Regulation
How cryptocurrency investors behave and why the industry needs regulation
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Instability has plagued cryptocurrency markets since the collapse of Terra Luna and FTX exchanges in 2022. Concern has only grown this year amid wild price swingsTHE belief of FTX founder Sam Bankman-Fried and the imminent sentence by Binance co-founder Changpeng Zhao.
Gary Gensler, chairman of the US Securities and Exchange Commission, believes events are unfolding in the industry require stricter regulations. MIT Sloan finance professor Antoinette Schoar, who studies the industry, agrees in principle.
“Regulatory uncertainty is always the worst thing, especially for well-intentioned and respectable players,” Schoar said. “They don’t want to enter an area where the regulatory situation is unclear because they have more to lose, but this in turn means higher barriers to entry.”
Insights from two new MIT Sloan research papers, co-authored by Schoar, compare lessons learned from Terra Luna’s 2022 collapse, show how retail traders trade cryptocurrencies, and demonstrate why the industry needs clarity on regulation.
How cryptocurrency investors behave
In “Are cryptocurrencies different? Evidence from retail,” Schoar and co-authors Shimon Kogan, Igor Makarov and Marina Niessner wanted to better understand how retail investors – “who dominate cryptocurrency trading” – approach the market.
“For a long time, people inside and outside of cryptocurrencies have basically said, ‘Oh, all these traders are just driven by hype and don’t understand anything,’” Schoar said. “There was a lot of judgment about cryptocurrency traders without having a lot of data on how they actually trade.”
To fill this gap, researchers examined patterns in retail investors’ trading data across cryptocurrencies, stocks, commodities and other assets on the discount brokerage platform. eToro. They found the following:
- Retail investors who trade cryptocurrencies hold onto their investments even in the face of large price swings, even if they are larger contrarian on shares or raw materials (in the sense that sell when the price has risen in the past and buy when the price has fallen). This model applies to all types of cryptocurrency traders, whether they are young males (the typical cryptocurrency trader), middle-aged women, or anyone else, Schoar said.
- The research also suggests that while there is a lot of hype about cryptocurrencies, there is also a method to explain this madness. If investors think that a higher price bodes well for the future of cryptocurrencies, making it more likely that other investors, or even regulators, will look more favorably on cryptocurrencies in the future, it helps to continue to push the price higher . As a result, investors do not find it irrational to bet on momentum or hold their cryptocurrency portfolio when the price rises.
These insights provide valuable information not only for market participants but also for regulators thinking about consumer financial protection.
Lessons from a cryptocurrency crash
In “Anatomy of a Race: The Terra Luna Crash,” Schoar and co-authors Jiageng Liu and Igor Makarov delve into the May 2022 collapse of Terra, which at the time was the third largest cryptocurrency ecosystem (after Bitcoin and Ethereum).
At the heart of the collapse was the rush for the blockchain-based lending and borrowing protocol (Anchor) that promised high returns to investors in its TerraUSD stablecoin (ticker UST). While the cryptocurrency market has evolved over the next 18 months, the lessons are even more applicable today, Schoar said.
Using data from the Terra blockchain and trading data from exchanges, the authors determined the following:
- The UST Terra rush was a complex phenomenon that occurred across multiple chains and assets.
- The transparency of blockchain technology has allowed investors to monitor the actions of others and amplified the speed of the ride.
- Richer, more sophisticated investors were the first to exit and suffered much smaller losses, while poorer, less sophisticated investors fled later and experienced larger losses.
A collapse of cryptocurrencies has implications for the rest of the industry and even other sectors of the economy. Looking specifically at Terra’s collapse, Schoar said it dramatically affected the cryptocurrency sector, depressing the price of Bitcoin and Ethereum, and also led to the demise of large institutions like Celsius, Voyager, and ultimately FTX.
The collapse had ripple effects and “showed how quickly it can have repercussions on the rest of the economy,” he said. For example, banks like Silver Lake that traded in cryptocurrencies they were immediately impressed. “This shows that in reality a collapse in cryptocurrencies can easily affect the rest of the economy,” Schoar said.
The 24/7 nature of cryptocurrencies amplifies existing risks
Terra Luna collapsed in three days in May 2022, wiping out a $50 billion valuation. Schoar’s research has shown that smaller, less informed retail investors have held onto their cryptocurrency investments, even in the midst of large price swings.
Consumer financial protection is indeed very important in a world where there are many uninformed retail investors.
Antoinette Schoar
Professor, MIT Sloan
“A lot of people — the little guys — had this willingness to resist, and I think unfortunately that shows that among the small investors, there were a lot of them who just didn’t understand how that system worked,” Schoar said. “Somehow they thought, ‘Oh, it’s like a stock is going down.’ Let me continue to resist because it will come back out when everyone is no longer afraid.’ But, obviously, not when there is a race.”
The 24/7 nature of blockchain has only made things worse. In a more traditional environment, trading stops and banks close their doors at the end of the business day, even if they are digital, whereas blockchain never closes. And with a traditional bank, the FDIC will protect small traders who have deposit insurance, so they often don’t experience such a rapid run. But none of these guarantees exist in cryptocurrencies.
“Everything is online and open 24/7,” Schoar said. “We don’t see any physical barriers in the cryptocurrency industry, but the fact that many small traders simply lack the human capital or means to trade, even when they could have traded, shows that consumer financial protection is very important indeed in a world where there are many uninformed retail investors.
Crypto platform transparency has its limits
Schoar said that just because transaction data is available on the blockchain, that doesn’t make it 100% transparent and doesn’t level the playing field for all investors.
For example, the authors’ main data source in their Terra Luna paper was Terra’s blockchain, which was substantially more complex than Bitcoin’s, which only records bitcoin transfers from one account to another.
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The structure of Terra’s blockchain, however, does not involve the simple transfer of tokens but incorporates the inputs and outputs of smart contracts, which is even more complicated because each smart contract has its own data structure, the authors said.
“It takes a lot of effort to process this data and it’s not easy to do,” said Schoar, who worked for six months to process the data for his research on Terra. “A normal retailer might not have the time or knowledge to do this, so this is clearly a barrier.”
Employees working at Terraform Labs, the company that founded Terra Luna, have also made many missteps. Even though they “probably processed and monitored the information in real time, probably even better than us, you can see the mistakes they made,” Schoar said. For example, “because they allowed so many USTs to be issued, they actually made the system much more fragile and prone to failure.”
“Maybe they didn’t do it on purpose, because it’s not in their interest to destroy their reputation with these bad decisions,” Schoar said. “But once there was so much publicity and the value increased dramatically, they were unable to manage the risks and fully understand the dynamics of the system. Even for relatively sophisticated players, there is still a lot of complexity to digest.”
The industry needs a regulatory framework, not regulation through lawsuits
Schoar said it makes sense for lawmakers to “regulate proactively” rather than sue companies that did something wrong after the fact. For one thing, lawsuits can take an incredibly long time to resolve. Schoar said organizations like it Coinbase AND Binance who have a lot of money have an incentive to drag out a lawsuit. And the fines are often small compared to the profits made by evading regulations.
“The Securities and Exchange Commission and the Treasury Department are pursuing enforcement action suing Voyager, Coinbase, Binance and other organizations, and that I think is actually a little bit suboptimal,” Schoar said. “It would be much better for Congress establish laws and provide a regulatory framework, because regulation through legal action is rather ad hoc.
Let’s take the case of Binance. The company’s CEO and founder recently pleaded guilty to violating U.S. anti-money laundering requirements in a Seattle court. While the fine of over $4 billion may seem large at first glance, it pales in comparison to the profits that Binance was able to accumulate. “This shows that we really need a regulatory framework, not just regulation through lawsuits,” Schoar said.
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