Understanding Crypto 13: Prof. William Magnuson: Blockchain and Democracy

August 26, 2022 Angelica Montagano

William Magnuson is an associate professor at Texas A&M Law School. Previously he taught law at Harvard, worked as an associate in Sullivan & Cromwell, and as a journalist in the Rome bureau of the Washington Post. He is the author of Blockchain Democracy: Technology, Law and the Rule of the Crowd, and has written for numerous leading publications including Harvard Business Law Review, Stanford Journal of Law, Business and Finance, and the Wall Street Journal.

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Welcome to another episode from our limited edition crypto series. The previous guests we have spoken to about crypto generally have experience in economics, finance, or technology. In this episode, we have a look at crypto through a legal lens with Professor William Magnuson, an Associate Professor of Law at Texas A&M University School of Law. He is also the author of Blockchain Democracy, which provides readers with a guide into the world of blockchain and Bitcoin, and highlights the reasons for their growing popularity. In our conversation, we delve into everything law and order within the crypto world as Professor Magnuson explains the causes of crime, the jurisdiction of crypto, the impact of decentralized cryptocurrency on the legal system, and how to overcome the legal challenges surrounding crypto. We also talk about the underlying ideology of crypto, the origins of cypherpunks, the people who are being negatively affected by, mechanisms to enforce regulations, and much more. Tune in to learn more about crypto and blockchain through the lens of the law with Professor Magnuson.

Key Points From This Episode:

A brief overview of the political philosophies of Thomas Hobbes and John Locke. [0:02:48]
Find out which of the two political philosophies is closer to reality. [0:04:55]
What it means for political or economic systems to be decentralized. [0:05:26]
An overview of the advantages and disadvantages of a decentralized system. [0:07:36]
Causes of a decentralized system to become centralized. [0:09:54]
Where power in an initially decentralized system tends to centralize. [0:11:38]
The systems that democracies use to maintain a desired level of decentralization. [0:12:33]
How close the underlying political philosophy of Bitcoin falls to the philosophies of Locke and Hobbes. [0:13:34]
We learn about the origins of cypherpunks and the associated ideology. [0:14:55]
Whether the current state of our world resembles the dystopian future that the cypherpunks imagined. [0:16:41]
Why digital cash was so important to cypherpunks and why early attempts failed. [0:17:36]
The relationship between anonymity and crime is explained. [0:20:16]
What role crime has played in the development and proliferation of cryptocurrencies. [0:22:48]
Why comparing cryptocurrency to cash as a similar mechanism for crime is incorrect. [0:25:53]
Professor Magnuson explains how social norms affect criminal behaviour. [0:27:48]
He outlines the norms seen empirically within the blockchain communities. [0:30:12]
Challenges in applying existing laws and regulations to cryptocurrencies. [0:33:04]
Where cryptocurrencies fall under current regulatory and legal interpretations. [0:37:44]
Whether cryptocurrencies are a regulation problem or a law problem. [0:39:43]
How to enforce regulations and laws for cryptocurrencies. [0:40:44]
He tells us if public blockchains jeopardize the existing legal system and democracy. [0:43:17]
The costs of lightly regulated or unregulated markets in terms of capital allocation. [0:47:11]
Who is bearing the cost of unregulated markets. [0:51:09]
Hear what he thinks blockchain's greatest accomplishments are so far. [0:51:36]
We end the show by hearing whether professor Magnuson thinks it is a revolutionary technology. [0:53:07]

Read the Transcript:

Ben Felix: This is a limited series of the rational reminder podcast. A weekly reality check on sensible investing and financial decision making focused on cryptocurrencies. We're hosted by me, Benjamin Felix and Cameron Passmore, portfolio managers at PWL Capital.

Cameron Passmore: Welcome to episode 13 of the understanding crypto series. And this week we take a look at the world of crypto through the legal lens with a really fascinating guest in Professor William Magnuson, who is an associate professor of law at Texas A&M University School of Law. It's so interesting to take a different look, and it seems like every week we've been doing this Ben, where it's a different look at this subject and wow, what a great clear communicator on things like what causes crime? What's a jurisdiction of crypto? What impact is decentralized cryptocurrency having on the legal system? How do you deal with all this? I mean, there's just such really fascinating questions.

Ben Felix: Even what does decentralization mean in an economic or political context? And that's not a super easy thing to define.

Cameron Passmore: No.

Ben Felix: Yeah. I read will William's book, which is how I found him. His book is Blockchain Democracy, which takes a look at cryptocurrencies, but like you said, Cameron, it takes the regulatory, political and economic lens largely I would say from a legal perspective, which makes sense of course, given William's background. It's an excellent book. And I'm probably getting repetitive, I've said this in multiple episodes, I think at this point, but the most amazing thing about crypto is that it makes you rethink your understanding of so many different things, including democracy, but also money, economics, where power should be located, where power is actually located. Anyway.

So we talked about a lot of that stuff with William. William studied international relations at Princeton, and he's got a law degree from Harvard. In addition to Blockchain Democracy, he has lots of legal review papers that touch on FinTech and cryptocurrencies and other topics. He's done work on private equity too, that would've been awesome to talk to him about, but we may save that for a future episode with William. He's also got a forthcoming book on the history of corporations and the relationship with society that'll be out in November.

Cameron Passmore: Should be fascinating. Let's go to our conversation with professor William Magnuson.

***

William Magnuson, welcome to the Rational Reminder podcast.

Thanks so much for having me.

William, can you start by giving us a brief overview of the political philosophies of Thomas Hobbes and John Locke?

Sure. So Thomas Hobbes of course, is the famous 17th century, British political philosopher. He's most famous for his book, The Leviathan, published in 1651. In the Leviathan Hobbes argues that the life of man and the state of nature is nasty, brutish and short. By that what he meant was that when there is no government to enforce law, people have to live in a constant state of fear, of theft, of violence. And so in order to avoid the state of nature he believed they needed to vest a sovereign power, a government with absolute authority. And that absolute authority would have total control over individuals and there would be no individual rights that could not eventually seed to the power of the nation, now the national government.

John Locke on the other hand has a somewhat opposed view. Oftentimes in an intro political theory class, you'll read Hobbes and Locke together. Locke was writing more or less at the same time. It was about 30 years later that his most famous work, The Two Treatises On Government came out. And in it, he argued that people created government, not simply to escape the state of nature, but to protect and preserve their lives and liberties and fortunes. He was the famous theorist of the social contract. And he believed that if they're creating, if individuals are creating government to protect these things, then they can't possibly be presumed to consent to government action that destroys those things. So if a government oversteps its rational and it's reason for existing, then individuals, people, citizens have a right to ignore its dictates or potentially revolt against the government.

And so in that way, he is often opposed to Hobbes, because Hobbes believed ultimately that there was an absolute power in the government that could not be trumped by individual rights. Locke on the other hand, believed that government was created through a social contract and that if those rights are overstepped, the government no longer has power.

Interesting. Do you have a view on which is closer to reality?

Yeah. So I think that today, most lawyers, I believe would say that there is a rule of law and that rule of law applies not just to individuals and citizens within a government, but also to the government itself. Even the sovereign, even the president, even the senators are not above the law. And so I think in that way, for the most part, people believe that Locke wins and from a purely legal perspective.

Interesting. What does it mean for a political or economic system to be decentralized?

Yeah, so we typically think about economic and political systems using different terminology. When we think about political systems as being democracies or monarchies, we think about economies as being capitalistic or state central planning oriented economies. But in both those areas, really the question boils down to where power lies. Does it lie in the hands of the few, or does it lie in the hands of the many? So in both economic systems and political systems, in a way we can define them by just how centralized or decentralized they are.

This goes back to ancient political theory. Plato, for example, thought about governments as being five different types on the spectrum. There was on the one hand tyranny, which was ruled by the one. On the very other side of the spectrum was democracy, which was rule by all. And then there are these sort of middle regimes, what he referred to as aristocracy, which was ruled by the best oligarchy, which was ruled by the wealthy and then timocracy, which we don't use too much today, which was ruled by property holders.

Economies similarly are viewed by how centralized or decentralized they are. We typically think today that capitalism is the predominant form that economies use. Private companies buy and sell their goods free of the government dictates for the most part, they of course have to abide by rules and regulations, but they can pursue their self-interest in any way they can, they desire to, without referring to a state central planner. But historically this was not always the case, right? An antiquity, we had palace economies and the Cold War, of course, many people thought that the Soviet system of central planning was actually preferable to the American system. It was going to out-produce us because if its ability to dictate exactly where the economy should go. And of course today we think about China as being some sort of a hybrid between the capitalist systems that are predominant Western societies and then also a state run central planning role.

What are the theoretical advantages of a decentralized system?

Sure. The theoretical advantages of decentralization are that it allows mob or mass rule to decide where economies move, where politicians go. So from a political standpoint, my political philosophers oftentimes argue that decentralization leads to greater freedom and equality, because it allows through the mechanism of voting, citizens can choose the policies and the representatives they wish that gives them the freedom to decide their affairs. Another way in which decentralization can theoretically be an advantage over a centralized system, is that it allows groups to make better decisions. And oftentimes there are some problems that simply require massive amounts of information, more information that any single decision maker could ever possibly process. And so when you have a decentralized system that allows a bunch of different people to participate in decision making, it can actually lead to better results, because they're able to, in a way, aggregate all that aggregate information that's dispersed within the system. So that's both from a political and an economic standpoint, decentralization can benefit the system in all sorts of ways.

And what are some of the disadvantages of a decentralized system?

Yeah, I mean, we see this oftentimes that we complain a lot about the way that our Congress works and how hard it is to wrangle even relatively reasonable policies through our legislature nowadays. And that's one of the real problems of decentralization is that it can lead to inefficiencies, it can lead to disorder, sometimes it can lead to shortsighted decision making. When you think about when power is within the hands of an entire system, let's say a capitalist system where everyone gets to make their own decisions about what goods and services to buy and sell, sometimes people can focus on shortsighted, short benefits and profits, rather than the long term sustainability of the system itself. And so that is one of the drawbacks of decentralization, is that if the group, as a whole engages in this sort of gullible, unsophisticated or simply greedy manner, then that can lead to long term harms to the system's sustainability.

Empirically systems don't tend to stay decentralized. What causes them to centralize?

Sure. So there are strong incentives, even within the most decentralized systems for power to centralize, just focusing on the perspective of economies. There are great rewards for corporations today to out-compete or buy out their rivals in such a way that they become a monopoly, right? Monopolies allow corporations to get greater profits, to pocket greater profits for themselves, for their shareholders. Of course, concentration isn't always bad for consumers. Economies of scale may justify engaging in a certain level of market share. Sometimes consumers simply prefer to be able to go to a single decision maker, right? It's helpful to be able to go to Amazon, to buy all of your goods and services. That's really simple, it's effective. And as long as it doesn't lead to higher prices for consumers, consumers can be happy about it. At the same time it also raises some risks about whether competition continues to exist if one actor manages to control all of the market.

Same thing in the political realm, right? In politics, there's all sorts of ways in which people and powerful interests have incentives to centralize power, in a way that's what political parties are. They're a way of creating order out of the sort of mass democracy that we have in the United States and Canada. But when political parties make all of the decisions about who gets to run for office, about what the policies for the nation are going to be, that can lead to dangers, if sort of outside voices are not heard as much as they would be otherwise.

Where does power in a initially decentralized system tend to centralize?

Sure. And I think it centralizes in a couple of ways, right? Large corporations have interests in centralizing power within themselves and political groups. There are interests to centralized power within the hands of a smaller group of influential or popular leaders. There's this interest to centralize power decision making within powerful groups within the system. It oftentimes leads to benefits to the most efficient producer. You can centralize power within the hands of the single corporation, if that corporation is able to outproduce or make goods and services at a lower cost than others. So that's one way in which centralization can exist within a decentralized system.

On the political side, what systems do democracies like Canada and the US for example, put in place to maintain the appropriate or desired level of decentralization?

Sure. I mean, we've had 2000 years of history of developing systems to protect the decentralization, the democratic nature of our governments. Ultimately it falls down to elections, right? Elections are when the people get to express their voice about the direction of the nation, representatives are elected, but then they periodically have to be reelected. If they make policies, they make decisions, they set priorities in ways that the mass people, the majority of the people disagree with, they can be voted out. So that ultimately is the backstop within democratic systems, is that they face election.

There's also a whole body of other laws that sort of protect those elections, right? There's election laws. There's a system of federalism that gives power, some powers to the national government, some powers to state governments. There are state and local regulations. All of these have been developed over centuries of history.

Where does the underlying political philosophy of Bitcoin fall with respect to the philosophies of Locke and Hobbes?

Great. Yeah. So this is a fun question, partially because these debates about the benefits of centralization versus decentralization, the political philosophies of Hobbes and Locke, these all came up when Bitcoin and other cryptocurrencies were first starting to be created. The creators of the initial cryptocurrencies and particularly Bitcoin, they debated these things within message boards and emails. They were philosophers in a way. So I think that Bitcoin, which was the first cryptocurrency that really gained widespread recognition, if you think about Hobbes as the great centralizer, Locke as the great decentralizer, the Bitcoin backers users, initial creators, they were heavily on the side of Locke.

And I would even say go even a bit further than Locke. They believed that state control of our financial system was wrong and then we needed to find an alternative. We needed to create a currency for the internet era, a currency that was outside the control of the state. And that would instead be run by all of its users, by the mass of its users. And that would guarantee, according to its users, the privacy and security of the system. And that was where sort of the philosophical underpinnings of Bitcoin lined.

Is the message board discussions, is that among the cipher punks that group?

Yes, that's right. So was this group called the cipher punks. It was a group of cryptographers, computer scientists and tech enthusiasts that was formed in the early 1990s. And they were primarily in the Bay area. Remember the early 1990s, the internet was just forming. Some of the America Online was just launching, Netscape, all these early internet browsers were just being created, but people thought that the internet was going to lead to widespread changes in society, the way that individuals interacted. And in many ways it was an exciting time. Wired Magazine was just getting started. Everybody thought that it was going to lead this massive community of users and knowledge in the world.

This group of cryptographers and computer scientists that became known as the cipher punks, they were really worried about what the internet would do. And in particular, they thought if the internet allows everyone to communicate and interact with each other, it also allows governments to communicate and interact with each other. And perhaps most worryingly from their standpoint was it allowed them to snoop on citizens and individuals. They were very worried about finding ways to protect privacy on the internet.

And so they started meeting, they had message groups, they had email chains and they started to create a philosophy that they referred to as the cipher punk philosophy. They wrote these manifestos that more or less said, we need to find a way, a cyber libertarian way, to protect privacy on the internet. And it was all devoted to, and the way to do that was through cryptography, the protection of communication.

Do you think that the current state of our world resembles anything close to the sort of dystopian future that the cipher punks imagined?

Yes. I mean, in many ways when you go back and you read the debates on the message boards, a lot of the discussions seem quite prescient, and in fact, probably more applicable today than they did in 1992, when there weren't that many people on the internet. Their primary concern was that in a world, in which everybody can communicate with each other, people will be able to snoop on each other. And in particular, they worried that corporations, large corporations would gain access to all this information about internet users and so would governments. And they would use these in ways that would not necessarily be in the interests of those users. These are all the debates that are going on today about social media, what corporations are using within this new data economy, whether our data really is being protected. So I think they were in many ways prescient about their worries about what the internet would do to the world.

Wow. That's so interesting. Why was digital cash so important to the cipher punks?

Yeah, so the cipher punks were not initially focused on digital cash, but they primarily were thinking about ways to protect communications. But what they kept coming up against was that ultimately communications oftentimes lead to financial transactions. If you're buying, selling goods or services or information, you need to go through a financial system. You need to have a financial system to interact with each other. And if ultimately you can engage all this interaction online, but you can't send money in a way that's private, then ultimately you are going to be connected back to that government snooping, corporations snooping, banks snooping on activities.

And so they said, well, we need to find a way to create a currency, a digital currency, that is solely on the internet. That's entirely outside the control of governments in which people's individual identities are protected. You should be able to go out and buy that copy of the banned book without telling Citibank or Capital One that you just bought that. And so they started playing around with different ways to solve that problem of creating a currency that would work and be accepted on the internet.

They were trying to solve that for a while before Bitcoin. Why do you think the earlier attempts failed?

Sure. You're right. They were working on this for decades and none of the early attempts worked at least in the early... In the 1990s, they had several efforts to create digital cash. All of them crashed and failed. There were things called B-Cash, Cash- Cash, Bit-Cold, B-Money, all these failed. A few reasons why they failed. Some of them of course were simply technical. One of the early ones that was created, didn't allow you to spend money that you received. And so that's not a great form of digital currency if you can't spend the money that you just received.

But other reasons were more related to timing. This was in the early 1990s, not that many people were buying and selling things on the internet. And so there was a bit of a chicken and egg problem there. You can't get people to invest value and buy digital currencies, if they're not willing to go out and buy stuff. You can't get merchants to accept these digital currencies, unless they've got some consumers who are willing to pay in them. And so if you don't have one of those, then you can't create the system itself. And so in the early 1990s, when there simply wasn't that much commercial activity by regular consumers on the internet, these cryptocurrencies really had a hard time getting off the ground.

In criminology theory, what's the relationship between anonymity and crime?

Sure. I mean, this is one of the biggest questions that criminology faces is what causes crime? There's a field of criminology that views crime as primarily the product of rational choice. The idea here is that criminals are like other individuals, they are simply rational actors. They commit crimes if it is in their interest to commit crimes, if they can get something that is a value to them and the cost of getting that thing, whether it's prison time or a fine, is less, or the expected cost of it, is less than what is the value is to them, they will make that decision. The economist Gary Becker has talked about this in his work. A person commits an offense if the expected utility to them is higher than not doing it. And so in this view of criminology, you oftentimes refer to as a rational choice theory of criminology.

Anonymity is a real problem, because if you believe that you are anonymous, then you also likely believe that you can't be caught, and you likely will not face any sanctions. And so if the cost of the committing a crime is zero, then as long as there is any benefit to that crime, then you will commit it if you are a purely rational actor. And so the rational choice view of criminology is that criminals are rational. If we've got an anonymous system that protects people's identities, then crime will be rampant. And this is I think, a relatively logical argument, and in fact one that repeatedly shows up in psychological studies as being indeed true. This basic insight that if people think they're not going to be caught, they are more likely to engage in immoral behavior.

There have been these studies of people where they surreptitiously watch people from video cameras, or they can check what the results of various tests are and they can find that people are more willing to cheat, even if they just are in a dimly lit room. If you're in a dimly lit room, you're more likely to cheat on a test, on an academic test. There's this real concern that if you create a system that is anonymous or even appears to be anonymous, it will lead to higher crime rates within that system.

Yeah. Appears to be as important, because as we now know, but maybe it wasn't obvious back then, Bitcoin's not actually great at being anonymous. What role though, do you think crime has played in the development and proliferation of well Bitcoin and the other cryptocurrencies that have followed?

Sure. Crime has been a troublingly pervasive problem in the cryptocurrency world really from the very beginning. Studies have repeatedly shown that there is a large scale use of cryptocurrencies within illegal activities and also illegal activities using cryptocurrency. And that actually gets a couple points here. One is that there are different ways in which crime is connected with blockchain. So when people say that blockchain is this criminal wild west, what they're really saying is one of two things.

One is that blockchain is a target, and blockchain and other cryptocurrencies are a target for criminals. You've got these cryptocurrency exchanges in which people are storing their money. And so criminals and as the market has increased in value, these targets become of greater and greater value. And so criminals have started targeting the cryptocurrency exchanges and have tried to hack them and repeatedly have successfully hacked them and they've stolen billions of dollars from them. So that is one way in which blockchain has been connected with crime is that it's a target of crime. People try to steal things that are stored within cryptocurrencies.

A second way in which blockchain and cryptocurrencies are connected with crime, is that it is oftentimes used as the currency of choice for criminals. What that means is that if you go onto a dark net website where you can buy stolen credit cards or drugs or other illegal products, the cryptocurrency of choice is cryptocurrency, typically Bitcoin, sometimes other versions of it, or other versions of cryptocurrency that are even more anonymous. Cryptocurrency has become the preferred source of payment for criminal activity. Often we've heard that of all these ransomware attacks in recent years against major utilities, against pipelines, against hospitals, they shut down these systems and then they say, we will unlock your computer, your computer system, we'll let these pipelines work again, we'll let all these sick people be protected and cared for again, if you pay us a bunch of money in Bitcoin. And so that's another major way in which cryptocurrency has been connected with crime, is that criminals have asked for payment using cryptocurrency.

We talked to somebody earlier in this series, Igor Makarov about how they'd done a bunch of analysis of the Bitcoin blockchain. And they found that speculation was by far, the most common use in crime was relatively speaking, not huge, but I think we could probably also debate whether the type of speculation in an unregulated market like that, could qualify as some sort of illegal activity. At least if you compared it to what legal trading in a regulated market looks like.

On your second point, a common response to that, to the crime aspect, like the ransomware and that... Well, ransomware is probably not a good example, but just financing crime in general, as a medium, that US dollar a hundred dollar bills are also anonymous, also used for crime. Is that a valid reason to dismiss the anonymity concerns about cryptocurrencies?

No, I don't think it's a valid reason to dismiss our anonymity concerns around cryptocurrencies. Of course it is accurate to say that it is very hard to trace a hundred dollar bill. You don't know where it came from. In a way actually Bitcoin is less, or is easier to understand and trace than a dollar bill, because Bitcoin has a record of, public record, that everyone can access about where the Bitcoin has been. And I've been watching the Netflix series Narcos recently. That shows you very clearly you can run a massive criminal operation, just using a hundred dollars bills.

At the same time that doesn't mean that Bitcoin and the anonymity from the perspective of cryptocurrency is not a problem. And I think that in ways it is a much bigger problem than dollar bills because of simply the scale and the convenience of cryptocurrency. It's a lot easier to steal a billion dollars of crypto than it is to steal a billion dollars in a hundred dollars bills. The Narcos, they had to be sending planes full of dollar bills on a regular basis between the United States and Columbia. That is not the case with cryptocurrency. If you manage to steal somebody's password, you've got the money immediately.

And this has occurred multiple times, sometimes in somewhat humorous fashion. There was a case early on where there was a Bloomberg interview where one of the newscasters gifted $20 in Bitcoins to a couple of the other newscasters. And they briefly flashed the QR code that had the username and passcode onto the screen. And within 15 minutes, the money was gone. So you see just how easy it is to get this. All you have to do is accidentally show your pass key and it can be taken.

That lack of physical proximity, that's a huge, huge piece of it right. That's why ransomware was a bad example when I asked a question, because you couldn't do that with a hundred dollar bills.

How do social norms affect criminal behavior?

Sure. So we talked earlier about the field of criminology that views crime as primarily the source of rational action. That is that people engage in criminal behavior when it's rational for them to do so. That rational choice theory of crime is oftentimes opposed, or contradicted by, a view of crime that views it as primarily a social phenomenon. So that view of crime is that what truly stops people from committing crimes isn't that it's going to be against their interests to do so, their pure sort of financial incentives to do so, but rather it's the belief that there is nothing wrong with it. In other words, what encourages people to commit crimes is that if they believe that there's nothing wrong with a committing a crime, then they'll be more likely to commit that crime.

These sorts of theories, the sort, the social norm view of crime, of course, utilitarian theories would say, that's nonsense. If there's a norm behavior, that's not backed by actual real sanctions, the threat of locking somebody up. That's not going to have any effect on behavior. But if you believe in the efficacy of norms and values and ethics, then I think it's rational for it, it's a logical conclusion to think that it's not just the material incentives that lead to you making or engaging in criminal behavior. Values, your beliefs, the community in which you're in which you live in, all of these are just as important. And so if you want to stop crime, according to these sort of social norm views of criminology, we need to find ways to ensure that individuals believe that law is legitimate and that they should obey them. They should obey laws.

And so these normative theories of crime have identified a number of ways in which social environment can influence your behavior. One of the primary findings of this field is that the beliefs and actions of your peers really heavily affect your own beliefs and actions. If everybody thinks that cheating on tests is wrong, you will also likely be found or you'll be more likely to believe that cheating on tests is wrong than you would be if they believe that it was okay. If you can surround people and create a community in which law is found to be worthy of obedience, if we want people to be law abiders, it will lead to less crime.

And what norms have we seen empirically within the blockchain communities?

So this is a really interesting question and it's been looked at quite a bit. The norms of the blockchain community, I think they have something of a schizophrenic nature. On the one hand, they oftentimes refer to themselves, whether it's on or the Twitter pages that some of the major creators or the Reddit pages or the Discord chats, they oftentimes refer to themselves as a community. They think about, we are engaging in this collective effort together and we need to cooperate for it to work. And so they talk about how this is a democratic currency, and we're all going to work in this, work on creating it and making sure that it functions correctly.

And in fact, we have seen a number of efforts historically, where people have sacrificed their short term interest in order to promote the sustainability of the cryptocurrency community. Some of the most prominent examples, there was an unintentional hard fork of Bitcoin in 2013, where the community came together and found a solution. And some of the minors actually had to sacrifice their block rewards in order to do that. There was an effort in 2016 within the Ethereum network where they also had to resolve a hard fork, or create a hard fork in order to resolve a hack. So in both those scenarios, we've seen the community and particularly the large actors within that community, come together, sacrifice their material, short term interests for the greater good of the cryptocurrency itself.

On the other hand, there is also, what can only be described as a laissez-faire approach to consumer interaction with cryptocurrency. Oftentimes you will see the sentiment that, if you didn't understand, if you the consumer, didn't understand what you were getting into, and if you got hacked it's your own fault. You see that sentiment quite a bit. Somebody, all these people in the early 2013s, many of them had their money stolen, because they had put their cryptocurrency in the wrong cryptocurrency exchange.

There was the famous hack of Mt. Gox in 2013. And many of the people, many of the community, simply said, look, it was your own fault for not storing it yourself, so you're responsible for that loss. And of course, as we know, as a practical matter, many of the people who are investing in, buying, holding, cryptocurrency are not trained cryptographers or computer scientists who understand they can actually look through the code to make sure that what they're investing in is solid and protected from hacks. And so I think that is a troubling dynamic. If we really do think that it's simply a caveat or kind of world in which you've got to buy it, and you have no assurances from the community or the creators that your investment is protected.

What do you think the challenges are in applying existing laws and regulations to new technologies like cryptocurrencies?

Yeah. So it's a common problem within all of law. How do you apply old laws to new facts? The reason why it's so problematic in the area of cryptocurrency, is that cryptocurrencies are a little bit like everything. They don't fit into any category perfectly and they fit into all the categories a little bit. They look a little bit like stocks, they look a little bit like commodities, they look a little bit like currencies, they're also just look like software. And they also don't look like those things in many important features. And so when you have that kind of a system, that kind of a cryptocurrency, lawmakers, regulators, they're going to have a really hard time figuring out just how to regulate the system.

And not only that, if they do attempt to enforce their regulations, they may well find their efforts shot down in a court of law if the court says, look, this isn't a currency or this isn't a stock. And so this classic problem is receiving attention in all these areas from securities regulations, to commodities regulations, to tax laws.

One of the sort of central debates, one of the ones that many lawyers like to debate among themselves, is whether cryptocurrencies, whether it's Bitcoin or Ethereum or Ripple, whether they are securities. I know that you are engaged in the securities industry, sales of stocks and bonds. And so the key question here is if you are, if the cryptocurrency itself is a security, like a stock or a bond, then security's regulations apply. Doesn't sound like a big thing, but it's a massive thing, because if something is a security, then it's subject, at least if it's in the United States, it's subject to regulation by the Securities Exchange Commission and it has to be registered, very, very expensive. And so it's a major question for all these cryptocurrencies, whether they are securities.

But if you just try to apply the test for what a security is, it becomes very quickly clear just how unclear the answer is. So the classic test in the United States, something that it was created in 1946 by the Supreme court, that was this case called the Howey Test. The Howey Test, it was all about the sale of some interests in some citrus groves in Florida in the 1930s. The Howey Test has three elements and the test is determine whether something is a security or not.

Three elements. First is, is it an investment of money? Second, in a common enterprise, and third, with the expectation of profits to be derived solely from the efforts of others. So if you step back and think about each one of those elements separately, you realize just how hard it is to come to a clear answer. Is it an investment of money? It probably is an investment. There's probably money in there, but if you bought it using another cryptocurrency, maybe it isn't money.

Is it a common enterprise? In a way it's a common enterprise, because Bitcoin has all these users. They've talked about themselves as a community. They have to have miners to work together with the nodes. So it's a common enterprise in one way, but on the other hand, it doesn't look a lot like the common enterprise that we think of when we think about a company. There's not a CEO for most of these cryptocurrencies, at least. There's not a body of shareholders. So it's not really common enterprise in one way, it is in another.

And then finally, if you look at the third prong, which is there an expectation of profits to be derived solely from the efforts of others. You mentioned earlier about how a large portion of investments in cryptocurrency is speculation. That is the hope for profits in the future. So I do think that many people are getting involved in cryptocurrencies with the hope of profits. But there's also this sort of hardcore group of believers who simply are getting into it because I'm not doing it for profit, I'm doing it because I believe in the future of cryptocurrency. We need to get out of the financial system that we are currently engaged in. And so in another way, a lot of people are investing in it, not for profits, but rather out of beliefs.

And then finally, just the last bit, are your profits derived solely from the efforts of others? It's primarily derived from investments of others, but you might also be engaged in it if you have a node and you're mining Bitcoin. So every one of those prongs is problematic, it's all unclear. And this is the problem when you're deriving a test from a 1946 Supreme Court case, and try to figure out whether it applies to a cryptocurrency that was created in the 2000 teens.

That was fascinating. So just to put a finer point on this, where do cryptocurrencies fall under current regulatory and legal interpretations?

Yeah, I wish I had a clearer answer for you. The answer is that there is not a lot of regulatory clarity, even over a decade after the creation of Bitcoin. That's to me still surprising. When I wrote this book, I thought that by the time it was going to be done, we would have some new rules. We would have legislation changing the law, or at least making it clear how our laws would apply to cryptocurrency. That still hasn't happened. We've been at this for over a decade and there's still a tremendous amount of regulatory uncertainty.

There's been some efforts by regulators to give some guidance. There was a 2018 speech by one of the SEC commissioners named Bill Hinman. In his view, we sort of need to, he said that he was applying the Howey Test, but I think he really created a new one. And he said that in his view, if a network was sufficiently decentralized, than it would no longer be viewed as a security. The reason why he thought that was the case was that if you've got a system like Bitcoin, which is no longer in Satoshi, the founder, Satoshi Nakamoto, it's no longer under his control. This is being run by this massive group of computers located all around the world. It's so decentralized that if we thought it was a security, who would we go to for the relevant disclosures, for the relevant registrations. There's nobody really, that would be able to provide the information that you would need. So it doesn't just make sense to impose securities regulations on a cryptocurrency like Bitcoin, that is so decentralized.

Whereas if you have a new cryptocurrency that's maybe being created and still in the control of a single entity, some of these stable coins that we've seen that have been launched in the last few years, are still controlled by a single creator or founder, those maybe are going to be more likely to be found as securities. We're getting some regulatory clarity, but a lot of this guidance that's coming out from regulators is being challenged in courts. So unfortunately we're still in a very hazy environment.

Is it a regulation problem or a law problem?

That's a good question. So I think that it is, in the best world, we would have Congress come in and pass a new law. A bill that says, here is how Securities Regulations apply or don't apply to cryptocurrency. That would be the best world. If we can't get that world, which at least for now I think is unlikely, the second best is to have the key regulators, the SEC, the CFTC and each jurisdiction that's relevant, come out and pass a rule, or regulation that shows their interpretation of what the statute says. So that would be the second best. That one is more likely than the first.

On enforcement, say we do have laws and regulations, when we get to enforcement, when things like privacy coins or stealth coins, as I think you call them in the book like Monero and Zcash, I think is the other one, and exchanges located outside of US legal and regulatory jurisdictions, how do you enforce that?

Yeah. So this gets back to our question earlier about what prevents crime? Is it simply the fact that there is a law out there that commands obedience, or is it the fact that you are likely to be caught and enforced against? Cryptocurrencies present a real, not just a problem about interpreting of what the law is, but there's also an even deeper problem, which is that even if we can figure out what the law is, does it matter if you can't enforce it? And as you mentioned, there are a number of anonymity focused cryptocurrencies out there. Bitcoin was the first and it provided a level of anonymity in that no one's name is listed on the public ledger, but it wasn't entirely anonymous because everyone is identified by a public address and you can go and look at the public address and how much Bitcoin it has.

Later cryptocurrencies found ways to increase the level of anonymity, including Monero, which is towered as completely untraceable and these have gotten into some hot water. There was a Wall Street Journal investigation a couple years ago, that found that North Korean hackers were using Monero to basically launder the ransom payments that they were getting from their hacking attacks on large companies. So that's one problem. If everything shifts towards these, in these truly anonymous cryptocurrencies, then law enforcement agents are going to have a really hard time enforcing the law.

But another one is that cryptocurrencies are by their nature borderless. You don't have to be in the United States to buy Bitcoin. You can buy Bitcoin, you can mine Bitcoin, you can create a node wherever you are. And so that means that if you get your money stolen and whether you're in Canada, the United States, if the person is not located in the United States or Canada, it's going to be really hard to get your hands on them and get the money back, or at least enforce the laws against the people located abroad.

Of course, there are law enforcement agents are getting savvier and savvier. Some of these ransom attacks have led to payments that have then later on been clawed back by law enforcement agents, they've been able to trace the path of the Bitcoin and bring it back. And there hasn't been a lot of disclosures about how precisely they're doing that, but I'm hopeful that there'll be more developments in the future that allow us to claw back money through the public blockchains. But it's a real concern. I mean, law enforcement agents are surging their efforts on this front to try to make sure that people aren't just having their money stolen willy-nilly.

Crazy. Does the decentralized nature of public blockchains actually threaten the existing legal system?

I don't know if it threatens the legal system, but I do think it presents a real challenge to law enforcement agents, that also presents a challenge to investors and it also presents the challenge to consumers. If we are moving to a system that has light regulation or no regulation, law enforcement agents are going to have a hard time enforcing and protecting individuals. Investors are going to have a hard time making sure that their investments are protected and consumers want to make sure that when they're buying and selling services, they know what they're getting involved in, and they're not going to have their money stolen. And so these are all real problems from a investor protection, law enforcement protection perspective.

I don't think that it presents a threat to our legal system broadly speaking, because even though the market itself has increased in size enormously over recent years, still the vast majority of actual economic transactions are still taking place through our regular financial system. And there are routes for law enforcement agents to take, to enforce currently existing laws.

One of the most important developments in the last say five years, has been the increased targeting of cryptocurrency exchanges. And so the cryptocurrencies themselves, they're borderless, everyone's anonymous, it's sort of hard to enforce laws against anonymous people on the computer. But eventually most people have to go back to a cryptocurrency exchange. Most people aren't savvy enough to be able to engage in all the transactions entirely through the blockchain system. Instead they use a cryptocurrency exchange to buy and sell goods. And when you go to a cryptocurrency exchange, except for some actual decentralized exchanges, most of them are located in jurisdictions like the United States. Coinbase, the most popular cryptocurrency exchanges is a US company. It can have its officers subpoenaed by law enforcement agents. And so that's the route that law enforcement agents increasingly use to make sure that regulations are followed.

And a follow on question, does the public blockchains threaten democracy?

Yeah. I mean, I think that decentralization and blockchain is a two edge sword. On the one hand, one of the biggest benefits is that, or the least that people talk about when they talk about the decentralization of currency, is that it allows consumers to protect their assets. And particularly it allows them to protect their assets from sort of unscrupulous governments. If you're in a government, if you're in a country where you don't trust the banking system, where you think that the government is going to engage in actions that lead to hyperinflation, or you think they're simply going to steal your bank account, cryptocurrency is a great way to get around those rules, because they can't steal your bank account if they don't know what your private key is.

On the other hand, it also, these cryptocurrency systems, they also allow users to protect their ill gotten gains, their stolen funds. And really those two sides of it are, I think, inseparable. You can't say that blockchain will have rules to enforce only the good rules that come from governments, but ignore all the bad rules that come from governments. And so, in a way, cryptocurrency has led to the system that says, we're going to create a system that ideally would be free of government regulation, whether that's good or bad. And of course now we're seeing some of the arms of that, is there's a lot of bad effects of it as well.

I want to keep going on that topic. You've got a really nice paper on the failure of market efficiency, which had a title that caught my attention because we talk a lot about the benefits of market efficiency, at least from the investor's perspective. Can you talk a little bit about the costs of lightly regulated or unregulated markets from the perspective of capital allocation?

Sure. Yeah. So thanks for bringing up the paper. It was a fun paper to write, because I do think that if there's one fundamental underpinning of all of our markets today or our stock markets, is that we should be aiming at efficiency. That should be the core goal of our systems. In that paper I argued and I defend today, the perspective, that one, we need to make sure that we have a good understanding of what efficiency means. And two, I think that we should be thinking about things beyond efficiency. We should also be thinking about things like fairness, things about justice, things like investor protection. And of course there's ways to define efficiency that bring those other concepts in, but you need to be careful when you define the efficiency in a way that doesn't take into account those other values.

But I think that generally speaking, I would say that there are benefits of lightly regulated markets. Regulations by their very nature impose costs. The idea is to either stop people from engaging in bad behavior, or to create incentives for people to engage in good behavior. Oftentimes that requires action by government actors. Oftentimes it requires even more action by the private actors. So those are costs. And so in a way, if you can have all the benefits of regulation without the regulation, then that would be great. We wouldn't impose any costs on these markets.

And there's a reason why American and sort of Western stock markets are some of the largest and most liquid in the world. And that's that we have credible regulators that are enforcing long tested laws in ways that protect investors, and that also promote business growth. So regulation can be a way that leads to more efficiency within a market. There are costs to light regulation, as well as costs to heavy regulation.

Now, when investors do decide to invest in less regulated markets, I think they need to be aware of the higher risks of those markets. Those risks of course, depend on the nature of the investment. In the cryptocurrency world, I think a few things are important to keep in mind. One is sort of the most technical level, there may be flaws in the programming of the cryptocurrency, might lead it to crash, might lead it to be hacked. We've seen these so-called algorithmic stable coins that are designed to track a certain value, but turns out the algorithms were wrong. And so they didn't track that value and so they crashed.

Two, there may be vulnerabilities in the middleman, in the exchange where the cryptocurrency is bought or sold. That's oftentimes the point where hackers target a cryptocurrency. They don't go at the core programming, instead they go at the cryptocurrency exchange where all the cryptocurrency is stored, and if they have a flaw in their cybersecurity system, then you can have your hacks. So you need to make sure also about the credibility and the protection of the exchange.

There may also be a higher likelihood front running or insider trading. And so that's sort of unconnected. Well, it can be connected to the cryptocurrency exchange. There have been incidents where a cryptocurrency exchanges have had employees who have had access to information about what's about to be listed, cryptocurrency exchanges, cryptocurrencies that are about to be listed and they go out and they buy the cryptocurrency, but you might not be getting the best price. So you have to make sure that you're aware of those, that kind of worry, front running and insider trading.

And then finally, the broader question is, what are the fundamentals that drive the price of the asset? And there may be a greater risk of variability in the price if it's trading solely on sentiment rather than economic fundamentals. So those are some things that I would want to make sure I was aware of if I was making capital allocation decisions on this.

Who do you think is ultimately getting hurt in unregulated markets?

Primarily small consumers. Small consumers who don't have the access to the most data, the most credible actors that end up paying the price. You hear these stories about people who have invested their life savings in a cryptocurrency, and then it crashes to zero or close to zero. They're the ones that you really have to worry about. In a way that the big fish, the ones that are investing millions of dollars in this, they have access to advisors and reputable actors in the space who you can protect them more.

What do you see as blockchain's greatest accomplishment so far?

Yeah, I mean, I do think that in a way it's sort of inspiring the way that this community has come together to create something out of nothing. It's a remarkable effort to rethink all the ways that our financial system works. And Satoshi Nakamoto was and still is, this anonymous coder, that was just chatting with other anonymous coders on websites. And then he launched this thing that was turned into a trillion dollar industry. That's sort of an amazing occurrence that they could do that. And it required a lot of people acting together. The idea that people could come together and create this system, that they could rethink the fundamental underpinnings of our financial system, of our society, it stands. And also, I think in a way, it shows that the level of distrust of authority and government and in our financial system in today's world.

On the other hand, it also shows you just how powerful technology can be, how it can reach people all around the world, and it can solve some of the problems, but it also can't solve many of the problems. It can't get around the fundamentals of human nature. We see the greed, the criminality that pop up again and again, market forces. So it shows both sides. It shows both the greatness of human cooperation, but also some of the terrible realities of human nature.

Do you think it's a revolutionary technology?

If it is, it hasn't shown itself to be quite yet. We may see sort of the killer use case emerge where it really affects everybody's day to day reality. So far that I don't think that I've seen anything that has given me hope that it will really revolutionize the way that our financial system works, or the way that our democracy works, but time will tell.

I sure will. All right William, this has been a fantastic conversation. We appreciate you coming on the podcast.

Well, thanks so much for having me.