Crypto Regulation: In Code We Trust? with Richard Berner of the Department of Finance, NYU Stern School of Business

Richard: Unfortunately, it does sometimes take a crisis to wake people up to the idea that there is risk out there as well as opportunity.

Dante: Hello. My name is Dante Disparte and I'm Circle's Chief Strategy Officer and Head of Global Policy. And as you could probably tell today I'm a guest host on today's episode of The Money Movement. It is a great honor to be joined in today's episode with Dr. Richard Berner, who's a Clinical Professor of Finance and Professor of Management Practice at NYU Stern and a Co-Director of the Volatility and Risk Institute. A whole host of areas very close to home from me as NYU Stern and particularly the Risk Management Program is my alma mater. So, Dr. Berner, welcome to the Money Movement. Very excited to have you on today's program.

Richard: Thanks Dante. Thanks for the opportunity.

Dante: Well, Dr. Berner, before we get into some new research and a new research briefing that you have written for The Bretton Woods Committee on a very, very hot topic, I think, at the moment, on governance and addressing governance issues in the crypto ecosystem. I can't help but ask how does a venerable professor, renowned economist and really great, thinker about risk and volatility in the financial system, find your way to the crypto industry into digital assets? What was the allure?

Richard: It's a great question, Dante. I think the allure was the notion that technology, which has made enormous progress in the financial services industry as well as in our economy at large, is taking another step in digital assets. And I just felt this is something we need to learn about and see whether or not we can learn about some of the issues in this new technology from what we've done in the past, or whether or not there are significant differences between the way this technology affects our lives and our financial activities and what we have done in the past.

Dante: Well, one question I have, Dr. Berner, is I have been personally party to many of the global policy and regulatory conversations on what to do with digital assets, what to do with cryptocurrencies, and more particularly what to do with stablecoins since at least 2019. And oftentimes regulators speak of this idea of technology neutral risk-based, activity-based regulation. But when it comes to Cryptocurrencies and Blockchain, and particularly the use of Open Blockchains, you often find that this question of technology neutrality starts to wear a little thin. And so I'd be curious, as you think about your research and lessons we can draw from history, is that assertion true in your mind of this lack of technology neutrality among policymakers and regulators when it comes to the space? 

Richard: It is, absolutely. And so I'd modify what you just said, and we've articulated this in our earlier work by saying, yes, we should be technology neutral in terms of principles, but we might be technology specific in terms of the tools that we need to address particular problems. And it's always a case of picking the right tool for the job. The other principle I think is relevant is when we look at the risks in each of these activities, as well as the benefits, we want to say same risks, same regulatory outcome. So if there's a need for regulation, then we ought to look to other areas where we've seen similar risks and think about ways that either those tools that we already have can be used or with some modification, that they can be adapted to the new ecostructure.

Dante: Right. And so herein maybe to jump into a little bit of one, just the policy direction of travel. And your thinking in this brief that you've written for the Bretton Woods Committee on Governance in the Crypto Ecosystem, is that does it take a crisis like we've had in 2022 in this industry with nearly $2 trillion of market value lost a whole host of cascading failures? When I was at the NYU Stern School of Business earlier this year, I delivered a keynote in which I analogized this point in time to a blend of the dot-com bubble bursting and to Dodd-Frank. And so if we've had that moment and we've put down a $2 trillion down payment on the future, what lessons do we draw more immediately from this existing sort of situation and market correction that we're in? And what lessons can policymakers, regulators, and candidly industry draw? And so I'll turn to you to look at some of the governance questions, because I believe where all else fails, governance is the real difference maker. But what sort of specific things stand out to you in these lessons of the recent crisis that we've had in digital assets?

Richard: It's a great and broad question, Dante. First of all, I'd say that unfortunately, it does sometimes take a crisis to wake people up to the idea that there is risk out there as well as opportunity. And so the whole purpose of regulation is to address market failure. And I think we may see examples of that, not just in digital assets, but continuing elsewhere. The recent banking turmoil, I think, is evidence of that. And what we're trying to achieve when we regulate is to protect investors, protect consumers, and make sure that markets are fair and effective so that we can have a financial system that's resilient to shocks and that it really works well. And that means we want to promote financial stability as well. And last, we want to prevent illicit activities and financial crime to the extent that we can. So those are the broad overarching goals. And in that regard, I think that most people agree that it's good to have transparency for market functioning and market effectiveness. It's also very important to have resilient markets and institutions that people can trust. 

And that five letter word is one of the most important in financial services, because when people trust what they're doing, then they're willing to extend credit, they're willing to engage with people, they're willing to engage in transactions and know that the other end of the transaction is something that's going to happen, more or less. There may be changes to it, but those things are all really important. So the whole idea of governance basically is about establishing rules of the game. It's about establishing the ways that we can build trust and that people understand on both sides of transactions, on both sides of activities, that they understand what those rules are. And if the rules are broken, there's going to be some recourse and some enforcement against them. So to get specific, and we should, I think that what you've seen with a big shock in the so called Crypto winter is some erosion of trust, but that doesn't invalidate the whole nature of the technology. What I think is really important is to demonstrate that there are benefits and that the way that people can use them or realize them is going to be trustworthy. And I think that's important. We can talk about some of the details around digital assets that really matter here, but I think that's the framework.

Dante: No, well, the framework makes entire sense. And candidly, as I was reading the report and thinking through the report, I also reflected back on Circle's journey. And one of the very first things we did as a company vis-a-vis this question of governance was stand up, effectively the equivalent of a self regulatory organization. And so the company went as far as we could get with domestic payments and money transmission licensing, which, as you know, is a state-driven activity and requires examinations amongst the states where Circle is licensed. But that put us at the outset on a level playing field to companies like PayPal and Stripe and everyday payments activities, but then realizing that the novelty of Blockchain based financial services, the open nature of it, and the expectations of trust, as you said, in a digital currency, would also warrant additional layers of governance. And so we created a consortium to effectively serve as that, to bridge that gap in a void of regulatory clarity, which is oftentimes one of the biggest complaints in the sector. Do you think that's a governance model that makes sense to sort of look at the self regulatory structure as one governance opportunity that can be better leveraged in the industry?

Richard: I think it is one for sure. Some other people have proposed that. And I think that the real question is, if you're trying to solve a problem to get people to agree on what those rules are. That's kind of a collective action problem, getting everybody into the corral and thinking about how we're going to agree on what those rules look like, then an SROs is certainly one venue in which those things can happen. But it's also important to have a framework for thinking about what those rules look like. So that people can agree on them and that they're pretty clear to people and that they are simple enough so people can understand them, but not so simple that they don't cover contingencies that might arise. And I think that's really the balance that can be achieved in part with an SRO. So I think it may be necessary, but maybe not sufficient to achieve what we're trying to accomplish.

Dante: Well, one of the things kind of going back to history and volatility and risk in some ways the advent of Cryptocurrencies was a response to the smoking crater left behind by the 2008 financial crisis and questions of excess leverage and the daisy chain of market risk and failures. And we all are now experts in hindsight around these types of risks and have effectively found that many of the same risks and same governance failures and same lapses in the digital assets economy might have just been uploaded onto the internet. And so the risks have become more discoverable. And oftentimes when risk starts to unravel in the digital assets market, it happens over days and typically weekends. Terra Luna, the Algorithmic Stable and name only coin for example, failed over the course of the weekend. We saw, of course, the epic failure of FTX, perhaps more to do with fraud and mismanagement and risks of opportunity than a native technology risk. But nonetheless, it was an unraveling that occurred very quickly over the course of a weekend. And then we've learned fast forward into 2023 that the banking system could import risk to the digital assets economy as well, with three successive bank failures back to back to back. And so the question then is have we drawn sufficient lessons from 2008? And what is the again, given the theme of governance in this Bretton Woods Briefing, where is the onus of obligation and accountability and opportunity? Is it regulators and public policymakers? Do you place the onus on industry? Do we need investors to do better vetting and underwriting or is it merely a blend of all of the above?

Richard: It's all of the above and I'm firmly of that belief because first of all, one of the big lessons from 2007, ‘09 in that crisis is that we need to look at the financial system holistically. We need to think about where there are vulnerabilities in the system and how shocks will expose those vulnerabilities. What we learned then, of course, was that there were lots of vulnerabilities. Unfortunately, the reform program really addressed banking system more than the rest of the system, including non-bank financial intermediaries and what I call systemically relevant markets. And we're starting to think about those issues. But I would argue that importantly, when you address one part of the system with a bunch of regulations which may be good and well intentioned and which may work nonetheless, you're going to promote regulatory arbitrage into other parts of the financial system. Technology also enables that migration. So that's important and I think in this case, as you mentioned Dante, there's no question that after the financial crisis, people's trust was eroded both in institutions public and private and in market actors. And so the erosion of that trust leads people to think, where else can I go? And this technology, I think, has been in part the answer to that. 

So one way of expressing the narrative around digital assets is that it is a rejection of the failed systems of the past. So my response to that is to say, okay, but let's look at those systems as they exist today. Let's try to make them more resilient. Let's try to make them better. Let's try to make them more trustworthy. And I think we can take lessons from what we have done in those directions and apply them to digital assets. Because the principle I articulated a moment ago of same risk, same regulatory outcome, I think is really an important one and also the one you mentioned, technology neutral principles, to be sure. But the tools that we might want to use digital assets could be quite different from the tools that we use even where there's technology applications in traditional financial services. So I think those are a couple of the things I could go on, but I'm sure ask more questions.

Dante: Yeah, no, well, each of those makes an enormous amount of sense to me, Dr. Berner. And, I suppose what I'm looking for. And I know there are no magic bullets, but I am deeply encouraged by your research and deeply encouraged by groups like the Bretton Woods committee paying more attention and energy into effectively what I esteemed to be this convergence between traditional finance and this sort of emerging Fintech and Digital Assets Economy. And that where once upon a time, especially with crypto, there was a narrative problem. There were Crypto Anarchists or Crypto Utopians. But in many cases, both parties might have argued that the technology would disintermediate banks and relegate Wall Street to history. But what these recent experiences have taught us over the last many years is that there's actual codependence here. And perhaps this is not about disruption or disintermediation of traditional financial systems, but rather convergence between the two. And so we've tried to do a lot at Circle on exactly promoting that kind of operating model and then, where possible, argue for exponential improvements. Whether it's financial inclusion, financial integrity, and sort of a host of other areas, the technology just isn't magically going away. And so I was going to ask you a question about this somewhat cynical market response that we've seen among regulators and policymakers of really presenting three choices let it burn, contain it, or regulate Crypto like gaming and kind of keep it isolated. Do you see that with some degree of cynicism or do you think it might not age well as a policy reaction to these last few years?

Richard: Well, on the first point, I haven't heard too many policymakers say let it burn. I have a tiny bit of sympathy for that perspective because if you lack the things that we've just been talking about governance, rules of the game and so on, then the whole ecosystem, there's a risk that it would deteriorate into something more like gaming. And it's pretty clear that while this space has been around for more than a decade, it has yet to prove itself in applications in a way that's scalable. And I think that we can say there's not sufficient regulation around it which clearly would be a benefit to it. But I think in addition, as we just talked about, the industry has to step up and demonstrate the benefits. The willingness to engage your efforts to promote an SRO and to have rules of the game that are consistent, that can build trust. Those are the kinds of things which I think some of the technology folks don't realize are much more important than the technology in building trust and in building scale and in building the growth of the industry. 

So to your point, I would say, yeah, there is a codependence, there's going to be a codependence. There has to be a balance between those two things because people see benefits in each area. It's pretty clear that the scale of the traditional financial services industry dwarfs that of the narrower Crypto asset space. But the truth is, as I mentioned earlier, financial services companies are technology companies that provide financial services. Now technology is an enabler for that. But technology can bring great benefits and risks. So take speed, which you mentioned earlier. Speed can provide benefits, it can be reducing of risks. If you narrow the time frame during which the process of transacting and then clearing, settling and paying for that transaction is reduced, then you're going to reduce risk. And that's a potential benefit of some of the technologies that have been developed recently. But the speed also brings some risk with it and people need to figure out how exactly to balance that speed so that we have some speed bumps or some speed limits. After all, the analogy that comes to mind immediately is our highway system. We build a safe and sound platform on which we can travel at higher speeds than city streets. We still have speed limits because if we don't have them, then you're likely to have some people who are going to be excessively speeding and that's going to create problems.

Dante: That's funny, you remind me of an article I wrote some years ago back in 2011. You'll remember the Algorithmic Trading, the high-frequency trading company Knight Capital failed over the course of minutes because it introduced a rogue algorithm that bought positions the business couldn't afford. And so there are always teachable lessons around the role of speed and the role of novel technology in finance. And I think the industry rightly has to learn some lessons around those boundaries. And that despite the fact that the rulemakers have no statute of limitations for when they could exercise those rules or their authorities. Nonetheless, money and the movement of money is rules-based irrespective of its form factor, whether a digital currency or a physical analog dollar. And in knowing the audience of the money movement. Dr. Berner, I'd be curious if you could impart a few lessons to the developers, the builders, the operators and the investors in this space for whom there is this maybe overly simplistic but pretty constant game of cat and mouse and game of regulatory enforcement and regulation through enforcement that's playing out. What sort of takeaways do you think the developers, the actors and the leaders in this space can draw around the critical nature of governance and the things that they can do themselves to establish what I like to classify as personhood. But also I like to classify as that trust quotient that you described, which I think is critical in any sector, but particularly when it comes to money? 

Richard: Sure. So we think there are four things that the industry could do that's not limit. There probably are more, but they think four are salient, and the first of which is develop codes of conduct that are shared and best practices for coders and money services, businesses and exchanges. I think that's important because it builds a culture of risk management, shared rules of the road in a way that regulation will never achieve. That's the other side of the regulatory framework, I think. Second, implement really strong expectations for transparency. As I mentioned earlier, if you have transparency in markets, people understand what's going on, then that reduces what we call the asymmetry in information that distorts incentives. People have the right incentives on both sides of a transaction or an activity. I think that promotes trust and market functioning. And by the way, both of those derive from Traditional Finance. So we're not saying stuff that's new here. We're simply adapting it to the Crypto space. The third thing I think is important is have a real constructive exchange between people in the industry and their regulators. 

Now, there's always a risk of regulatory capture, right? And people are very wary about that. So they want to maintain arm's length between regulators and those they regulate. My view is, having been involved on both sides, is that that dialogue really promotes understanding, it promotes learning. And I think that's particularly important in the Crypto arena because most regulators don't understand the technology and its implications and they need to so they need to learn. Conversely, I've talked to many people in the Crypto space who don't understand regulation and they need to learn about that too. And they need to understand why it matters and what people are trying to do, not necessarily to limit their profitability, but actually to make them more viable and more resilient. And the last piece relates to cross-border issues that are so prevalent. Finance is a global industry. Everybody knows that, we want to make sure that the playing field is level not only within borders but across borders. And so sure, there are different laws and jurisdictions and different cultures across and within many borders. But if people want to transact on a cross-border basis and have efficient markets, then we need to have some principles that apply across the board. So I'm not in the let it burn camp because I think we need to protect consumers and investors. And if you let it burn I think many people will find that they are singed by the fire. But I don't think equally that we should have a light touch set of principles or a light touch regulatory environment that is designed perhaps with good intentions to promote the growth of the industry. I think that's going to end up in tears.

Dante: Yeah, well look, I entirely agree and I think America at least and the piece of me that remains always optimistic that will figure it out societally is it often takes a crisis to sort of galvanize regulatory responses. You needed the 2008 crisis to get banking reforms. You needed the dot-com bubble bursting to get a more durable, credible, value adding internet development and roadmap. I would sort of hope that to your point around internationalization and the global nature not only of finance but certainly of finance at internet scale implied by Digital assets requires real regulatory harmonization. The very first of those pillars was actually financial crime compliance and financial integrity all the way back to 2016 with the Financial Action Task Force. And so today you see a lot of jurisdictions, most prominently Europe, with a very comprehensive framework for Digital assets. But you're seeing this sort of despite Crypto winter, it might become a Crypto ice age unchecked. You're seeing whole jurisdictions competing for the time, talent and treasure of the developers in this industry. I do think this call for harmonization is being answered. The question is what's the most appropriate regime and how do you ensure that industry has a seat at the table as a lot of these jurisdictions are kind of contemplating new rulemaking?

Richard: Well, I think for their part, some of the regulators are trying to promote that. They've opened offices of innovation, at least in the US. The BIS, the Bank for International Settlements has set up an innovation platform with offices around the world. So I think there are venues and opportunities for collaboration and cooperation and what people need to do is sit down at the table and listen to each other so that they can learn. As I said earlier, I think that's the first and most fundamental step to think about where are the benefits? And I think that the industry needs to acknowledge where are the risks, not to advertise their wares as something that is bulletproof from the get go, because I've never seen anything that's bulletproof completely. And so I think that, again, that's why we have speed limits. That's why we have why we have some rules of the game. And people break laws. And the laws you may not like the laws, but if they break the laws, then our justice system is such that we need to enforce those, and we need to have some appropriate penalties to create incentives not to break the laws. And if the laws are flawed or the regulations are flawed and need adaptation, then we should change them. But the point is, the underlying framework has to be something on which people agree. That's what's going to build trust.

Dante: Right? Well, I totally agree with you. And sort of as we wrap up our conversation, you remind me of a couple of my own adages around thinking about risk in this space is that we're often doing with enforcement actions things that can be solved with better disclosure. And as the Crypto companies, I think, look at themselves in the mirror, there are a number of arguments that have been made historically that have not aged well, not least of which is this issue of Token Agnosticism. We, as an exchange, will list any token that any market participant or consumer would want to have, and the choice should be theirs. I think history has not that model has not aged well in history, and it's one of these simple fixes. And here in Washington DC for example, the Algorithmic Stablecoins Terra Luna bought the branding rights for the National Stadium. And for a period of time, even after its collapse, each of the seats in the National Stadium bore the name Terra Luna almost like a monument to the worst kind of Financial Alchemy. And so, Dr. Berner, I guess any last words on the research. We will, of course, in this particular Money Movement episode, link to the report for the Bretton Woods Committee titled Addressing Governance Issues in the Crypto Ecosystem We're all going to be great beneficiaries of not only your research in this space, but of course of the work the Bretton Woods Committee will do to continue having this conversation around responsible innovation, irrespective of the technology stack and irrespective of the actor. So I'll leave it to you. If you have any parting words for the Money Movement audience that you would like to share, then last word is yours. And then I'm going to end with a big thank you.

Richard: Thanks, Dante. I think that's a great way to wrap it up. I think that the most important point that we've discussed today is, how to build trust and how people in both the regulatory and industry spaces need to get together cooperatively to achieve that.

Dante: Well, Dr. Berner, thank you so much. The Physical Dollar would say, “In God We Trust”, in a Digital Currency would say, “in code we trust”. But in your research I deeply trust. And all of us will be great, great beneficiaries of your work and your insights here. And grateful to you for joining us on today's episode of the Money Movement.

Richard: Thanks for having me.