The cryptocurrency market continues to grow across the world as new products make it easier for people to invest, sell, and trade with cryptocurrency. But without changes to the mindset of regulators, many of these products will fail to make it to consumers.
Look no further than Coinbase, which last week stopped plans to offer its new lending product due to threats of legal action by the Securities and Exchange Commission (SEC). The "Lend" program would have allowed users to earn interest on their holdings if they held specific types of cryptocurrency. The SEC rationale for the lawsuit is that the Lend program violated longstanding security regulations, even though it's more akin to a traditional savings account.
This is unfortunate. Not only does it stall financial technology innovation, but it also denies consumers the ability to earn high interest rates at a time of rising inflation. There's a better way to deal with innovative financial products than through threatening lawsuits. They're called regulatory sandboxes, and the SEC should take after forward-thinking states and adopt one.
A sandbox is an alternative regulatory structure to deal with products that come with regulatory uncertainty. Companies that have such products can apply to test their products for a set period of time as long as they still comply with consumer protection standards. If they are accepted into the sandbox, they can offer it to consumers. When the testing period ends, they either comply with existing regulatory standards or they work with regulators to change those standards based on their experience in the sandbox.
The first regulatory sandbox was deployed in the United Kingdom in 2014. It's had 700 participants since 2015 with approximately 80 percent of those companies still in existence, a much higher rate than non-sandboxed firms. Companies in sandboxes were also more likely to raise money, raised more venture capital funding, and made it to market faster.
There are now 70 different sandbox programs in 57 jurisdictions and countries. Arizona was the first state to adopt a sandbox in 2018, and the Consumer Financial Protection Bureau (CFPB) has recently updated its sandbox program at the federal level. The most common type of sandboxes across the world are within financial technology. There are 27 companies in financial technology sandboxes across Arizona, Hawaii, and West Virginia, with the CFPB sandbox granting regulatory relief across 10 different financial products.
One of the most interesting companies to be granted participation in a sandbox is BlockFi. Like the product Coinbase proposed, BlockFi offers interest-bearing cryptocurrency accounts in the Hawaiian sandbox. But BlockFi has also run into trouble with attorneys general in other states for the same product. New Jersey, Vermont, Alabama, Texas, and Kentucky have ordered cease-and-desist or show-cause orders to the company over its interest-bearing product.
It's likely that these attorneys general and financial regulators didn't have a regulatory structure to deal with this new kind of financial product. Rather than allowing permissionless innovation, they opted to shut down the products entirely because of some nonzero risk of consumer harm. As the SEC attempts to grapple with the cryptocurrency industry, it almost certainly made the same calculation.
But this need not be the case. The CFPB and states have shown that sandboxes can deal with new financial products by having regulators and companies work together to spur innovation, all while protecting consumers. The revamped CFPB sandbox has issued eight no-action letters in 2020, giving companies certainty that they can provide their new products. Some products include small-dollar loans that provide cheaper rates than payday lending, allowing earned wages to be made available before they are paid, and autosave programs for employees. These programs all have pro-consumer benefits; they just needed regulatory certainty to get off the ground.
The cryptocurrency industry quickly evolved from a little-known technology 10 years ago to a market worth an estimated $2 trillion, with hundreds of companies across the world providing services to consumers. An estimated 46 million Americans own bitcoin (to say nothing of alternative cryptocurrencies). El Salvador's recent recognition of bitcoin as legal tender and other reforms were controversial, but they show a growing acceptance of cryptocurrency. Whether the SEC wants to admit it or not, changes to our financial system are already here.
What is happening now with Coinbase will certainly happen to more financial technology companies down the road. Threatening to sue every company with a new cryptocurrency product is not only a poor use of taxpayer resources, but it also causes the United States to fall behind on blockchain and cryptocurrency technology.
The SEC should follow the lead of the states and CFPB and adopt a regulatory sandbox for cryptocurrency. In the meantime, states should continue to lead the way and bring some much-needed regulatory federalism to financial technology and other industries.