Is crypto cleaning an action?
Is crypto cleaning an action?

In January of this year, the SEC approved spot trading on exchanges of funds invested in Bitcoin, making the investment in Bitcoin accessible to ordinary investors. These exchange-traded funds (ETFs) raise funds by issuing shares to purchase bitcoins, which are then held in a secure digital vault. The ETF’s share price therefore reflects the dollar price of bitcoins and effectively allows ordinary investors to trade bitcoins without taking on the custodial risks. With this endorsement, the crypto asset sector is clearly on a path headed straight for the financial mainstream.

Of course, serious obstacles remain, not the least of which (at least in the United States) is the lack of federal regulation created specifically for cryptocurrency. And without a clear set of rules to separate the next Sam Bankman-Fried from the honest participants, the crypto market will likely never be seen as fully mature in the eyes of some investors.

However, there is evidence that regulatory deficiencies have been addressed. Several US states already require crypto entities to obtain licenses to do business locally, and the sector is of course tightly controlled by the SEC, Department of Justice and other federal agencies. In addition, the sector itself has taken steps to self-regulate in an attempt to signal to investors that the Wild West days of the “initial coin offering” (ICO) boom are gone forever. For example, some cryptocurrency exchanges have registered as money services firms with the Financial Crimes Enforcement Network (FinCEN), which requires compliance with the US Bank Secrecy Act.

My research shows that these self-regulatory efforts are much more than a PR stunt — they are concrete signals of the maturation of the crypto market and its willingness to embrace regulation, despite the relative lack of action by the federal government to go beyond crypto production controls -specific regulation. In a recent paper on Journal of Financial and Quantitative Analysis, Mahendrarajah Nimalendran, Praveen Pathak, Liangfei Qiu and I looked specifically at market efficiency, which is commonly used to measure the predictability of returns and the ability of the market to self-regulate.

Essentially, market efficiency tracks how well asset prices absorb newly available information and change accordingly to inform investors. In inefficient markets, better-informed traders can earn abnormal returns, while uninformed traders are at a disadvantage due to information asymmetry. By requiring publicly traded companies to disclose financial information on a quarterly basis, the SEC aims to curb such rent-seeking behavior by informed traders in the traditional stock market.

Researchers traditionally measure performance through coefficients of variation (VR)—which reflect the predictability of price movements over time. If the market is efficient (ie, new information is constantly being valued), one should not be able to predict the future price of an asset based on its current price. Statistically, more efficient markets should produce variance ratios closer to 1.

Our research compares the performance of three crypto asset classes with varying degrees of regulatory oversight. Initial Coin Offerings are unbound by any formal legal framework, just as they were in the theft-ridden late 2010s. A newer innovation, initial exchange offers (IEOs) are launched by crypto exchanges rather than independent entrepreneurs, a form of soft regulation that promises to provide an extra layer of due diligence. In addition, many leading exchanges, e.g. Kraken and Coinbase have chosen to obtain Money Service Business licenses from FinCEN, mandating compliance with anti-money laundering regulations, etc.

finally initial decentralized exchange offerings (IDO) use a permissionless blockchain to raise money directly from investors. In this model, cryptocurrency owners pool their assets and issue standard tokens against the pool that can be instantly traded across the blockchain. The trading process is automated, which reduces market friction and speeds up trade settlements. In theory, pooling and reducing friction should promote market efficiency. However, IDOs are unregulated — which led us to investigate whether a radically decentralized but unregulated asset like IDO would be more efficient from a market perspective than one with third-party oversight, ie. IEO.

We analyzed VRs for 174 crypto-assets issued between January 2021 and December 2022, as well as initial public offerings (IPOs) for the same period. Analysis of price movements for these assets between January 2021 and March 2023 showed that FinCEN-compliant cryptocurrencies—i.e. licensed IEOs—are comparable in performance to IPOs in their first year on the market. Comparing IPOs in our sample with ICOs, we found that the former were on average 3.8 percent more efficient. Finally, we find that although IDOs are slightly more efficient than licensed IEOs in the short term (100 days), their advantage fades over time, suggesting that the efficiency gains derived from algorithmically delivered liquidity are short-lived compared to the benefit of additional regulation.

The bottom line is that from an investor’s perspective, not all cryptocurrencies should be lumped together. The fact that there are crypto-asset vehicles that have taken additional steps to comply with third-party regulations signals that the sector is maturing and substantially evolving in a direction designed to inspire investor confidence. This is despite the lack of federal regulations on cryptocurrencies.

Our research suggests that the crypto sector as a whole has indeed moved away from the ICO craze of 2017-18. In addition to our core sample, we performed a longer-term historical analysis comparing the average VR for IPOs and ICOs that were issued between 2016 –2018, with those of 2020–21. The difference in performance between regulated stocks and unregulated tokens was a third smaller in the later sample.

There are a number of factors that lead to this. As investors become more informed about crypto, they are better able to identify and avoid low-quality projects. The introduction of more professional products like IEO demonstrates the need for the entire industry to up its game. High-profile SEC enforcement actions against Coinbase and Ripple have scared off many would-be fraudsters.

In short, our research paints a picture of a crypto market whose players are diligently preparing for more mainstream adoption, albeit at different speeds and stages of development. While political gridlock may prevent lawmakers from crafting custom crypto regulations anytime soon, encouraging crypto projects’ self-initiated compliance with comparable frameworks to those implemented by FinCEN may serve as a workable solution.

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