It is my great pleasure to join the Yale Journal on Regulation’s Notice & Comment as a contributor. I am currently a First Lieutenant with the Republic of Korea Air Force, working at the Office of the Judge Advocate General as an international law officer. Before joining the Korean Air Force last year, I was a corporate associate at Wachtell, Lipton, Rosen & Katz in New York. My posts will mostly focus on financial regulation, with occasional detours (given my current role) to military law and government procurement, and comments on my posts are always welcome. I want to highlight that my posts do not necessarily represent the views of any government agency (including the armed forces) of the Republic of Korea or any of my former employers and that none of my posts will contain any government or military information that is not otherwise public.

My first post concerns a hot topic of the financial world: cryptocurrency regulation. Broadly speaking, cryptocurrencies refer to any currency that uses cryptography for generation of new units and verification of transfer. However, in common parlance, cryptocurrencies have become synonymous with blockchain-based currencies. The difficulty with digital currencies that lack a physical form is that their ownership and authenticity cannot be verified easily (unlike putting a 100 dollar bill under UV light). To solve this problem, with blockchain technology, every time a transaction is made, it is broadcast to a peer-to-peer network. The transactions are verified by “miners,” who add the transaction blocks to the distributed ledger and in return are rewarded with units of the cryptocurrency for their efforts. Although Bitcoin was the first blockchain-based cryptocurrency and remains the most prominent one, a number of other cryptocurrencies have risen in popularity, such as Ethereum (Federal Reserve Bank of Chicago has a good primer on Bitcoin).

With surging demand from East Asia, particularly South Korea and Japan, cryptocurrency prices have skyrocketed, with prices of Bitcoin surging by more than tenfold in 2017 alone. At the same time, the extreme price volatility in the cryptocurrency market has led to fears of a sudden crash, especially among naysayers, and, in some countries, push for tough regulation. In September of last year, China ordered all cryptocurrency exchanges in Beijing and Shanghai to close. More recently, China has indicated that it will cut off electricity to cryptocurrency miners and potentially ban cryptocurrency trading entirely. South Korea has joined in enacting regulations for the cryptocurrency market as well, with temporary halts in creation of new accounts and bans on exchange accounts by minors and foreigners. South Korea’s Justice and Finance Ministers have indicated that closing cryptocurrency exchanges is an option as well.

The calls for regulation of cryptocurrencies has created a dilemma for policymakers. On one hand, from the perspective of opponents of such regulation, it is up to the market, not the government, to decide whether the price of a certain asset is justified. To designate a particular asset as not worthy of investment by the public, although not without precedent, would be infringing upon the market’s role. Moreover, given that cryptocurrencies rely on blockchain technology for which many see widespread applications, regulation of cryptocurrencies may hamper development of this new technology. On the other hand, the proponents of such regulation argue that the current pattern of investments in cryptocurrencies represents a speculative mania and that the market is vulnerable to price manipulation. Once the prices of cryptocurrencies plummet, they argue, the effects, both to the individual investors and to the financial system, can be devastating, so the mania should be stopped. The proponents of regulation of cryptocurrencies also assert that cryptocurrencies have been used as a tool of hackers and criminals, as seen in the fact that the hackers behind the WannaCry ransomware attack demanded payment in Bitcoin. This tension among development of new technology, freedom of investors to choose, protection of investors, and systemic risk makes no solution entirely satisfactory. Furthermore, this tension represents a common pattern found in many other asset classes—one close example is the dot-com stock bubble—so this debate over regulation of cryptocurrencies has implications not just for the immediate cryptocurrency market but for future new assets that draw investors’ attention as well.

In light of this dilemma, I argue that limiting levered investments in cryptocurrencies, rather than regulating the cryptocurrency market itself, can best resolve this tension. There is already some circumstantial evidence that many retail investors are borrowing money to invest in cryptocurrencies; South Korea’s consumer debt rose abnormally fast in 2017, coinciding with the cryptocurrency boom. While this solution may not entirely shield investors if the price of cryptocurrencies plummets, it strikes the balance between investors’ freedom to choose and their protection. On one hand, from the freedom of investment perspective, limiting levered investment in cryptocurrencies does not curtail or limit investment in cryptocurrencies, as long as the investor is using his/her own money. The regulation does not touch on whether any cryptocurrencies are suitable investments or whether the prices are justified but merely on how such investments are funded.

From the investor protection perspective, limiting leverage sets a floor on losses that an investor can suffer. Also, if the price of cryptocurrencies plummet, a levered investor may be forced to file for bankruptcy or otherwise default on his/her loans, with long-term negative consequences, such as limited employability.

Targeting the debt, rather than the asset itself, has the added advantage that it can minimize the balloon effect that can arise from national regulation. With national regulation, particularly in the financial sphere, there is always the risk that the activity regulated may move overseas, to a less regulated jurisdiction. In fact, the pattern emerges in the cryptocurrency market as well. Once China banned cryptocurrency exchanges, many of those exchanges moved abroad, for example to Singapore, and some have even made efforts to attract Chinese investors through an intermediary. While it is certainly possible that debt may move abroad as well, at the individual, retail investor level, securing credit from a foreign financial institution would be harder than merely trading on a foreign cryptocurrency exchange. There are difficulties with verifying identity and income, as well as compliance with local regulations, that make extension of credit to a foreign retail investor less likely. Furthermore, if an exchange were to move from Country A that regulates cryptocurrencies to Country B that does not, and investors from Country A flock to Country B, Country B has no incentive to enact tough regulations, as it can get all the benefits of cryptocurrency trading (fee income, etc.) without the risks (as Country A will shoulder the risks of a market crash). However, if Country A’s investors are restricted from obtaining credit in their own country and instead reach out to Country B’s financial institution for debt, Country B also has incentive to create its own regulatory mechanism, as Country B’s financial system is now at risk as well.

Looking beyond the investor, as we saw in 2008, the end of an investment mania fueled by debt can lead to negative ripple effects across the financial system, such as increase in bad assets on the books of financial institutions. Indeed, there are studies, such as this one, that indicate that debt-fueled asset bubbles are more dangerous than asset bubbles not fueled by credit.

Such regulation is not without precedent. The Federal Reserve Regulation T sets the margin requirements for stock purchases, thereby setting the upper limit (currently 50%) on the amount of stock that can be funded with margin loans. In a different setting, for example in South Korea, limits on the loan-to-value (LTV) ratio have been used as a tool to curb real estate price increases.

Indeed, the implementation of this proposal is not without obstacles. For one, money is interchangeable. While the easiest cases to curb are those in which there is a direct link between the investment and the debt—such as loan secured by the investment asset—in many cases, there is tenuous link between the investment and the debt. One can take out credit card debt or a personal loan, without revealing the purpose of the fund or with a falsified purpose, and direct the funds toward cryptocurrency investments. Nonetheless, these obstacles are not fatal and do not negate the merits of the proposal. One possible solution is imposing obligation on the part of the lenders to conduct due diligence to ensure that the funds are not used for cryptocurrency investments. Alternatively, the regulators can mandate that cryptocurrency assets may not be used as collateral (thus cutting off secured loans) and may not be considered in determining ability-to-repay for unsecured loans.

The most direct way to solve a problem is not necessarily the most effective or precise way. Although this proposal does not call for direct regulation of the cryptocurrency market, by targeting the fuel that keeps the investment frenzy going, this proposal can instead target the specific risks and dangers of the cryptocurrency investment market with greater precision.