Crypto Regulation is Coming. Some Historical Context.

What has been going down in Washington these past few weeks may seem strange to many of us in crypto.

Between aggressive speeches and tweets by SEC chair Gary Gensler, new SEC settlements and the requirement from miners and protocols to report taxable transactions in the latest infrastructure bill, crypto is under attack.

What exactly do regulators and legislators want? And how will they get it? There are no easy answers. Regulation and enforcement actions have many origins and a variety of outcomes are possible. How exactly policy is made is even less well understood.

We at Hartmann Capital thought it might be useful, therefore, to provide a few examples of how and why regulation occurs, and what crypto, if anything, has to be afraid of. 

Three examples of the regulation of market innovations – (1) US wheat futures in the 20th century, (2) private machine-made token coins in Britain in the 18th century and (3) cooperative microfinance in 19th century Ireland – reveal three very different results from government involvement in what began as extremely successful and purely private enterprises.

The first deals with the first regulation of futures markets, the second with the co-opting by government of a privately-created means of exchange, and the third with how lobbyists and therefore a government dealt with a threat to the TradFi banking oligopoly of the time. Parallels may be seen in DeFi, cryptocurrencies (as payment) and lending/borrowing protocols.

In all three cases, the markets got so popular that they could not be ignored, and regulation followed. That is where crypto finds itself now. But regulation does not have to be devastating or even a net negative for an industry, as can be seen in the first case, below.

The Commodities Futures Trading Commission (CFTC) and the Chicago Board of Trade

In 1921, the Chicago Board of Trade (CBOT) was already a hugely successful private organization, facilitating the trading of mainly wheat and corn, acting as the price discovery for the global trade of grains. It was under the gun right from the start; from state legislators and courts who saw the grain futures markets as pure gambling, and from competitor exchanges, legitimate and not. 

The Chicago Board of Trade in 1903. Source: Wikipedia via Creative Commons.

Congress legislated new regulations for the exchanges in 1922, publicly announcing that speculation and manipulation in wheat markets would finally be under control. The co-sponsor of the law, Senator Capper, said this:

The grain gamblers have made the exchange building in Chicago the world's greatest gambling house. Monte Carlo or the Casino at Habana are not to be compared with it.

Does this sound familiar? Compare this to Representative Tim Budd last week:

Some in the House that sit not too far from me on the House Financial Services Committee that would call blockchain basically a financial 9/11.

But, behind the scenes, the futures industry knew what the public did not: The CBOT had effectively written the legislation, which eliminated competition and legitimized the markets in the eyes of the law. The Secretary of the Board wrote:

[Capper’s ‘gambling’] tirade … in no respect had reference to legislation enacted by the adoption of his bill.  The plain and simple facts are … the bill is drafted substantially as we wished.

This case of the markets dictating the rules is not well known. Indeed it’s difficult to know exactly what influenced any regulation. Luckily, the CBOT released many of its internal papers, allowing researchers to be “in the room where it happened”, where the “sausage gets made”.

Source: Chicago Board of Trade Archives at the Daley Library, University of Illinois at Chicago.

Thus another case of what regulation students refer to as facilitative regulation was born, and the CBOT enjoyed a half century of near monopoly. Speculation was not curbed, it was institutionalized. 

The economic theory of regulation, associated with the University of Chicago, predicts that lobbying and voting power determines who benefits from regulation.

…regulation is acquired by the industry and is designed and operated primarily for its benefit. - Stigler, 1971

While the CBOT had strong lobbyists with inside knowledge on Capitol Hill, it also had the inside track to the regulators on the ground at the precursor to the CFTC, the Grain Futures Administration (GFA). Though the regulations were “captured” by the special interests at the grain exchange, however, the GFA (which became the CEA and then the CFTC) worked with the exchanges over the next 15 years to improve the functioning of the markets and monitor and discourage manipulation and fraud as well as reducing credit risks to all users. The clearing house model to reduce counterparty risk, the segregation of client and firm funds, disciplinary committees, mandatory margining and many other innovations that still exist in the present day all date from this period.

Crypto exchanges were born in much the same way as 19th century futures markets: Fragmented, unregulated, speculative and often considered gambling. Yet by the 20th century the regulators and industry had worked together to build (mostly) trusted liquid markets for many kinds of risk. Can the crypto lobby be as effective as the CBOT was in the 1920s and 1930s? 

The First Fintech, 1780s Britain

We now go back in time, and to another continent. Ever since the Romans left Britain and up until the 19th century, the countryside suffered from a dearth of (legal) small change.

An economy based on local credit and personal trust could not provide a monetary basis for the nascent industrial revolution, where small anonymous payments were required by employers and workers, alike.

What may be the world’s first fintech, the steam press invented by James Watt and popularized by Matthew Boulton in the late 18th century provided mass-produced small token coins to be used to provide a means of exchange for the new industrial working class, successfully mitigating a potential disaster for millions of wage-earning Brits and their employers. Employers could pay “cash” that was accepted by town merchants. 

Matthew Boulton and the original steam press. Source: Wikipedia via Creative Commons.

With the steam press ensuring scalability and uniqueness, the Parys Mine Company of Anglesey Wales and several large competitors were able to supply all the tokens needed for the industrialized economy to function. Millions of coins such as the one shown below were minted: One issuer minted three hundred tons, at 600+ coins per minute.

Source: LinkedIn.

As the private sector’s efforts gained in popularity, the solution and the underyling technology were both eventually monopolized and adopted by the state and survived into the 21st century as the British copper penny. The state-backed coin was in fact an improvement over the private token, the latter of which was always subject to legal uncertainty: it was not always accepted across Britain.

As in the case of the CBOT regs, the government had a laissez-faire attitude to the private tokens until they became too big to ignore. In this regard, Britain was fortunate. In other countries, private currencies were often swiftly banned when they penetrated beyond a very small niche.

The larger cryptocurrencies share many similarities to the 18th century tokens.

Source: LinkedIn.

Boulton recognized a perhaps not-so-obvious use case of the steam engine: to transform payments. He stated:

I sell here Sir, what all the world desires to have, power.

The British government allowed the private sector to wield that power in private currency, until it didn’t. The government simply took over the technology and created its own copper penny. Interestingly, it’s a threat that could come to pass in the present. Will CBDC force out stablecoins?

A Bank Lobby Crushes the Home-Grown Competition

Known more for his biting satire than his financial entrepreneurship or impact investing, Gulliver’s Travels (1726) author Jonathan Swift should be more celebrated for its efforts to introduce an entirely new financing tool to individuals and small businesses in 18th century Ireland.

Source: Wikipedia via Creative Commons.

In the present day, cooperative banks and microfinance are common, especially in the developing world. At the time, however, banks did not serve entrepreneurs, as mass migration and the Irish legal system meant that keeping track of borrowers and enforcing loan contracts were both nigh impossible. Swift funded his own non-profit economic development project, making interest-free loans to “poor industrious tradesmen”, based on their social capital: two neighbors had to guarantee every loan.

One hundred years later, there were 300 microlending funds, making 500,000 loans per year and serving 20% of the population. As none of the microlending clients were commercial banking clients, microlending had stayed under the radar of the powerful bank lobby.  Until the middle of the century. First, legislation forced microlenders to focus only on the smallest borrowers and by the turn of the (19th) century, even more legislation had all but wiped out the entire microlending industry. The working poor and entrepreneurs had nowhere left to go for funds.

Like the private token distributors, microlenders in Ireland were using private ingenuity to fill unmet needs. Private currencies existed because the government had ignored the needs of the workers and their employers. Microlending existed because banks didn’t see the working poor as a profitable clientele. 

While government intervention in the case of private currencies may have been beneficial if tardy, the crushing of the Irish microlending industry only benefited the bank oligopolists, at the expense of the citizenry.

Whether in payments, lending or markets, crypto has the potential to disrupt the banks. The banks are coming for us. 

Crypto Industry, Assemble

There is a lot more complexity to how regulations and policy get made than can be covered here, but these three representative historical examples may provide some clues as to the future of crypto reg.

Could DeFi co-opt regulators and regulations the way that investment dealers (1933 Act), investment funds (1940 Act) and the futures exchanges did in the interwar US? Will governments appropriate stablecoins and/or introduce their own CBDCs that make current decentralized pegged assets illegal and irrelevant, as they were able to do with private token coinage in the early 19th century in Britain? Will the bank lobby crush crypto lenders as they did with microfinance in 18th century Ireland? 

It may come down to who has the power to influence Congress and who can present a united front. The CBOT was a monopoly at the time. Dealers and funds in the 1930s were coordinated oligopolies. Also it might be worth considering a carrot over a stick approach. Being an insider works better than influencing Washington from the outside.

As crypto legal mind Jake Chervinski tweeted on Saturday:

Crypto. Has. Arrived.

Government attention, however, is generally not a good thing. In any event, the US government has awoken. The crypto industry must unify and respond in kind. 

Further Reading

We know it’s a shameless plug, but more on the CBOT can be found in Saleuddin (2018) The Government of Markets.

For more on the tokens of the 19th century, see George Selgin’s (2008) excellent Good money: Birmingham button makers, the Royal Mint, and the beginnings of modern coinage, 1775–1821. There is a short essay linking copper tokens to cryptocurrency here.

For context on the last two examples, see Chambers, Saleuddin and McMahon “The Regulation of Technological Finance in Historical Context” in Rau, Wardrop and Zingales (2021 (forthcoming)) Handbook of Technological Finance. 

Jonathan Swift’s legacy is covered in Hollis and Sweetman (1998) “Microcredit in prefamine Ireland”. EEH.