(Fortune) - Following the recent collapse of FTX, it’s time to repurpose an old Reagan-era phrase: “Trust, but verify.” First used in the context of Cold War nuclear arms diplomacy, the phrase now applies to today’s cryptocurrency markets, which have exposed small investors to disproportionately high risk.
The federal government is at a crossroads, facing two possibilities: They can either continue on the current path and keep the door open to more instability or regulate crypto, potentially lending legitimacy to a novel financial product–but also putting it through a stress test that will require it to demonstrate that its much-touted merits can stand up to scrutiny.
I’ve spent decades studying the sociology of trust as it relates to credit, regulatory arbitrage, and financial markets–and I would argue that regulation is most likely to serve as a stabilizing force, while protecting small investors from the extreme losses that many suffered after FTX’s downfall. If crypto is here to stay, it’s time for regulators to step off the sidelines.
A perfect storm has been brewing over the past few years in crypto markets. Retail investors rushed in, perhaps motivated by the fear of missing out or inspired by the prospect of spectacular gains. Promoters eased their way by creating user-friendly apps so that people could trade from their home computers and smartphones. Investing began to seem like a game.
Many of these new entrants into the market didn’t fully understand what they were getting into and the risks they were running. They may have trusted prominent market figures like FTX’s now-disgraced founder Sam Bankman-Fried, well-placed celebrity endorsements like Larry David’s Super Bowl ad for FTX, or the “smart money” put into crypto by venture capital firms, hedge funds, and private equity.
We’ve since seen that even the smart money wasn’t so smart. Cryptocurrency markets have gone through multiple booms and busts as they gradually moved from the anarchic fringe of the tech industry toward the center of financial markets.
The SEC's job has been made easier
Many federal politicians have been swayed by industry lobbying efforts, so until now there has been little effort to set standards or establish protections for small investors. Regulators have also been hesitant about what to do, not sure if these exotic and unstable assets involved financial securities, derivatives, money, or something entirely different. They were reluctant to meddle with transactions that seemed to be on the cutting edge of wealth generation.
As cryptocurrency markets face their own “Lehman Brothers moment,” one must consider whether the sudden losses could be contagious, or even threaten to destabilize the broader financial system. The bigger crypto markets become, and the more they involve major financial institutions, the greater the danger.
It’s possible that by deferring intervention in crypto markets, the SEC allowed some investors to get their fingers burned. Nothing concentrates minds like losing money: it changes both the general conversation and the political landscape by making regulation seem more necessary, which also makes the SEC's job easier.
Had regulators tried to move earlier, it would have been more difficult for them to argue that bad outcomes might occur without oversight. Now, everyone knows what those bad outcomes look like, and subsequent regulatory moves have become easier to justify.
The SEC and other regulatory actors should seize the moment. Small investors, who lack the deep pockets and flexibility that large investors benefit from, should be able to participate in a system where more than social trust is required. They deserve the kind of regulatory protection that verifies the relative stability and security of crypto investments.
President Reagan could rely on an elaborate U.S. government intelligence apparatus to independently verify Soviet compliance with nuclear arms treaties: He didn’t simply have to trust the Russian leadership.
Today, small investors need a robust public regulatory apparatus that will oversee market actors and independently ensure their compliance with rules to protect investor interests. Adequate capitalization of key market players needs to be done transparently, rather than through layers of offshore shell companies.
Someone must make sure that complex ownership interests do not create conflicts of interest that fuel the temptation to treat investors’ funds like a piggy bank to be raided when convenient. Those seeking funds from ordinary people must be forthright about the downside risks as well as the upside potential of cryptocurrency investments. Crypto markets will benefit from the legitimacy that regulatory oversight can offer, providing assurances to market participants that the “wild west” era is over.
It is good to be able to trust–but much better to also verify. For small investors in cryptocurrency markets, this is now an imperative that the government can’t ignore.
Bruce G. Carruthers is the John D. MacArthur Professor of Sociology at Northwestern University, and author of The Economy of Promises: Trust, Power, and Credit in America.
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By Bruce G. Carruthers
