As cryptocurrency has seen some of its major players topple, policy makers have set their sights on regulation. So what are some of the possible scenarios for crypto policy? U.S. Public Policy Researcher Ariana Salvatore and Head of Cryptocurrency Research Sheena Shah discuss.

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Ariana Salvatore: Welcome to Thoughts on the Market. I'm Ariana Salvatore from Morgan Stanley's U.S. Public Policy Research Team.

Sheena Shah: And I'm Sheena Shah, Head of the Cryptocurrency Research Team.

Ariana Salvatore: And on this special episode of the podcast, we'll focus on the issue of cryptocurrency regulation. It's Wednesday, March 15 at 10 a.m. in New York.

Sheena Shah: And 2 p.m. in London.

Ariana Salvatore: The recent news about the U.S. banking system has brought even more focus on the cryptocurrency markets. Our listeners may have heard about a series of insolvencies and collapses of major crypto players last year, with the most notable being the FTX exchange. These events have raised concerns among policymakers and are signaling a need to regulate cryptocurrencies as a means of protecting investors. Sheena, before we dig into any potential regulatory path for crypto from here, I think it's important to try to get a grip on a question that might seem basic, but in fact is one that policymakers have actually been grappling with for quite some time. And that is, what is a cryptocurrency from a regulatory perspective. Is it a security or is it a commodity? How should it be classified from a regulatory perspective?

Sheena Shah: So cryptos could be classified as many things: securities, commodities, currencies, or even something else. But the U.S. regulators are making their view very clear. The SEC is saying every crypto apart from Bitcoin is a security. The definition will determine what products can be offered, which companies can offer them, which regulator will be in charge and maybe even how transactions are taxed. There is agreement that Bitcoin should be classified as a commodity, partly due to its decentralized nature, and no regulator is classifying Bitcoin as a currency as this would admit that it's a direct competitor with the U.S. dollar.

Ariana Salvatore: Got it. So taking a step back for a second, cryptocurrencies up until this point have been largely unregulated and volatility is obviously nothing new in the space. What has been happening in crypto markets lately that's just now suggesting a need for regulation?

Sheena Shah: Well, last year crypto prices were in a bear market and the collapse of the FTX exchange just increased the politician interest in this area. Trading data tell us that the average U.S. retail investor purchased crypto when Bitcoin was trading above $40,000, around double the current price. So regulators want to make sure that retail investors understand the risks and to limit the volatility spillover from crypto to the traditional financial system. Now that we know why there's a need for regulation, what do you think the core principles would be behind a potential regulatory framework?

Ariana Salvatore: So when we think about the way that Congress approaches the crypto space, there are really two key principles. The first is restrictiveness, or how much lawmakers want to rein in the space. And this we kind of see as a spectrum, so ranging from status quo or continuation of regulation by enforcement, to a scenario that we're calling comprehensive crypto crackdown. And that would be probably the most severe outcome from our perspective. The second principle is pretty binary. So whether or not Congress is able to delegate authority or control over the crypto space to one agency or another. One thing I'll just mention back on that Restrictiveness idea, it's not necessarily a question of just how much Congress wants to reign in the space, it's arguably even more so a function of what's possible in the legislative sense. Remember, the Republican Party controls the House of Representatives, so there are some structural constraints here that might make any regulatory efforts a little bit lighter touch than what you could expect in a unified government scenario or single party control.

Sheena Shah: So there are lots of opinions on crypto regulation. What do you think is a viable eventual scenario for some regulatory framework?

Ariana Salvatore: When we think about what's possible, like you said, there's a range of outcomes, but our base case is what we're calling scoping in Stablecoins. So in this scenario, Congress does in fact deliver a clear delegation of authority to either the FDIC or the CFTC, effectively answering that question of mapping out control. And it also puts into place some baseline consumer focused protections. So, for example, requiring Stablecoin issuers to be FDIC insured and imposing federal risk management standards, primarily things like reserve requirements. Now, why do we think they're going to target Stablecoins first? Besides the fact that that's pretty much all lawmakers can agree on for right now, we think there are two pressing reasons. First, most stablecoins are U.S. dollar based, and the services that some crypto companies have been offering are quite similar to what banks offer, which provides pretty direct competition with the U.S. banking system. And secondly, a large portion of crypto trading is also done via stablecoins, which means that regulating this area first could have a significant impact on the broader market without having to necessarily stretch those regulations further. So Sheena, turning it back to you, how do we think other governments around the world are looking at crypto regulation? Are they focused as the U.S. is, or are we kind of leading the way in this area?

Sheena Shah: Most countries are looking at crypto regulation right now, and many are applying the similar rules, such as requiring exchanges to register with the regulators. I would say that the European Union is further ahead than the U.S. in terms of a crypto specific framework, with their MiCA regulation due to be put into law soon. In the U.S., they've gone down a route of enforcing current financial rules on crypto products. At first glance, the actions are thought to be pushing crypto innovations to other parts of the world. We think it's a bit too early to tell whether that will occur in the long run.

Ariana Salvatore: Now, one specific area I'd like to touch on also, because it's become a global debate, is Central Banks Digital Currencies or CBDCs. Given the role of the U.S. dollar in the global economy, do you think the U.S. needs a CBDC? And if it does, what form do you think it could take?

Sheena Shah: The U.S. only started investigating a CBDC because everyone else was doing it too. Most notably China and the Eurozone. The U.S. doesn't actually necessarily need a CBDC for domestic payments as instantaneous bank settlements are going to be possible through FedNow being introduced later this year. We don't know what form a CBDC could take as that's still being researched, but some forms could have dramatic implications for the banking sector should banks not be required to create the currency. This year we're paying more attention to the developments of the digital euro as that may be available within 2 to 3 years. Now, Ariana, if we bear in mind everything we've discussed so far, realistically how much do you expect to be accomplished in terms of crypto regulation by the next election?

Ariana Salvatore: So in the note, we rank our scenarios in terms of likelihood. And as I mentioned before, scoping and stablecoins is our base case. So we do think that something gets done in this area ahead of the 2024 election, although obviously it's a very complex space and there's quite a ramp time associated with lawmakers learning about crypto and all the different nuances and working out those details. I think this question also brings up a really interesting point, though, in particular on timing and how that could relate to potential market impact. So back to your Civics 101 class, when Congress passes a law it technically goes into effect immediately, but the rules themselves can take some time to come to fruition. If the legislation directs federal agencies to come up with regulatory parameters within a certain time frame, that time frame can vary. It can be years, but sometimes it can be months following the legislation. So that is to say that although right now we're seeing significant legislative discussion underway, it's possible that markets have some time to digest the impact as these rules are introduced and developed and fine tuned to then eventually come into effect. We think that delay could create a ramp period for companies to make adjustments to become compliant with some of the new rules which we think could, overall in the longer term, soften the blow of regulation and mitigate the shock to markets. So, Sheena, last question for you. Given all of this, what key events or catalysts should investors be paying particular attention to in the coming months?

Sheena Shah: Broad investor focus is clearly on the traditional banking sector. For crypto, we watch to see if there are any further announcements related to these recent coordinated actions from regulators aiming to define crypto products and any that could reduce the on-ramps between the fiat world and the crypto world.

Ariana Salvatore: Got it, that makes sense. So this is a continuously evolving space with a lot of potential new developments along the way, and we'll be sure to keep an eye on it as it evolves. Sheena, thanks so much for taking the time to talk.

Sheena Shah: Great speaking with you, Ariana.

Ariana Salvatore: And thanks for listening. If you enjoy Thoughts on the Market, please leave us a review on Apple Podcasts and share the podcast with a friend or colleague today.

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