What’s Next for Crypto: Implications of Deflated Prices and Turmoil in Cryptocurrency Markets

[Music]

 

Ryan Lacey:  Hello, and welcome to this Federalist Society webinar. This afternoon, September 14th, 2022, we discuss “What’s Next for Crypto?” and analyze the implications of deflated prices and turmoil in cryptocurrency markets. My name is Ryan Lacey, and I’m an Assistant Director of Practice Groups here at The Federalist Society. As always, please note that all expressions of opinions are those of our experts on today’s program.

     

      Today, we are fortunate to have an excellence panel moderated by Alex Pollock, whom I’ll introduce very briefly. Alex Pollock is a Senior Fellow at the Mises Institute. He previously served as Deputy Director of the Office of Financial Research at the Treasury Department, a Distinguished Senior Fellow at the R Street Institute, and as a resident fellow at the American Enterprise Institute. Pollock is a graduate of Williams College, the University of Chicago, and Princeton University.

 

      After our speakers give their remarks, we’ll turn to you, the audience, for questions. If you have a question, please enter it into the Q&A feature at the bottom of your screen, and we will handle questions as we can towards the end of today’s program.

 

      With that, thank you for being with us today. Alex, the floor is yours.

 

Alex J. Pollock:  Thank you, Ryan, and let me add my welcome to our expert panel and to all of you who are joining us today. Well, what is next and coming for crypto?

 

As we all know, the prices of cryptocurrencies, including Bitcoin, have fallen by about 70 percent from their highs. Some cryptocurrency firms have gone bankrupt and/or cut off redemptions. Unsophisticated retail investors have taken heavy losses—a clear signal to politicians and regulators that they wish to be involved.

 

The stocks of some crypto mining firms are down 60 percent. The overall market capitalization went down about $2 trillion—$3 trillion less than one—and a lot of money people thought they had is now gone. As my friend, Wolf Richter, put it, “The instant play money vanished.” That’s a typical thing that happens at the end of a financial craze or a bubble.

 

How shall we think about this whole cryptocurrency situation? Is it best thought of as the deflation of a bubble, or better to think of it as a to-be-expected correction after an enthusiastic bull run and a lot of experimentation in the innovative sector? Is this a normal winnowing out of losers so the winners can proceed?

 

Now, this year has been often called a “crypto winter.” Does that mean that spring comes after the winter or not or what? Of course, the recent losses to retail and turmoil have caused great interest in increased regulation of cryptocurrencies by the SEC, the SFTC, the Federal Reserve, the banking regulators, Congress, all of that in this country, and of course, all of the corresponding organizations and governments abroad. And they’re all trying to impose more regulation and debating how that should be done, and that includes states.

 

We learned recently that Vermont regulators alleged that bankrupt crypto platform, Celsius, through its chief executive, made false and misleading claims to investors about the firm’s financial health, even as it suffered huge losses. And obviously, that’s not the situation you want to be in as a management—having such claims raised against you. And this whole topic does raise the key question of disclosure of financial statements and other key information in cryptocurrencies, and especially for stablecoin issuers, which many people think are most like banks.

 

In fact, thinking of the regulatory question we can ask of the various forms of cryptocurrencies, are they more like banks? Are they more like money market funds? Are they more like exchange-traded funds? Are they more like speculative investments? And depending on which analogies you think apply, you get various regulatory answers. And the panel is going to explore many of these issues. And, of course, The Federalist Society has a long history of interest in regulation: what forms of regulation do make sense or do not make sense.

 

In short, we have for you today a most timely set of issues and people to address them. And let me introduce our panel in the order in which they will speak.

 

First will be Steve Lofchie, who is a Corporate Partner at the law firm, Fried Frank, advising financial institutions on regulatory issues and on financial instruments. He’s the founder and manager of a legal website, Fried Frank Regulatory Intelligence, and was part of the team that was named the 2020 best regulatory team of the year.

 

The next speaker will be J.W. Verret, who is an Associate Professor of Law at the Antonin Scalia Law School of George Mason University, where he has been since 2008. In 2013, J.W.—and I remember well working with you at this point, J.W.—took a leave to be Chief Economist and Senior Counsel for the US House Committee on Financial Services, and he’s also a Senior Scholar at the Mercatus Center Working Group on Financial Markets.

 

Our third speaker will be Alexandra Gaiser. She is the Director of Regulatory Affairs at River Financial, which is a cryptocurrency firm, where she works on new product strategy and interfaces with regulators. Previously, Alexandra was in the U.S. Department of Treasury in the General Counsel’s office and then as Executive Secretary.

 

And our final speaker will be Bert Ely, who is a well-known analyst and theorist of banking, financial services, and monetary policy. Bert established his consulting practice in 1972, which means, like me, he has seen a lot of things come and go, and a lot of financial enthusiasms come and go or cycle. And we very much look forward to all of the presentations of the panel.

 

Each panelist will speak for seven or eight minutes with opening comments, and we’ll give them a chance to reply to each other or to clarify points. After that, we’ll turn to questions from you all, the audience, and we’ll adjourn promptly at 2:00. And, Steve, you have the floor.

 

Steven Lofchie:  Thanks very much. So I’m going to come at this not from an economic standpoint but as a regulatory lawyer. And I knew the kind of -- this discussion is supposed to be, I’ll say, about crypto and the economy as opposed to on one side or on the other side yes/no. But I’m a really quarrelsome person.

 

So I’m going to ignore that and say that, in a lot of ways, from a regulatory standpoint, from a political standpoint, I think the crash in crypto will really have a very limited effect on the politics of what’s going on and the regulation that’s going on. Those are driven by forces other than the immediate crash.

 

So I’m going to start with Congress, and then I’m going to work down to the regulators and talk about where they are really as a matter of political philosophy, political ideology, political power—whatever you want to call it.

 

So I know that President Biden issued an executive order, obviously, on digital. That order, I will say, was kind of a mess or all over the place. It was, “Hey, digital could create lots of jobs, and on the other hand, digital could be used for terrible crime.” So it wasn’t really anything definite in that order.

 

But now, let’s move down to the senators. And I would say it is a matter of -- I’m going to say “mainstream Democratic Party distrust or opposition—”whatever you want to call it—to digital assets generally. And what do I mean by the mainstream of the Democratic Party? So, Senator Warren, Senator Durbin, Senator Whitehouse, Sherrod Brown, Tina Smith, then, if you want to include him, Bernie Sanders—all very skeptical about digital assets. And you can justify that in any number of ways.

 

It could be consumer protection. It could be worry about the use of digital as a means of tax evasion or money laundering. But whatever the reasons, they’re not enthusiastic about digital assets.

 

And by saying it’s kind of a mainstream part of the Democratic Party philosophy/ideology right now, I’m going to analogize it to ESG or climate concerns. You tell me how worried somebody is about digital assets. I’ll tell you how worried they are about climate change or the opposite way around. It’s just part of the mainstream Democratic Party philosophy right now. Now, there is a cracking out, which I’ll come to in a minute.

 

Now, on the other side, you have the Republicans, who are much more in this way, I’ll say, open to innovation. And I would point to Senator Toomey on the Republican side as really trying to move the debate towards innovation and criticizing the regulators and, particularly, the SEC. Now, there is one crack, as I mentioned, in the unity of the Democratic Party. And if one is cynical—which, of course, I never am—that may go to political power, and that relates to -- the SEC basically reports up to the banking and finance committees and the CFTC to the AAC committees.

 

So the CFTC would like to get some sort of authority over digital assets, and therefore, that benefits the AAC committee, which has authority over the CFTC. And that is, to some extent, where you see the cracks in Democratic Party unity. And you have Kristen Gillibrand and Senator Stabenow, who are sponsors of bills that would give the CFTC more authority over digital assets and, I think, would indirectly lead to some deregulation of digital assets. Maybe deregulation isn’t quite the right word, but some expansion of access to digital assets. So that’s where we are on the congressional side.

 

And now, I’m going to move down to the banking regulators. And again, I think clear links between where you stand on ESG and where you stand on digital. So FED worried about digital, wants to regulate stablecoin—but not really adamant about it—and the same thing on climate. They’re working to understand climate.

 

Move to the OCC acting controller suit. Well, he is -- one of his four priorities is acting on climate change. And he actually acted to reverse a number of prior OCC actions that would have let banks get more involved in crypto assets and custody in stablecoin and in node validation and said, “No. We really need to be stable. We really -- stability is our focus, and innovation is important, but safeguarding trust is paramount—” i.e. doesn’t like digital.

 

Same at the FDIC. Financial Institution letter 16-2022: “Crypto-related activities pose significant safety and soundness risks as well as financial stability and consumer protection issues.” And again, the tie to energy and climate as being part of the political ideology saying, “Climate-related risks threaten all financial institutions regardless of their business models.”

 

The Department of Labor actually really -- very strong statements against digital saying it has serious concerns about the prudence of a fiduciary’s investment in crypto. And all of this, by the way, is pre-winter, so pre-the crash. And at the same time, the DOL is taking steps to allow greater investment based upon ESG-related concerns.

 

I don’t really need to say anything, I think, about SEC Chair Gensler because chances are, if you are interested enough in crypto to watch this seminar, then you know where he stands. But his position on crypto and it’s all a security and there’s no real explication of how crypto firms really can comply with the securities rules -- extremely consistent with his position on currency -- sorry, on climate saying that “Investors recognize that climate can pose significant risks to companies of all types.” Now the one --

 

Alex J. Pollock:  Steve, you’ve got one minute to go here.

 

Steven Lofchie:  All I need is one minute. The one agency that is somewhat supportive of crypto, as you might expect, is the CFTC, which stands to gain. And so, not only is there support of crypto from Republican Commissioner Pham, but also from Democratic Chair Behnam and from Democratic Commissioner Johnson.

 

      So that’s where we are on the politics, the regulation of crypto, markets high, markets low. It’s not really driving where the government or where the regulators are.

 

Alex J. Pollock:  Thank you, Steve. Thank you. J.W.?

 

J.W Verret:  Thanks for having me, Alex. It’s always good to see you and always good to see all of this panel. So I’ll start with what I think is probably the strongest frustration among my friends in crypto in the policy debates you’ve described, Alex.

 

      During the crypto winter, the people I know that have been in crypto since 2013 said, “Yeah. It’s winter. It’s a season. It comes along every four years in crypto investing. This is another one, but this is the third or fourth one I’ve been through. And don’t worry. It’s going to come back around again.” So, at least in my own role as a crypto investor, I take a lot of heart in that because this is my first season.

 

      But look, I would separate it into three different groups here: total scams that are as present or more present in traditional finance as they are here in crypto. It’s a new, versioning industry. It makes an easy target for scammers, and they’ve jumped in, and they’re trying to poison it -- parts of it for the rest of us.

 

But I would not say that it happens with more regularity than in traditional finance, particularly when you include the kind of scams that target -- I mean, I’m getting alerts from Bank of America for particular types of phishing frauds that might use data hacked about my Bank of America account all the time. So I don’t think it’s even any more prevalent in any other market -- in this market than in any other.

 

      I would say the real distinction that it’ll draw—and this is what really frustrates,  I think, some legitimate builders and attorneys working in the crypto and the decentralized finance space—is they say this: “This is what crypto is all about—at least the finance part of crypto—decentralized finance. Finance that happens without the need for centralized intermediaries, the big banks, the big underwriters. Instead, technology allows us to facilitate transactions on a decentralized ledger that isn’t controlled by one centralized party that can fail, that can get a bailout, that can extract tremendous rents from serving in that role as a centralized intermediary. Instead, transactions can happen on a blockchain. That blockchain is either mined or validated by a dispersed network of—on the Ethereum network, 400,000 different individuals who are working to validate those transactions—and applications built on top of that network can serve the same function as banks, as exchanges, as derivatives exchanges, but without the need for any centralized intermediary in those operations as well.”

 

      Now, that’s great. It works somewhat in some places, but when you reference Celsius -- so my friends in the DeFi community look at Celsius, and they say, “You see? I told you so. That’s not really crypto. That’s a lot more like traditional finance or TradFi.” Celsius was a centralized intermediary. They take custody, and then they do stuff with your crypto, and they don’t really tell you what they’re doing with your crypto. But the true DeFi applications say, “That’s not what happens here.” And they’re right.

 

      That’s not what happens with Uniswap. That’s not what happens with Aave. That’s not what happens with MakerDAO. Three prominent DeFi—probably the three most prominent DeFi crypto applications—that have done perfectly well in the last couple of years. I mean, prices have gone down, but no counterparty risk, no insolvency because it’s not possible on those—at least particularly with respect to MakerDAO, right?

 

      You put your crypto into a smart contract. You control the smart contract. You take it out with a smart contract. You don’t custody it with someone else. You control your interaction with the smart contract that handles it. And with respect to MakerDAO, it’s kind of like a bunch of different vaults—a potentially infinite series of vaults—existing on the blockchain.

 

      You go, you put your crypto in a vault, and you get a key in exchange. And not only can you use that key to go back and get your assets. You can also do other stuff with that key on other blockchains. No centralized intermediary. And to the extent there’s lending on some of these protocols—this is what I think is -- another thing that’s really cool—you go, you put your Bitcoin as collateral, and you take out a loan with other crypto that you want to go do something else with, or that you get cash with and you buy a home with. People are doing that.

 

      Your Bitcoin, if it goes down in value and there’s a collateral call and you miss it, automatically liquidate it using automatic liquidating protocols. No living person has to interact with them. The auction takes place. They’re interacting with bots. And so you lose a lot of those frictions that make -- create counterparty problems in the traditional financial system.

 

So all of that is to say it really frustrates me and a lot of people in DeFi when the regulators and the politicians kind of paint with a broad brush and say, “Because Celsius happened”—and I would never have put my money with Celsius -- “because Celsius happened, therefore, let’s regulate DeFi, Uniswap, and Aave” when they’re saying, “Wait, wait, wait. We’re the answer to Celsius. We’re not part of the same problem as Celsius.” So I think it’s a very important distinction to draw.

 

With respect to, specifically, securities regulation and disclosure, another source of frustration among my friends in the community is the fact that the SEC chairman often says, “Oh, just comply. You’re all mostly securities in the token world. Just comply. Just register. It’s the basic bargain of the new deal.”

 

Let’s think about, for a second, what would happen if one of my favorite tokens had to somehow go and register under the ‘33 Act and ‘34 Act. First of all, I’m not sure who would sign the financial statements in a lot of those because they are decentralized. There’s no board of directors, and there’s no CEO. There’s no CFO. There’s no audit committee. So there’s a whole lot of Reg S-K that I don’t know what to do with, even if I’m trying my best to comply.

 

The disclosures about the protocols -- there’s a lot of things I’d like to know. And a lot of -- a number of suggested -- a number of folks have written to the SEC suggesting optimal disclosures for protocols that might register. None of that is currently included in Reg S-K or Reg S-X that the SEC administers. So you don’t really have provision for the kind of information you want, like how many tokens are going to continue to be issued over time, how many tokens are owned by the developers, and maybe they’re going to dump and cause the price of new investor tokens to drop. None of that stuff is really included in the current regulations.

 

Gensler has kind of flirted with the idea that maybe Ethereum has to register—I don’t know; it’s not clear—or maybe Avalanche or maybe Solana or one of the other major blockchains. Who is the party that registers? I’m still not sure. Is it the Solana Foundation or the Ethereum Foundation that helps to kind of curate the code? Okay. That’s a non-profit group that’s involved with the blockchain, but they don’t own the blockchain, and they don’t own the vast majority of the tokens that are traded on the blockchain.

 

So what are they really going to disclose? They’re just going to disclose the office where the foundation works and a few of the tokens that they own. That doesn’t tell me anything useful as a new investor, as a new buyer of the Avalanche or the Solana token. And you can’t put the assets that are in smart contracts on the blockchain onto the books of some party associated with the blockchain because that’s not gap compliant. Gap doesn’t allow you to put assets that you don’t control onto your books.

 

So we often hear from the SEC, “Just come in and register,” when we realize the next chapter in that book and every succeeding chapter in an effort to do that is a complete and utter disaster right now, which is why it makes that representation fundamentally misleading that we are hearing from the leadership of the SEC.

 

Beyond that, I can kind of keep going, but I’ll reserve my time to say there are other fights in privacy going on with respect to treasuries sanctioning of Tornado Cash. A lot to talk about there. Folks are interested, but I’m very passionate about crypto as I am about securities regulation. And hopefully, that helps to clarify the discussion. But thanks, everyone, for the opportunity.

 

Alex J. Pollock:  Thank you, J.W. When you began talking about the fraud in financial markets, it made me think of Walter Bagehot, who wrote in 1873, “The good times of high price almost always engender much fraud. People are most credulous when they are most happy.” And he didn’t say it exactly this way, but he went on to say, “And what makes them most happy is if they think they’re making a lot of money.”

 

      And so, none of us who have been around financial markets a long time would be surprised by the emergence of fraud when there is a frothy market that is a universal event.

 

      Anyway, thank you, J.W. And let’s come to you, Alexandra.

 

Alexandra H. Gaiser:  Thanks so much. So I agree with a lot of what J.W. has said in terms of how to frame this and think about it and some important distinctions to make. So I’m going to kind of go over my own metrics that I use when thinking about the space and specifically what consumers and regulators mean when they say “cryptocurrency.”

 

      I’ll give you a couple of factors to watch on the price of Bitcoin. I’m at River Financial. We are a Bitcoin-only company, so I usually say other companies go wide with a lot of different cryptocurrencies. River is going deep with really focusing on Bitcoin and financial products that use both Bitcoin and the US dollar. And so, that’s kind of my area of expertise. And then, on a final note, we’ll look at the market overall and where it might be headed.

 

      So what do we mean by cryptocurrency? The definition of cryptocurrency is a decentralized digital currency that verifies its transactions through cryptography, usually a blockchain. The two keywords in this definition are going to be “decentralized” and “currency.” So if you can think of these as two axes where you’ve got centralized versus decentralized and then currency versus something else, that, I think, really helps organize the space.

 

      So in the decentralized currency quadrant is the digital gold that cannot be inflated. There will only ever be 21 million of them. Bitcoin is mined by computers solving complex math problems and adding blocks to the blockchain. This also includes some Layer 2 and Layer 3 solutions on the Bitcoin network—so the Lightning Network that facilitates off-chain transactions so you can increase transaction speed.

 

      Bitcoin really is created to hold value and facilitate transactions. It wants to be a currency. Moving down to the [inaudible 27:26] currency staying on the decentralized side, we’ve got Ethereum and, I think, a lot of what J.W. talked about—so a lot of DeFi DAOs, or decentralized autonomous organizations.

 

      You have some of this in Bitcoin as well, but I think Ethereum is kind of the right ownership mechanism here. And so, again, this is going to be a lot of smart contracts. And Ethereum is sort of the token or the gas that smart contracts run on. And so, there, they sort of say, “Oh, a currency that’s so jejune. We’ve moved past that. There are more exciting applications for the blockchain.” So there, it is often decentralized but not really trying to be a currency.

 

      So if you come over to the centralized side of our chart, up top, centralized currency quadrant, you’ve got stablecoins and CBDCs, or central bank digital currencies. Both of these are going to be controlled by an identifiable party. So in the case of stablecoins, that’s going to be a private company, like Circle. And in the case of CBCDs, that’s going to be a central bank.

 

      One other note is that central bank digital currency, like China’s digital one, are often not using cryptography or blockchain technology. Sometimes, it’s just kind of by fiat, or it might be tied to China’s social credit system.

 

      So here, I would think of this as your on-and-off ramps to the crypto payments highway. It poses a different set of pros and cons for regulators than some of the other boxes. But again, you want to think about, “Is it decentralized?” No, it’s actually very centralized, so the regulation questions are quite a bit different.

 

      And then in the final quadrant, you have centralized and something other than a currency, which is where I would put a lot of the altcoins. So again, J.W. touched on this. This is where SEC Chair Gary Gensler tends to really want to regulate heavily. And I think, looking at the Howey Test as it is, a lot of these things are going to fail the Howey Test. They’re too centralized, and they also tend to be optimized for a use case other than currency—so Dogecoin, Monero. Dogecoin is sort of optimized for internet jokes. Monero is optimized for privacy. Again, maybe you will use it in transactions. Maybe you can use it to trade for different goods and services, but that isn’t really the use case.

 

      So in looking at those four quadrants, I think the amount of fraud can vary, and the use case is certainly very -- which I think, by definition, means the regulatory approaches that are going to work well can and should vary. So again, I work at a company that focuses on Bitcoin, so that’s going to be the area I know best.

 

When you look at the price of Bitcoin, absolutely true that it is down by a third—a little more than a third—from its all-time high in October of last year. Even still, it is up two to three times from September of 2019.

 

So a lot of people, when they’re looking at the price of Bitcoin, are going to pay attention to the overall economic environment [inaudible 30:51] to other items—so stock price, S&P 500. This is generally correlated, particularly over the last five years, where we’ve seen a lot more institutional money coming into the Bitcoin space.

 

That said, Bitcoin does have its own internal economics, and so you want to really pay attention to having episodes. Roughly every four years, the amount of Bitcoin that a computer gets for correctly adding a block to the blockchain gets cut in half. So, right now, you get six and a quarter Bitcoin. In probably spring of ’24, that’s going to drop to 3.125 Bitcoin.

 

Historically, around a year after a halving event, you hit an all-time high, and around a year after that, you hit the new nadir. So I think we are likely on track for that, but I would note, one, this is not investment advice, and, two, if I knew what the price of Bitcoin was going to do, I would have planned accordingly. So that’s something that I think, again, is interesting.

 

Another thing to pay attention to is Ethereum has a merge scheduled this week where it’s going to move from proof of work to proof of stake. The idea behind this is it will help use less energy. It will also change the centralization question. So it’s possible that, after this week, Ethereum kind of moves around on where it falls in those quadrants. So definitely something to watch and something that has really changed the price point for Ethereum because something pretty fundamental about that coin is going to change.

 

And finally, just zooming out, I know both Alex and J.W. have touched on this, but I think it bears repeating. Fraud is always illegal. And it is much easier in a high cash-flow environment to perpetuate fraud because you don’t need a strong proof of concept in order to get funding.

 

And so, I would note that among all of the calls for increased regulation, you do have the market calling—not just bad actors, but also weaker ideas—pretty quickly and effectively. So, certainly, no one wants to see consumers lose money but query whether they would have lost any less money had regulation come sooner or more differently. Thank you.

 

Alex J. Pollock:  Okay, thanks very much. Very interesting comments. Bert?

 

Bert Ely:  Hey, Alex. Can you hear me?

 

Alex J. Pollock:  We can’t see you, but we can hear you.

 

Bert Ely:  Okay, good. You don’t need to see me.

 

Alex J. Pollock:  We agree. Go ahead, Bert.

 

Bert Ely:  Okay. The three key issues that I want to address here—which I won’t stir some controversy—first of all, as I look at cryptos, to me, they divide up into two basic buckets. Either you have what, effectively, are stablecoins—and that would include central bank digital currencies—or they’re non-stable.

 

      The thing about a stablecoin is that there’s an implied promise that it will hold value. And the reason it will hold value is because there are real assets that are backing that stablecoin that, in effect, provide a basis for a full funding of any stablecoin redemption.

 

      And again, that is—although central bank digital currencies aren’t -- haven’t been called this—essentially, that would be true of central bank digital currencies, too. So you have, what I’ll call, the stablecoin piece of the crypto world, and then you have the rest of the crypto world—the bitcoins and so forth.

 

      And to me, the best analogy to use in describing something like a Bitcoin, a non-stable coin, is it’s kind of like baseball trading cards or, in an earlier era, tulip bulbs. In other words, there’s no inherent value behind the cryptocurrency. There is no real -- nothing real backs the Bitcoin other than just a belief of those who own that particular cryptocurrency. And again, Bitcoin, I think, is probably the classic example.

 

      From a public policy standpoint, I really don’t worry about the bitcoins too much. It’s just, again -- any more than we worry about fluctuations and the value of baseball trading cards or other types of trinkets.

 

      Where I do worry is with regard to stablecoins, and that comes down to the fact that there is a -- maybe not a legally-binding promise there, but certainly a commitment to maintain the par value of that coin and to back it up in some fashion. And this is where I think there is a need for regulation.

 

      Again, I don’t worry too much about the regulation of the bitcoins of the world. But with stablecoins where there is a promise, there has to be some backing to that promise, both in terms of assets that have been specifically segregated —or in custody—to back up the face value of the stablecoin and, correspondingly, a need for regulation. To me, they are -- stablecoin is essentially a money market mutual fund, and that’s why I think the SEC is the logical observer of that, leaving the Howey Test aside for a minute.

 

      The thing that -- the second issue or concern that I have -- regards to the amount of leverage that may be going on in the crypto world to the extent that people are making bets. And this is where concerns can come up with regard to Bitcoin and other non-stable coin cryptos, and that is if there is a lot of leverage—and we don’t know how much is there—that if there is some kind of market crash that we may see systemic risk concerns come out of that driven not by the collapse in the value of the cryptocurrency, but what the implications are for those who have borrowed money to invest or speculate. I won’t use the word invest, but to speculate in the value of a non-stable coin cryptocurrency.

 

      And what troubles me is we don’t really know how much is out there in the way of leverage and where that leverage finance is coming from. My sense is that, at least at times -- and a lot of credit card money people have drawn on their credit cards to invest in cryptos. And so, I think we need to, shall we say, kind of keep our fingers crossed as to how much leverage is -- that the leverage hasn’t gotten out of control. But, of course, we really won’t know that until there is a crisis.

 

      The third issue is a matter of interest rates. Cryptocurrencies and Bitcoin and the others have really been very appealing as an investment in a very low-interest-rate environment. As rates move up—and I believe they’re going to move higher than they are today—then that, I think, creates a real issue for cryptocurrency investors, and that is what -- how do you gain in a high-rate environment?

 

      Well, you gain only if the price keeps going up. And so, what happens if rates move up and people become increasingly dissatisfied with a lack of yield on whatever -- what bitcoin or whatever crypto they’re holding and then they start to sell?

 

      And this is where I think there may be potentially some concerns that -- would rise about what happens if we see a drop in Bitcoin and the price of other non-stable coin cryptocurrencies. And just to go through a thought experiment, what happens if interest rates are at ten percent on short-term borrowings or that you can get ten percent on your money in a bank? What does that do to the crypto world?

 

      My sense is that it would be very damaging to the bitcoins of the world. But it also raises an interesting question with stablecoins, and that is, might stablecoins have to actually start paying interest in some fashion? And I believe that it would be possible to do that, leaving aside regulatory issues. So I think that cryptocurrencies—and particularly the non-stable coin cryptocurrencies—have not yet really been tested in the context of a full swing of the interest rate cycle.

 

      So just to sum up, I think that, number one, a strong differentiation needs to be drawn between stablecoins backed by real assets—including financial assets. Number two, the systemic risk issues that may be posed outside the stablecoin universe if there is a lot of margin involved in -- people borrowed a lot of money to speculate on those coins. And again, my concern here is we really don’t know, and we won’t know until there is a crisis. And then the third point is I think the economics of investing in cryptocurrencies, particularly non-stable coins, is going to be how well will they survive in a high-interest-rate environment?

 

      So I’ll conclude with those comments. I look forward to the discussion.

 

Alex J. Pollock:  Thank you, Bert. You may remember my saying that “leverage is the snake in the financial market garden of Eden.”

 

Bert Ely:  And the thing about it is that there --

 

[CROSSTALK]

 

Alex J. Pollock:  And it’s certainly always right to look for the leverage that we -- that may be hidden from sight and find out later.

 

Bert Ely:  Yeah. I think the concern is -- my concern is that if there is an area in the economy where we don’t have much insight at all into the presence of leverage and the extent of it, it’s in the cryptocurrency world.

 

Alex J. Pollock:  Okay, thank you. Now, I want to go through the panel with some of the time we have left here. Two minutes each; that’s all. Two minutes is all you get in the same order we did before to respond to what somebody else said or add more thoughts of your own. And so, let’s start with Steve. Two minutes --

 

[CROSSTALK]

 

Steven Lofchie:  I’m just actually going to pick up on what J.W. said about disclosure and the SEC. In the early days of digital crypto, people said, “Oh, this is something so different, so new, not going to be regulated at all. It shouldn’t be regulated at all.” Real world, that’s not going to happen.

 

      It is a consumer financial product. It’s going to be regulated in some way. The question is how. And the problem with Chair Gensler is he says, “Hey, we’re going to regulate it as a security.” Okay, maybe that’s okay. But saying “it’s a security” does not really answer the question of “how do you regulate it?” because the securities rules simply are not run up for digital assets.

 

      And therefore, as J.W. said, you look at the disclosure rules at SK. They are irrelevant. And so, the problem that Gensler refuses to address is not whether they should be regulated. Okay, you won that battle. The problem is how they’re going to be regulated, and he refuses to address that question. And that really is the question that congress and the regulators need to turn to—not whether, but how.

 

Alex J. Pollock:  Thank you. J.W., two minutes.

 

J.W Verret:  So what fascinates me about -- so first, one quick response to Bert. You mentioned that cryptocurrency has no inherent value. It’s also true of the dollar, right? The dollar only has value because we all believe it does. It’s not backed by anything. The full faith and credit of the government is just a phrase. It doesn’t have any meaning or significance. It’s losing value at two to now eight percent per year.

 

But a more cogent example is Argentina, where Bitcoin is incredibly popular. When you’re in a 40 percent inflation environment, and you have capital controls that make it hard to put your money in dollars instead -- huge use of Bitcoin in Argentina and other cryptocurrencies as well.

 

I think that’s part of why I believe in Bitcoin and other crypto—maybe Ethereum, maybe Solana, maybe others. If all they do is replace currency in the hundred worst nations in the world and they also replace -- let’s be honest, the remittent system that is fundamentally broken -- if you want to send money home as an immigrant in the United States, you’re going to pay ten percent in fees, and it’s going to take you a week to get moving. If you’ve ever tried to wire money overseas, it’s a nightmare.

 

I sent Bitcoin to the Ukrainian army in about ten minutes, okay—for pennies on the dollar in fees—the night that Russia invaded, which was pretty cool—pretty fun, right? So I think that’s an incredible power of these -- of this technology.

 

On stablecoins, also I’d mention that stablecoins is definitely not a money market fund per se, particularly the leading ones, because they don’t pay returns. So you can’t classify them as an MMF on the statute.

 

And the other thing about the non-centralized stablecoins, like MakerDAI, is that, yeah, they are backed by something. They are backed by a group of other cryptocurrencies, including USTC, but that’s all on the blockchain. It’s all fully disclosed. There’s no questions about the non-centralized stablecoins. The only real questions are what are behind these centralized stablecoins? And I think they’re trying to work those out right now. USTC is obviously ahead of tethering, but anyway…

 

Alex J. Pollock:  Two minutes is up. Thank you, J.W., and very interesting point about Argentina and other high-inflation countries. It makes us think of that famous Hayek essay, which is central to the cryptocurrency philosophy of private money and breaking the government monopoly of currency. Okay, two minutes, Alexandra.

 

Alexandra H. Gaiser:  Yeah. So picking up on J.W.’s point about inherent value, I would actually take a slightly different approach on Bitcoin and anything else that’s a blockchain-based coin because what you have is, if everyone tomorrow immediately quit using Bitcoin, never bought it again, and the real value went to zero, you would still have a record of every transaction that’s occurred on the blockchain.

 

So, from a historic or financial analysis standpoint, you do have quite a bit more information value built in than you ever had on really anything up to this point. I think I came of age during the Beanie Baby craze, and I think you hit those sorts of things pretty regularly. And again, there are some key differences between Dutch tulips and Beanie Babies on the one hand and Bitcoin on the other.

 

We don’t have to get into all of it, but I think it’s pretty telling that a coin invented right after the 2008 financial crash has unbelievable staying power, is down by over a third from its all-time high, and is still the number 27 world currency by market cap. Earlier, when the price was higher, it was closer to, I think, 14.

 

When Bitcoin is ahead of the Egyptian pound, the Chilean peso, the Danish krone -- I mean, these are legitimate countries whose currencies are traded less and less valuable than Bitcoin.

 

So I think it’s easy to want to dismiss it and say, “There have been speculative currencies that haven’t worn out before. Surely, this is another one.” But I think it’s -- again, we’re lawyers here at The Federalist Society. I think we can use our critical thinking skills and actually look for differences and similarities. One other note is --

 

Alex J. Pollock:  The two minutes is up, Alexandra.

 

Alexandra H. Gaiser:  All right.

 

Alex J. Pollock:  I’m going to call time on you, unfortunately. Just to be clear on the Bitcoin move, the high of Bitcoin was $67,000 per Bitcoin. It’s about more or less 20 now, so that’s the move. That’s, approximately, a 70 percent drop. Bert, two minutes.

 

Bert Ely:  Okay. Just a couple of points. First of all, with regard to the dollar, what gives the dollar value is the ability to, at par, convert dollars into interest-bearing federal treasury that is backed by the tax-collecting powers of the Internal Revenue Service.

 

      And I think the US and some of the other major industrial countries do have solid currencies, and therefore, their value is protected. That’s true in many other countries, such as Argentina. But for the dollar, there is the backing of the Internal Revenue Service.

 

      Second of all, we didn’t really touch on central bank digital currencies. I have very serious problems with that, particularly in terms of what the impact would be on the ability of the banking system to fund itself.

 

      And a final point is—it’s one I made before—the growth of cryptocurrencies has occurred in a low-interest rate environment. How popular will even stablecoins be—much less other cryptocurrencies—if short-term interest rates are at ten percent?

 

Alex J. Pollock:  Thank you, Bert. And time for a quick word from the sponsor. The Federalist Society is having a major conference on “Central Bank Digital Currencies: Their Risks and Their Characteristics” in November at the National Lawyers Convention. We hope you’ll all be there.

 

      Great discussion. Thank you all. Ryan, if you would come back and let us know what questions we’re hearing from the audience, we’ll take them up.

 

Ryan Lacey:  Yeah, absolutely. And thank you all for that erudite conversation. And if our audience has any questions, please put them into the Q&A section.

 

We have two to start off with the first one being from Wayne Abernathy. “I understand that one of the sources -- source of appetite for cryptocurrencies has been the desire to have a means of exchange without control of government. Has it not, however, both by the sharp rises and falls in value, invited government interest—and more—by, perhaps, this technology innovation, encouraging central banks to adopt the technology as a way of absolute control of monetary exchange?”

 

Alex J. Pollock:  Thank you, Wayne. Who wants to take that?

 

Bert Ely:  Well, let me start off by saying that one of the things that has been interesting is the extent to which, despite the supposed anonymity of cryptocurrency transactions—and Bitcoin specifically, in fact, where some serious frauds have arisen—the police, if you will, the investigators, are able to actually track transactions.

 

So the assertions that there is complete anonymity, I think—with regard to cryptocurrency transactions—is very much open to question.

 

Alex J. Pollock:  Other comments?

 

[CROSSTALK]

 

Alexandra H. Gaiser:  Yeah. So I would note that’s -- yeah. So Bert’s right that, on Bitcoin and a lot of other coins, transactions are anonymized. They’re not anonymous. And so this is why, if you’re a criminal, the best way to get paid for your crimes continues to be a duffle bag full of cash. It’s significantly less traceable than cryptocurrencies.

 

As far as the government intervention question goes, I think I would challenge the premise a little bit, saying that, historically, it has not always been the case that currency is controlled by government. That’s been the whole premise of the gold standard.

 

And so, the idea that government has to be the sole issue of currency has not always been the case. And so, I think that can sometimes shed interesting light on the question of government involvement.

 

Alex J. Pollock:  Any other comments?

 

J.W Verret:  Sure, just quickly. And I’ll say I love to hear -- somebody on this call is using a ledger to trade cryptocurrency during the call. I assume it’s not Bert, but I can hear the “ding-ding-ding,” and I love it. I love to hear it. We need to hear more of that.

 

On Bitcoin, I love Bitcoin. I love the promise of Bitcoin. The one area where it has failed the dream of Satoshi Nakamoto’s white paper is on privacy, and that has led to censorship from Canada. That has led to targeting of individuals. It’s even led some Bitcoin owners to be subject to kidnapping and some pretty serious consequences there.

 

But there are L2s on top of the Bitcoin—particularly the Lightning Network that Alexandra mentioned aspires to privacy. It hasn’t gotten there yet, but it aspires to add a component of privacy to transactions. There is also the whirlpool function that links up to Samourai Wallet and Sparrow Wallet—my favorite privacy tools for Bitcoin. And I highly recommend those. Those are great.

 

I don’t recommend Wasabi, but I do recommend Sparrow and Samourai. But that’s limited also. It stops transaction history, but that doesn’t really help. That’s why I think I’m probably a bigger fan of privacy coins—Monero and Zcash. And, Alexandra, I think they are a great solution for privacy-enabled transactions, and you can even use different -- something built on top of those to pay for -- I bought stuff at Baskin-Robbins and at Chipotle with cryptocurrency. I bought Doritos and ice cream with my Zcash and Monero privately.

 

Alex J. Pollock:  Thank you.

 

Steven Lofchie:  I’m going to say, sticking with the theme of why the regulators aren’t really that affected by the economics going up and down, at the end of the day, the government does not like privacy. And that’s not going to change whether the markets are high or low.

 

Alex J. Pollock:  It’s also a threat to actual cash for the same reason. Anyway, Ryan, do we have another question?

 

Ryan Lacey:  Yes. So our next question is for Steve. “Do you think that the CFTC’s support of crypto, generally, will stay the hand of regulators from cracking down on exchanges, such as Kraken, which allows its users to trade crypto futures on margins up to five times leverage?”

 

Steven Lofchie:  Look, I don’t know what stays the hand. I think that part of my talk is really about regulatory power and political power. The CFTC clearly has an interest in the I committee, clearly has an interest in expanding what constitutes a commodity.

 

I think where the CFTC -- I would like to see them be more active is not just in saying, “Hey, we want to have authority. We think we should have authority.” But I think the CFTC needs to deal with the issue of disclosure, meaning if an exchange trades crypto or offers trading in a digital asset, what disclosure does the exchange need to make sure is available to investors on the exchange as to that asset?

 

When you trade oil or wheat, there’s some level of disclosure, and I think that’s a problem that the CFTC needs to deal with or a challenge the CFTC needs to deal with beyond just saying, “Hey, we want to regulate this.”

 

Alex J. Pollock:  Thank you. Any other comments on that? Okay. Ryan, any other questions?

 

Ryan Lacey:  Yes, this one for J.W. or Alexandra. Thoughts on the constitutionality of the addition of crypto trade question on Form 1040?

 

[LAUGHTER]

 

Alexandra H. Gaiser:  So I would say I think this is something where Americans are actually pretty used to purchasing items with -- through means other than the US dollar, so that’s what you do when you spend your credit card points, or you use airline miles. It’s what you use a gift card for. Any number of -- there are a lot of ways to execute a transaction that may or may not use cash. And so, this is something where, I think, purchasing your Chipotle burritos or your Baskin-Robbins ice cream with cryptocurrency right now is kind of bizarrely classified as a capital gains taxable event.

 

I think that that speaks less to constitutional issues and more to practicality. So I would look towards use cases. Certainly, it would be nice for me to not ever be taxed on anything touching crypto. I’m not sure that’s super practical. So instead, I’d say I think you can actually pretty reasonably say if you’re purchasing a good or service, that is meaningfully different than buying and selling as an investment activity.

 

We make that distinction all the time in a number of different areas. It shouldn’t be that hard to do the same for Bitcoin and other cryptos.

 

Alex J. Pollock:  Next, J.W.

 

J.W Verret:  I’ll build on that point to say—and it’s a very important point here—it’s amazing what crypto has accomplished despite the headwinds against it as an asset class. And with respect to its aspiration to become currency, more -- so $11 trillion transferred on the Ethereum network last year compared to $10 trillion on Visa.

 

They beat Visa. They beat Visa last year—the Ethereum network—in terms of transfers of value from international remittances and speculation in art, basically. Bitcoin has 10,000 merchants.

 

Alex J. Pollock:  I’m sorry. Did you say speculation in art?

 

J.W Verret:  In art. In art. In digital art.

 

Alex J. Pollock:  All right.

 

J.W Verret:  And Bitcoin -- Lightning Network has like 10,000 merchants involved. And as Alexandra mentioned, Bitcoin has made it to the top 20 currency, all despite the fact that the US IRS still treats every purchase as a taxable transaction.

 

Imagine what’s going to happen when that’s no longer the case. Imagine the explosion that would happen in the usage of that currency.

 

Steven Lofchie:  What are the [inaudible 58:59] IRS agents going to do?

 

[LAUGHTER]

 

J.W Verret:  They can go work for Coinbase.

 

Steven Lofchie:  Yeah, I don’t know.

 

Alex J. Pollock:  I think that was a great question, by the way, from the audience. That item of the 1040 is very meaningful, I think, in terms of government interest.

 

Anyway, this was an excellent panel. Thanks to all the panelists for really interesting, informed presentations and to the audience for your questions. And, Ryan, we are at our end with thanks to all. And back to you.

 

Ryan Lacey:  Absolutely. And echoing what Alex said, on behalf of The Federalist Society, I would like to thank our panel for the benefit of their valuable time and expertise today. And I would like to thank our audience for joining us and participating, especially with those questions.

 

We welcome listener feedback by email at [email protected]. And as always, keep an eye on our website and your emails for announcements about upcoming webinars and other programming, including the convention coming up in November.

 

Thank you all for joining us today. We are adjourned.

 

 

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