica Wachter and Timothy Massad

Itay Goldstein: Welcome, my name is Itay Goldstein. I’m a professor and chair of the finance department. We are focusing the second season of the Future of Finance podcast on cryptocurrencies, digital assets, decentralized finance, and everything related to that. These are new innovations that are promising to change the world of finance, the way that we trade, the way that we pay, and the financial system more generally.

An important part of the story of cryptocurrencies and digital assets is certainly regulation. Some people will say that we have too much regulation or regulatory uncertainty, and that this is stifling innovation in this space. Others will say that we need regulation, and maybe we need even more regulation, because there are many threats, potential fraud, and potential risk for the system as a whole.

We have two perfect guests to talk about these issues. One is Jessica Wachter, who is the Dr. Bruce I. Jacobs Professor of Quantitative Finance here at the Wharton School. I’ve been here with Jessica over the last 20 years or so. I think she arrived one year before me. And she’s thought a lot about the regulatory aspects of digital assets and cryptocurrency, because she just came back from serving as the chief economist at the SEC, the Securities and Exchange Commission. Welcome, Jessica.

Jessica Wachter: Thanks so much for having me.

Goldstein: The second guest that we have is Tim Massad, who is currently a senior fellow at the Kennedy School of Government at Harvard University. He also has vast experience in policy and thought a lot about crypto and digital assets. Among other things, he is the former chairman of the U.S. Commodity Futures Trading Commission, the CFTC, and he has been participating in many of our events here at the Wharton Initiative on Financial Policy and Regulation, WIFPR, where we have been thinking quite a bit about the regulatory aspects of crypto and digital assets. Hello, Tim.

Tim Massad: Thank you for having me.

Goldstein: With this introduction, let’s dive right in. We talk a lot about regulation in the space of digital assets, but this is not disconnected from broader financial regulation and regulation that we have in other markets and other financial institutions. I want to take a step back and understand a little better, what is potentially special about digital assets, and why is regulation of digital assets potentially different than regulation in other areas of the financial system?

Wachter: I think there’s a couple of things to be considered. One is that the original vision of cryptocurrency, going back to the bitcoin white paper, is one of decentralization. And that’s going to create a tension with our regulatory system. Moving more towards the present, this is a situation where securities and non-securities are inseparable. Just to put it in nondigital asset terms, we don’t normally use gold to, say, buy Apple stock on the New York Stock Exchange. We don’t really know how that might work, and that’s the situation that we have with crypto platforms.

I think another challenge is that the crypto ecosystem developed outside of the regulatory system, and that’s created a bit of a chicken-and-egg problem. In the traditional financial system, we have securities that trade on registered exchanges. That’s a very important part. It’s not the full financial system by any means, but it’s a very important part of how institutions and retail interact with the financial system.

But what do you do when both the tokens, which are kind of like the equities here, and the platforms, are unregistered? You need one to go first, but neither can operate while the other is still unregistered. So, I think that those — decentralization, the intertwined notion of securities and non-securities, and the chicken-and-egg problem — are three challenges that would need to be overcome.

Goldstein: Tim, do you want to weigh in?

Massad: I would first say the problem is that we speak of digital assets as if it’s an asset class, and it isn’t. It’s a technology. We’re talking about blockchain and tokenization technologies, which can be used in all sorts of ways. You can have tokenization of securities, of stocks and bonds, and potentially other real-world assets or other financial instruments. You can have network tokens of blockchains, which is what bitcoin and eth are. You can have tokens that are really for consumption, as in games. You can have meme coins. You can have collectibles.

We can’t really regulate digital assets, per se. What we need to do in regulation is three things. One is, we have to address the gap we have in the United States with respect to regulation, which is that insofar as some tokens aren’t securities, but are financial instruments — whether you want to call them commodities or something like commodities — we don’t have a federal regulator for that spot market. And that’s been something that lots of people have recognized, but we haven’t done anything about it.

Secondly, we do need greater clarity on when is a token a security, when is it not a security? As Jessica said, there’s a lot of gray areas to that, because tokens can change over time.

The third thing we need to do is make sure that the rules we have about how to use this technology are neutral. That is, the rules we have for things like record keeping, custody, clearance, and settlement should be technologically neutral. They shouldn’t be inhibiting use of this technology, but I don’t think they should be promoting it. Let the market decide that.

Goldstein: What both of you are saying is pointing to one friction that has been on the minds of many people who are observing this … and this is the potential fragmentation. The fact that it is not clear who should regulate what. You have some tensions, you have different rules coming from different agencies, and that creates even greater uncertainty. Is that a bug that we can overcome, or is that a feature of the system?

Massad: It certainly has been a cause of some of the difficulty in addressing this. We have two market regulators, the Securities and Exchange Commission and the Commodity Futures Trading Commission. And when you have a technology that allows for the development of innovative products that cut across those agencies’ jurisdictional lines, that becomes very challenging. If, for example, we had a unitary regulator, as some jurisdictions do, it is easier to address financial innovations. Because you say, “All right. My jurisdiction covers all financial instruments. I see this new technology, and I’m going to address that.” So, we have been saddled with that.

I think that’s one of the reasons, when we think about the solution, about how to regulate, we actually need to bring the agencies closer together. A lot of people say, “Well, what we need is very clear lines of jurisdiction, what the CFTC regulates and what the SEC regulates.” That all sounds good, but in fact, there are gray areas here. You can have tokens, which seem to be securities at first, but then can become commodities because they are decentralized. And again, you want rules on how to use this technology that are reasonably consistent between the two agencies.

I think the solution lies in bringing the agencies closer together in various ways. You don’t have to merge them. That’s been suggested many times before, and we’ve never wanted to take that step. But we do have to create ways that they’re going to work together on these issues.

Goldstein: Jessica, what is your take on fragmentation? Obviously, you just experienced some of it in D.C. I don’t know how much you want to discuss that.

Wachter: I think Tim said it well, which is that I don’t believe that creating one financial regulator is the answer here. But this is clearly something that the CFTC and the SEC will have to, and actually do currently work together on. That’s something that both agencies know how to do. It does, at the margin, create some frictions and perhaps slows things down a little bit. But I believe, in my experience, the extent to which that happens is somewhat overstated. I think that fragmentation itself is not really the problem that we have. The issue is that some of these problems are difficult problems, and it’s not obvious what the solutions are. But I think that many issues actually are similar to the types of questions that the SEC has worked on for many decades.

I generally think, both here and in other settings, that the fragmentation of the U.S. financial market story is a little overstated. I think that there’s strengths to our system vis-a-vis other jurisdictions. For one thing, we have a strong and experienced market regulator, and not all jurisdictions have that. And I think that’s been very helpful for the development of financial markets.

I think having the CFTC and the SEC separate has allowed for experimentation. In some cases, for some sets of rules — and this is outside of crypto — the CFTC has gone first and the SEC has been able to see how things have worked out and learn from that, and vice versa. So, I think that there’s actually some real benefits to our system.

Massad: I would agree with a lot of that. I don’t mean to suggest that fragmentation is the main problem here. I do think there are benefits to the fact that we’ve had two regulators. But I do think when Congress thinks about what to do here, it’s not just going to be a simple process of writing legislation that says, “OK, this is a digital commodity. CFTC, go regulate that.” Because those are difficult questions. I just think we want the two agencies working together. And I agree they’re capable of that, particularly when they’re led by chairs who have that mentality.

Goldstein: One of the biggest questions when it comes to regulation is the idea that because of regulation and regulatory uncertainty, we don’t see as much innovation in the space of digital assets and decentralized finance as we would have hoped. Proponents of this theory would say that we have a set of new technologies that promises to revolutionize the way we do finance and monetary economics. But because of all these regulations and regulatory uncertainty and potential political issues, there is just not enough innovation and we are falling behind. What is your take on that?

Massad: I think it’s overblown. The industry loves to say this, and you could certainly make the argument that, “Gee, if we had regulatory clarity, people could more easily launch products, raise money. They wouldn’t even consider doing something abroad,” and so forth. But in the grand scheme of things, I think it’s an overblown argument. I don’t think that’s what’s preventing this technology from displacing JP Morgan or something like that, which sometimes crypto enthusiasts love to say. “Oh, this is really going to transform finance.” I think it’s an important technology. I think we will see it used in a lot of ways. I think we’re getting there. I don’t think we’re as far behind other jurisdictions as some would have to believe.

Goldstein: Jessica, do you agree with that?

Wachter: Yes, I do. I’ll add a couple points. One is that the broad crypto space developed for years without this. It developed to be actually quite large and significant, relative to where it started, without the regulatory certainty. I think it’s possible that the regulatory uncertainty has impeded some of the large traditional financial players from having as large a role in crypto as they might otherwise. But the fact is, crypto has generally been a retail and sort of decentralized-driven business anyway. So, I do agree that this is an overblown argument. That said, I think regulatory clarity would be quite helpful.

Goldstein: Going a little deeper into why we need regulation to begin with, I would say one issue that seems to be particularly prevalent when it comes to digital assets is fraud. We have seen a fair share of fraud, probably more than was anticipated initially, and this has caused a lot of concern and led to a call for more regulation. What do you think about that? Why do we see so much fraud in this space, and is there a clear way forward where we can avoid it, or is that just going to be part of the system?

Massad: I think we’ve seen a lot of fraud and manipulation and other problems for two reasons. One is, it is an unregulated sector, largely. At least what we often call the spot market, in tokens that are not securities. And of course, the crypto industry has argued that basically, most tokens are not securities. That’s unregulated, number one.

It’s also easy to enter. You can be 18 or 20 years old and in college and create a token or create an app and launch that. Who knows, you might make a lot of money at it. But you also have a lot of people, as you do in any area of financial activity, who are looking to make a quick buck, and often not through the most ethical means. You have pump-and-dump schemes. You have a lot of wash trading on platforms. Wash trading is where people essentially trade with themselves to push up the price of something or make it appear there’s more interest than there is. We saw with the whole ICO phenomenon of people selling tokens without good disclosure. It’s not surprising that we’ve had all this. Again, it’s the reason why we need a comprehensive, regulatory approach to it.

Wachter: I would say that it’s surprising from the point of view of our current markets — some of the most visible parts do not appear to be rife with fraud. We’ve never done the experiment, but I think in large part it’s because of our securities regime going back to the ‘30s. But the point is, people forget that we’ve got that. It becomes in the background. It’s like part of the air we breathe. It’s like the fish in the water. We forget that that’s protecting us from what would otherwise be probably rampant fraud in traditional securities as well. Crypto developed and it didn’t really have this backing.

I’m actually not sure it’s more prevalent. Maybe it is. We don’t have the data. Part of the issue is that we don’t have the regulations. But there’s plenty of fraud in the dark corners of the equity markets too, with very small equity securities that don’t trade on exchanges.

Goldstein: The other reason why we have regulation in financial markets more generally is the concern about systemic risk and the idea that if there is a problem in one type of asset, one type of institution, this is going to spill over, affecting the rest of the financial system and ultimately also the real economy. This has been mentioned in the context of cryptocurrencies and digital assets, but it’s not clear that this is, at this point, big enough to worry us. What is your take on that?

Wachter: I don’t think crypto at the present time is large enough to pose a systemic risk. I tend to think that the nature of some of these contracts is not such that it would normally tend itself to systemic risk, because they’re more equity-type contracts. But of course, stablecoins, which perhaps we’ll talk about, are a big exception. Because those are demand deposit contracts, like a deposit in a bank account, and in some sense, you could say, are asking for trouble.

Massad: I would agree with that. The only thing I would add is that when we talk about systemic risk, it’s hard to identify where that’s going to come from. You can imagine scenarios where, because of the overall context, something happens in crypto, it’s gotten a little bigger and maybe the overall environment has some other factors that are contributing to anxiety or concern. It’s the proverbial thing of the butterfly flapping its wings in Brazil or whatever. But I would agree that today, the sector is is not so large that it would be my top concern for systemic risk, that’s for sure.

Goldstein: But you did mention stablecoin, Jessica, and I would say this is potentially an area where we might see it, because the whole point of stablecoin is to offer stability. You have the usual problem where you commit to certain payments, but the underlying assets might not support it, and this might generate a run. That might be one place where we might fear about systemic risk.

That is a good segue to thinking a bit more about stablecoin. Because if we are focusing on regulation, I would say stablecoin is one area where there is a clearer path for regulation. As we speak, there is a bill that is making its way through Congress. What is your take on the regulatory aspects of stablecoin? Are we headed in the right direction?

Massad: I think we’re headed in the right direction. As you mentioned, at the time we’re recording this, the Genius Act is coming up soon for a vote in the House. It may very well have gone to the president by the time this has aired. The Genius Act creates a basic framework for the regulation of stablecoins, and I think it gets some things right. It’s good on some of the basic prudential requirements that we would want to see.

A stablecoin is a token whose value is pegged to the dollar, to another fiat currency, or or to another sort of asset. There can be stablecoins that are tied to other crypto tokens. I’m just talking about the ones that are tied to fiat currencies. The legislation that is currently being considered requires that a stablecoin issuer have full reserves backing the stablecoins that it’s issued. Meaning for every token, you have to hold that dollar, you have to conservatively invest it. There are limitations on the activities of stablecoin issuers, and that’s all good. I do think there are some weaknesses in the legislation. We can get into those if you want.

But the real question is, will this market grow significantly? We’ll have to see. There are a lot of elements to payments and why people choose certain payment instruments. And the big volume of payments, of course, is not retail, it’s business to business. Will we see large use of stablecoins among businesses? That’s not clear.

Wachter: I would agree. I think this is directionally right. I think anything with a structure like a stablecoin is going to have some kind of run risk. And I think that can be mitigated by the certain safeguards that Congress is putting in about restrictions about what they can hold and the requirements for audits.

There is this question about how stablecoins relate to the vast money market fund industry. There’s this question about whether stablecoins pay interest. I’m not an attorney. My understanding is that this is still a little bit of a gray area. People might want a stablecoin that pays interest. But currently it’s money market funds; this is how they differentiate themselves. The more stablecoins come to look like money market funds, the more we might start to see the tendency for regulatory arbitrage versus the money market fund regime. And that’s probably an area where we don’t want a race to the bottom.

Massad: Yeah, and we’re already seeing tokenized money market funds. I agree, there are going to be a lot of participants who want an interest-bearing tokenized instrument. I think for where we are, it made sense to stay in the legislation as it currently does, that stablecoins can’t pay interest. But there’s clearly going to be the development of tokenized products that pay interest. Now, whether those are more account-based in some way— tokenized deposits or deposit tokens by banks. That’s another innovation that we may very well see, and in the not-too-distant future.

Goldstein: How big do you think this sector is going to be going forward?

Wachter: I really think this is just impossible to say. It depends on too many things and, in part, on whether some of the more optimistic claims for the crypto sector as a whole bear out. Because that’s obviously one of the possible uses for stablecoins.

Massad: Clearly, people who are in countries with weak currencies or high inflation, who want access to the dollar and who can’t get a U.S. dollar bank account, might turn to stablecoins. And they are. Clearly, to the extent we’re talking about trading tokenized assets on chain, you need on chain cash. That’s what a stablecoin is. Though, again, you might see tokenized money market funds used for that as well. If you see tokenization of other products and trading on chain, that use case could grow. But again, when you look at sort of business-to-business payments that now use chips or the Fed wire, are they going to suddenly move to stablecoins? There’s a lot of issues there, and that’s why it’s so hard to predict this market.

Goldstein: Going back to the topic of regulation, I think we had a good discussion on what are the reasons for regulation, what’s good about the current framework, what’s not so good, what could be improved. One argument that often comes up is that the U.S. is falling behind other jurisdictions. Europe is often mentioned as a system where they acted faster and they have a more uniform approach. There is the MiCA framework that is supposed to capture the whole system of digital assets and stablecoins and so on. What is your take on the issue of the U.S. versus other places, and what might explain why the U.S. has not done so well on this?

Massad: I don’t think we’re as far behind as some crypto enthusiasts might lead you to believe. Yes, Europe has passed MiCA, but they still have to implement MiCA. And implementation of MiCA involves the 27 member countries, in many cases, writing rules. That is a challenging process. I just held a four-day training session at Harvard for regulators around the world on digital assets, and a lot of them were saying, “No, we still face a lot of the challenges that the U.S. faces.” Even with MiCA, for example, it regulates things that aren’t financial instruments, so they actually have the similar challenges that we have. When is something a security? When is it not a security? If it’s not a security, what is it?

We’re getting there. It may not be as fast as as we’d like. Clearly, the Trump administration wants to move forward. Congress wants to move forward. I don’t think this is as big a problem as the industry might like you to believe. But I do want to see us develop a regulatory framework so that we can see how this technology can be used.

Wachter: The Commission has indicated that people should come in and discuss their product, so I think that the case that we are currently impeding innovation is pretty weak. The U.S. just has an enormous financial market, just in absolute as well as in relative terms. I don’t see evidence that we’ve fallen behind here. I do think that it’s going to be valuable to solve some of the problems that we’ve been discussing. That’s going to be helpful. But I think that there’s a commitment to doing so. That’s really what people need in terms of putting these ideas forward. Again, the barrier at this point is not a regulatory one.

Goldstein: As we are coming close to the end of this episode, I would like to offer you a chance to summarize your view on future regulation and what you would like to see going forward.

Massad: The first thing I would say is, while this is a very important technology, it might be used in lots of ways, we want to be sure that the regulation we develop does not undermine our existing markets. The securities and derivatives markets that we have, and the equity and debt markets that we have, are so important to the world, not just to the U.S. economy. They’re very, very large, $120 trillion market cap, securities alone. When I say undermine, what I mean is, we don’t want to rewrite the securities laws in ways that undermine a framework that’s been developed very thoughtfully and carefully over 100 years. We don’t need to create a lot of exceptions to promote the technology. We want technologically neutral rules. Again, we need to be careful.

The three things we need to do are: One, create a framework for regulation for what we typically call the spot market in digital tokens that are not securities, to the extent they’re financial instruments. Two, provide greater clarity as to how we regulate tokens, whether they should be regulated as securities or not. The SEC is working on that today. And that’s not something that can be easily defined in a statute in a couple of paragraphs. Because it depends on, does the token represent an interest in the business? Is there a capital raising going on? How might the token change over time? Things like that.

The third thing we need to do is, again, make sure our rules on things like how you tokenize assets, and how you keep records, and how you custody tokens, and how clearance and settlement works — we want to make sure our rules work for this technology. Again, it shouldn’t be promoting it excessively, but they shouldn’t be inhibiting it either.

Wachter: Yeah, I agree. That is a great vision, and that is absolutely where we want to get. I will just bring up the the case of the exchange-traded fund. That was a case where there was an innovation and it solved a very real problem. Now, these are a very important part of our financial system, and this is a completely different situation. But I think it is similar in the sense that we’ve seen an innovation, and it exists to solve problems that people have, and they like it for that reason.

A path towards bringing this into the regulatory system, I think, is key. I think that the three elements, which probably will involve some kind of temporary relief — this is what’s happened with ETFs — that will probably be part of it. Also, the sort of chicken-and-egg problem. If these three elements are solved, I think we’ll be on our way. One of them is decentralization. One is the fact that non-securities and securities are going to be traded together. That ties very intimately to this question of the fact that the CFTC currently does not have the authority to act as a regulator in the same sense as the SEC over non-security markets.

Lastly, what do you do about the fact that these are unregistered tokens trading on non registered platforms? I think solving those three pieces, which will involve some tricky line drawing, at least in the short run, that’s what I would like to see.

Massad: If I could add maybe a word on the decentralization point. Because I agree, that is one of the aspects of the technology that is quite novel, quite interesting. The question, though, is what do we really mean by decentralization? And what is truly decentralized finance? Clearly, if you have software protocol that operates autonomously, that people can use on their own without going through an intermediary, you would call that decentralized. But what we actually see in the world is a lot of what even Commissioner Hester Parson, who’s quite sympathetic to the crypto industry, recently called DeNo, “decentralized in name only.” Because you have that protocol, but then you have a business that’s facilitating how people use it. Or a business that’s administering or maintaining that.

That’s where it’s important to take the position that decentralization doesn’t equate to a regulatory pass. We have to think about, what is the activity that’s taking place, and how do we achieve the same regulatory objectives? Now, maybe some of those objectives we don’t worry about. If I’m custodying my own assets, then maybe I don’t worry about what someone might do with them. But we still want market integrity. We still want to prevent fraud and manipulation. It’s not the case that just because it involves some kind of autonomous software, that we should say, “No regulation.” We just have to figure out who are the actors who are in a position to meet some of our regulatory objectives, and how do we meet those?