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March 23, 2022

The Dangerous Allure of Unbound Innovation

A mildly amusing truism in football is that, often, “[n]o player is more popular on a team than the backup quarterback.”  In other words, football fans (particularly of lousy teams) are almost constantly clamoring for something different, convinced that a new approach, as represented by a new quarterback, will solve whatever problems are plaguing the team.  This tendency is not limited to fickle football fans, but is common to the human experience—psychological research has shown  “that novel objects perk up the reward system of our brains, indicating our sense of adventure—exploring or learning something new—may be just as tempting as cash and other prizes in the choices we make.”

Simply put, we are enchanted by new things.   To be sure, there is a good reason for this—intractable problems often demand new approaches, so a willingness to try new things is often a prerequisite to progress.  But this can be taken too far, and for some the allure of the new and “innovative” is so strong that they seem willing to abandon all safeguards, no matter how important, to dive headlong into a new and unproven approach without balancing any other considerations.  Just as sailors enticed by the hypnotic song of the Sirens of Greek mythology never realized they were being lured to their deaths on the dangerously rocky shores of the Sirens’ island, we often let the natural appeal of new things blind us to the inherent risk of the untested until too late.  This may be fine when “hitting the rocks” only means losing a football game with an unproven backup quarterback.  But when it comes to financial regulations that must protect the American public, “hitting the rocks” means at best, widespread investor losses, and at worst, financial crisis and all the devastation that entails: lost jobs and livelihoods, lost homes, and ultimately destroyed lives.

The risks inherent in the new and untested must be kept front of mind because “innovation” figures prominently in debates over financial regulation, inevitably conjuring up the enticing possibility of new and creative solutions to intractable problems.   In turn, deregulators, taking advantage of the deceptively appealing concept of innovation, frequently wield it as a weapon, accusing those who advocate for strong regulatory oversight of themselves harming the public by stifling innovation to the detriment of consumers and the economy.  This is part and parcel of a longstanding, Chicken Little sky-is-falling tactic by the financial industry and its allies to fend off regulation, arguing that meaningful regulation will inevitably hurt consumers and even damage the economy.

Currently, this argument is most visible with regard to cryptocurrencies, and associated technologies like the blockchain and decentralized finance (“DeFi”), with even some financial regulators arguing we need to deregulate to spur innovation.  For example, SEC Commissioner Hester Peirce, in a 2021 interview, argued that a robust approach to regulating cryptocurrencies would not “be great for innovation.”  More recently, in January, CFTC Commissioner Dawn Stump expressed concern that bringing enforcement actions against companies offering supposedly innovative cryptocurrency and DeFi products could stifle “innovation that provides solutions to meet new market demands.”   These concerns are frequently combined with a sort of patriotic appeal, in the form of an argument that stifling regulations could cause the U.S. to “fall behind” other countries that have fewer restrictions on new products, ignoring that strong protective regulations are the source of the strength of America’s markets.

The thrust of these claims is clear: Innovation is good, regulation stifles that innovation and only those driven by an irrational fear of a changing world would seek to smother such important opportunities. The position is bolstered by a belief in self-regulation:  Commissioner Peirce, for example, has argued that in the cryptocurrency community, “people hold each other accountable not only through unbridled public discourse but through using or not using a protocol.”  It’s an enticing argument, but like all siren songs, leads to danger.

New and innovative technologies, although they may hold some potential for solving difficult problems, are risky—innovation and risk go hand-in-hand.  Simply put, taking a hands-off regulatory approach to new and innovative technologies necessarily invites significant risk of harm to the public.  This is why, for example, new drugs go through a rigorous, lengthy, and from drug companies’ perspective, burdensome testing process before they may be brought to market, notwithstanding that those drugs may hold life-saving potential.  Innovation can be good, but only when there are safeguards in place to protect the public from the inherent risks of new and untested approaches.

This concern applies with even greater force to financial innovations like cryptocurrencies, which may enable financial intermediaries to extract more money from consumers, but whose actual benefits to consumers is decidedly less clear than technological innovations like better drugs and faster computer chips.  Proponents of cryptocurrencies frequently talk up their potential benefits, arguing that they hold the key to democratizing finance by eliminating or reducing the need for intermediation, integrating the underbanked and unbanked into the financial system, and ultimately creating a more fair and equitable economy.  These claims hold even more appeal when accompanied by endorsements from prominent and beloved celebrities and framed in a way to induce FOMO (fear of missing out) by insinuating those who don’t embrace crypto are falling behind their peers or what is then perceived/claimed to be cool, exciting and cutting edge.

Cryptocurrencies and associated technologies like the blockchain and DeFi, may one day fulfill these promises (although this is far from a given).  But, they have not done so yet. At the moment, cryptocurrencies are little more than wildly speculative investments with extraordinarily volatile values.  And the cryptocurrency market is also undoubtedly rife with fraud, scams, and crime.   So when opponents of strong regulation of cryptocurrencies fret about “stifling innovation,” the argument they are actually making is that we should tolerate the harm currently being caused because proactively regulating cryptocurrencies might prevent crytpocurrencies from realizing the benefits they might provide at some unknown point in the future.

And of course, we don’t need to speculate about what might happen if we follow the siren song of deregulation—we’ve done it in the past and we know how it turns out. Ronald Reagan entered office in 1981 as a strong proponent, espousing the philosophy government itself was always the problem. It was undoubtedly alluring; this hostility towards regulation prevailed over the next 25 years, and it had a profound influence on the shape of financial regulation. During that time there was no shortage of financial innovation, fervently championed both inside and outside the government by deregulatory evangelists such as Alan Greenspan, who served as Chairman of the Federal Reserve from 1987-2006.

Indeed, Greenspan made many of the same arguments that are being made today by Commissioners Peirce and Stump, predicting that financial innovations were changing the economy for the better.  He also downplayed the risks posed by those innovations because of a steadfast belief in the superiority of self-regulation over government regulation.  Thus, the Federal Reserve under Greenspan’s watch scuttled proposals to increase oversight of subprime lenders, as he believed subprime mortgages were a “constructive innovation” that would help consumers access credit and achieve the American Dream.  Likewise, Greenspan successfully prevented meaningful regulation of new and exotic derivatives, such as swaps.  Those, he insisted, “have contributed importantly to the development of a far more flexible and efficient financial system” while also apparently leading to “[g]reater resilience…in many aspects of the financial markets.”  With the blessing of regulators, these and other financial innovations, including mortgage-backed securities (often knowingly filled with worthless subprime mortgages), collateralized debt obligations (“CDO”), CDO-squared, synthetic CDOs, and the assortment of other needlessly complex innovations that made it easier to extend credit (without concern for whether the credit could be paid back) and to spread risk around (without concern for whether the resulting interconnections increased risk, rather than reducing it).

Of course, we know-how following the siren song of unbound innovation and deregulation turned out.  We crashed right onto the rocks.  The proliferation of subprime mortgages, which was supposed to make the American Dream more widely available, instead resulted in an American Nightmare—the subprime mortgage meltdown sparked a devastating foreclosure crisis that resulted in millions of families losing their homes.  Similarly, the proliferation of swaps and other exotic derivatives did not make the financial system more resilient, but in fact directly contributed to its near-total collapse.  Self-interest proved to be a wholly ineffective method of regulating in the public interest.

Ultimately, the hands-off approach to these supposedly promising innovations resulted in a devastating financial crisis that cost Americans’ over $20 trillion, not to mention untold damage and suffering from lost jobs, lost homes, and financial hardship.  This lesson from recent history is one Commissioners Peirce and Stump would do well to heed as they argue for a hands-off approach to regulation of new, risky products such as cryptocurrencies.

Fortunately, not all financial regulators find the siren song of unbound innovation so appealing.  SEC Chairman Gary Gensler and CFTC Chairman Rostin Behnam of the CFTC have both indicated that they favor a proactive regulatory approach to mitigate the risks that emerging products, such as cryptocurrencies, pose to consumers, investors, and the financial system.  Indeed, as Chairman Behnam has recognized, not only does comprehensive regulation not necessarily stifle innovation, it is necessary to ensure that such technologies can thrive; otherwise, the fraud, mistrust, and volatility that currently characterizes the cryptocurrency market will eventually dissuade people from participating.  Thoughtful regulation, not thoughtless deregulation, is the necessary and appropriate response to innovation, notwithstanding how appealing some might find the Siren’s song.

Better Markets


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