How Crisis Affects Crypto: Coronavirus as a Test Case

Abstract

Everybody is talking about Cryptocurrencies. These digital tokens, which began as a one-asset market, have swiftly ballooned into a massive and diverse “cryptomarket”. The cryptomarket is still mostly unregulated, but this is about to change, as a presidential executive order on “crypto strategy” reportedly lurks ahead. In light of the expected regulatory changes, two important questions emerge: is there a clear rationale for legal intervention in the cryptomarket? And if so, what type of regulation would be optimal?

We take a two-step approach to answer these pivotal questions: First, we analyze empirical evidence from the early days of the Covid-19 pandemic in order to better understand the risks posed by the cryptomarket when a crisis emerges. Second, we apply a law and economics approach to identify which market failures are consistent with the data and derive novel regulatory lessons.

Our empirical analysis reveals an interesting pattern: investors initially shifted funds to the cryptomarket when the pandemic erupted but then made a U-turn, which led to a plunge in the market. We maintain that this behavior of investors can have both rational and behavioral explanations, which, in turn, affects the optimal choice of regulation.

Accordingly, we map each explanation onto potential market failures by surveying different possible interpretations of our findings, such as substitution effects between traditional markets and the cryptomarket, exploitation of investors in the form of pump-and-dump schemes, and other criminal activities. We then discuss how each type of failure can serve as justification for regulation and derive regulatory lessons on how to best intervene in the cryptomarket, depending on the source of the market failure.

To the best of our knowledge, this is the first paper dealing with regulation that analyzes how the Covid-19 pandemic affected the cryptomarket.

This Article was published in the Hastings Law Journal. The version of record can be found here: https://repository.uchastings.edu/hastings_law_journal/vol74/iss2/6/

Keywords: Coronavirus, Covid-19, Cryptocurrencies, Blockchain, Financial regulation, Securities Law

JEL Classification: E44, E52, G01, G14, G18, K22